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The bid/ask spread

The “bid” is the highest price any buyer is willing to pay for a stock. The “ask” is the lowest price that any seller is willing to sell a stock for. The difference between these two prices is the bid/ask spread. The bid price is shown first, then a division sign, followed by the ask price. For example, stock XYZ has a bid price of 2.5 and an ask price of 2.56. It would appear as 2.5/2.56.

Understanding the price of stock:

A basic understanding of how the price of stock is determined is necessary to be an effective trader. Stock price is chosen directly by the limit orders of the investors trading the stock unless there is an unreasonable gap between the bid and the ask price. If there is an unreasonable gap, or in other words if the bid/ask spread is large, the market maker or specialist will step in to close the gap. There is always a gap between bid and the ask price. The gap is usually anywhere between one to several cents. These limit orders that dictate the spread don’t get filled by other limit orders. They get filled by market orders. Market orders are placed by investors that either don’t have the time to negotiate their price or don’t think that a few cents will matter. The price and behavior of a specific stock is driven by several factors including the ratio between supply and demand, the emotions fear and greed, and the health of the company and public news of that health. There are other factors, but these are the main ones that have potential to really drive the price of stock.

Supply and demand isn’t necessarily a hard concept to grasp in the business world but an additional understanding is needed when referring to the stock market. In the business world when referring to a particular product, supply comes from the company and demand comes from the consumer. When there is less of a product that is still in need, the demand increases. When there is a lot of a product that is in less demand the supply increases. In the stock market the number of shares outstanding for the most part stays the same. Supply comes from the amount of shares that are currently being traded. The demand of a stock is defined as its desirability to the investors which is usually dictated by its price or potential. As the demand increases, so does the price.

This model represents how the price of stock changes. The first phase is accumulation. The stock moves sideways in anticipation of a break out. This phase is a result of indecision and a dead heat between the optimistic and pessimistic investors, often called the bulls and the bears respectively. Investors are still not willing to pay higher prices for the stock but they also have not devalued the stock. Eventually there is an unbalance between the bulls and the bears which causes the price to move. In this model the optimists begin to outnumber the pessimists and their limit orders push the price of the stock up which leads to phase 2. The price moves because the investors start placing their limit orders at slightly higher prices than before. Investors become more willing to pay more for the stock and so the demand also increases, which drives the price even further upwards. The price eventually plateaus when pessimism grips the stock and the investors are no longer willing to pay such higher prices. This leads to phase 3. The pessimists are beginning to outnumber the optimists. There is a moment of indecision until the pessimistic investors take over and more and more traders are placing lower and lower limit orders which begins to drive the price back down and turns into phase 4. The stock then returns to a phase of indecision. Other factors that drive the price of stock fit into this explanation also. Good or bad news for example has an effect on stock prices. This effect still follows this model. When good news of the company is heard by the investors it can cause the stock to gain value. The good news can trigger greed which causes the investors to be willing to pay more for the stock. This will cause movement that will follow the model. The price of stock is what the investors are willing to pay. Stocks repeat this model yearly, monthly, weekly, and even daily.