Bid & ask

Bid/ask spreads are maintained by market makers in the secondary market. As you saw in the previous chapter, market makers are financial firms that are willing to trade directly with the public. The bid and ask are the prices they’re willing to trade at. The bid is the price the firm is willing to pay to buy a security. The term “bid” is from the market maker’s point of view: the firm is bidding for the security, hoping a customer will sell to them. Along with the bid price, the market maker also states how many shares they’re willing to buy at that price. We’ll come back to this quantity in a moment. The ask, sometimes called the “offer,” is the price the firm is willing to accept to sell a security. Again, this is from the market maker’s point of view: the firm is asking a price, hoping a customer will buy from them. Along with the ask price, the market maker also states how many shares they’re willing to sell at that price.

Here’s an example of a bid/ask:

GM stock

$40 bid / $41 ask 4x7

In this example, a market maker is quoting GM stock. The quote shows both price and size. On the bid side, the market maker is willing to buy up to 400 shares at $40 from the public. When a market maker publishes a quote, the size is shown in round lots. The “4” on the bid side means 4 round lots, or 400 shares, at the stated bid price.

Round lot

100 shares of stock; common denomination for stock trading

On the ask side, the market maker is willing to sell up to 700 shares at $41. The difference between the market maker’s buy price ($40) and sell price ($41) is the market maker’s potential profit. This difference is called the spread. Even small spreads can add up because market makers may execute thousands of trades each day. A $1 spread is not typical for actively traded stocks. In most cases, popular stocks have spreads measured in pennies. In an efficient market, firms can still earn substantial profits because trading is active and spreads are small. As long as the market maker trades frequently with the public, those small spreads can accumulate over the day. Every trade has two sides. So far, we’ve described the bid and ask from the market maker’s perspective. When a customer trades, the customer takes the opposite side.

Here’s a summary of the two sides of the bid/ask:

Bid

Market maker buys

Customer sells

Ask

Market maker sells

Customer buys

Key points

Bid/ask spreads

Maintained by market makers

Provide best buy & sell prices

Bid

Market makers buy at the bid

Customers sell at the bid

Ask

Market makers sell at the ask

Customers buy at the ask

Round lot

100 shares of stock

Efficient market

A large number of market participants

Small spreads and active trading