In this guide, we’ll delve into a fundamental concept of financial markets – bid and ask prices, also known as buying and selling prices. We will explain what these prices represent and how the mechanism for determining them works in the trading of assets, talk about the relevance of the spread or the difference between bid and ask prices, and look at what implications these prices have for investors operating in the markets.
Additionally, we will approach the topic from a practical perspective, using real examples to make it easy to grasp the dynamics of bid and ask price formation.
Bid and Ask Prices Defined
The bid price, also known as the selling price, is the minimum price at which a seller is willing to sell a financial asset, such as shares of a company traded on the stock exchange.
On the other hand, the ask price, commonly known as the buying price, represents the maximum price a buyer is willing to pay for a particular financial asset.
The difference between the bid price and the ask price is called the spread. This spread is a significant indicator of the liquidity of the financial asset.
How Bid and Ask Prices Work
In financial markets, bid and ask prices are determined through a continuous auction system, where market participants enter their orders to buy and sell a specific financial asset. Each order specifies both the price at which the participant is willing to buy or sell and the quantity of the asset they wish to trade.
Buy orders, known as demand, indicate the quantity that participants want to acquire of an asset at a specified price or lower. On the other hand, sell orders, known as supply, signal the willingness to sell a certain quantity of an asset at a specified price or higher.
These buy and sell orders are grouped by price and displayed in the trading systems of financial markets. As new orders come in, demand and supply adjust dynamically.
When at a specific price, the quantity demanded equals the quantity offered, a transaction occurs for the common amount, resulting in what is known as the equilibrium price or market price for that financial asset.
As mentioned earlier, the spread or difference between the bid and ask represents the gap between the price at which buyers are willing to acquire a financial asset and the price at which sellers are willing to part with it. It’s also referred to as the price spread.
In general, the narrower the spread between the bid and ask prices, the more liquid the market for that financial asset is considered to be. A tight spread indicates that it is easy for market participants to find counterparties to buy or sell the asset quickly and at a fair price.
On the contrary, a wide spread or a large price bracket signals low liquidity and difficulties in executing transactions, since buyers and sellers are far from agreeing on a crossover price.
Although it may vary depending on the type of asset and market conditions, spreads of less than 1% of the asset price are generally considered to represent financial markets with good liquidity. Spreads greater than 1-2% are associated with low liquidity assets, and excessively wide brackets would indicate highly illiquid markets.
To illustrate with real prices, let’s take the example of shares of Nvidia Corporation (NASDAQ: NVDA). At the close of the market back on October 20, 2022, NVDA stock had a bid price of $433 and an ask price of $433.30. This means that buyers were willing to pay up to $433 for each share of Nvidia, while sellers were asking for at least $433.30 for each share to let go of it.
In this case, the spread between demand and supply was only $0.30, or 30 cents. Such a narrow difference indicated a highly liquid market for Nvidia’s shares, with a broad base of buyers and sellers. This allowed investors to enter and exit NVDA positions with ease, quickly finding counterparties to execute their transactions at fair and competitive market prices.
A spread of $0.30, equivalent to less than 0.069% of the price, was considered entirely normal for a widely traded stock like Nvidia.
Determining the Bid and Ask Prices
Bid and ask prices are determined exclusively by the interaction of market participants through their buy and sell orders. When demand for a financial asset exceeds supply, it exerts upward pressure on prices. Conversely, when supply outpaces demand, it exerts downward pressure on prices.
In this way, bid and ask prices (and consequently, the spread between them) are constantly adjusted according to real-time market forces. This results in narrower spreads when there’s high trading volume for the asset, whereas spreads widen when trading is limited.
Meaning for Investors
For most retail investors, the spread between bid and ask prices represents an implicit cost of trading financial assets. Typically, these small investors are compelled to sell at market demand prices, which are lower, and buy at market supply prices, which are higher.
This implies a slightly reduced return because they have to sell at a lower price and buy at a higher price due to the spread. However, in highly liquid and actively traded assets, the impact of the spread is minimal for individual investors.
Understanding how bid and ask prices work is essential for effective operations in financial markets. It is also crucial to comprehend the spread or difference between these dynamic prices, which indicates market liquidity and adjusts in real-time according to supply and demand forces. The narrower the spread, the more liquid the asset.
Therefore, knowing the mechanism of bid and ask price formation and the meaning of the spread enables investors to have more information to make effective decisions when operating in financial markets.