Friday, October 20, 2006

Bid Ask Spreads

The Bid/Ask Spread is important factor in stock trading. The Bid Price is the current highest price at which someone in the market is willing to buy a stock. The Ask Price is the current lowest price that someone is willing to sell a stock. The difference in these two amounts is called the Bid/Ask Spread.

The Bid/Ask Spread is determined mainly by liquidity. If a stock is highly liquid, meaning there is a large volume of shares being bought and sold, the Bid/Ask Spread will be much lower. A low Bid/Ask Spread is important to traders because that extra cost will eat away at your profits.

For example, on the stock PALM, the Bid Price is $22.70 and the Ask Price is $23.06 so the current Bid/Ask Spread is $0.36. If you were to buy 100 shares and then immediately sell them using market orders (assuming everything stays the same and not factoring in commissions) your loss would be $36 just because of the spread. Remember though that the spread can change throughout the day depending on orders that are coming through.

You can also easily see how volume affects the Bid/Ask Spread by comparing different stocks. The exchange traded fund QQQQ is probably the most liquid asset. The average daily volume for QQQQ is almost 100 million shares, which brings the Bid/Ask Spread down to $0.01 at all times. PALM's average volume is just over 4 million shares a day so it is still very liquid, which makes the Bid/Ask Spread pretty small. Stocks that trade only a few hundred thousand shares or less will start to show spreads much larger then PALM.

It will be comprised of three components, the Short-Term Trends, the Sector Timer and the Economic Outlook. Each one will provide data, systems and research to help you make trades over a variety of different time periods.

The Bid/Ask Spread can cut into your trading profits slightly with stocks. With the PALM example, the stock has to show a gain of about 1% for you even make any money but this isn't a huge problem. Options are where spreads can really start to hurt. With options, the difference between the Bid and the Ask will almost always be at least $0.05. If the option only costs $0.70 then the spread is a fairly large piece of the trade. This is one good use for limit orders, to make sure you get in where you want. But if the market moves too fast a limit order might keep you out of a profitable trade.

Overall, the spread shouldn't be a huge concern for most traders, a good trading system should have no problem overcoming the spread. You should be aware of it though and how it effects your trades.

Click the Bid Ask Spreads header link above to learn more. Have a good weekend.