Bid/ask spreads are maintained by market makers in the secondary market. If you recall from the previous chapter, market makers are financial firms willing to trade directly with the public. The bid and ask represent prices they are willing to trade at.
The bid is the price the firm is willing to buy a security at. The term ‘bid’ comes from the perspective of the market maker. The firm is “bidding” on the security in the market in hopes of a customer showing up and selling. In addition to the bid price, the market maker also specifies how many shares they’re willing to buy at that price. We’ll discuss this later in this section.
The ask, sometimes referred to as the “offer,” represents the price the firm is willing to sell a security at. Again, the term ‘ask’ comes from the perspective of the market maker. The firm is “asking” a price for the security in the market in hopes of a customer showing up and buying. In addition to the ask price, the market maker specifies 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, we have a market maker for GM stock. According to the bid, they are willing to buy up to 400 shares of GM stock at $40 from the public. When a market maker publishes a quote, they signify how many round lots they’re willing to buy or sell with the public. With 4 on the bid side, it tells us they’re willing to buy 400 shares at the bid price specified.
According to the ask, the market maker is willing to sell up to 700 shares of GM stock at $41. The difference between the market maker’s buy price of $40 and sell price of $41 is how they make a profit. Often referred to as the “spread,” this $1 difference can add up as market makers are known for performing thousands of trades daily.
A $1 spread is not common with actively traded stocks. In most cases, popular stocks have spreads in the pennies. In an efficient market, financial firms make substantial profits even with small spreads. An efficient market is defined as one with active trading and small spreads. As long as the market maker trades enough with the public, these small spreads tend to add up over the day.
There are always two sides to a trade. We’ve discussed the bid and ask from the perspective of the market maker. When a customer is involved, they take the opposite side of the trade. Here’s a summary of the two sides of the bid/ask:
Bid
Ask
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