File this one under the more you, the better.  Even if you’re not actively trading, it still helps to know how it works when you do actually decide to buy or sell a share of stock, an ETF, or anything else that trades on the market.  In this post, let’s talk about the concept of bid/ask quotes and what they mean when you place an order to buy or sell a share of stock.

If you use an online broker, you’ve probably logged in, looked up the stock you wanted to purchase, and saw the price at which it was trading as you were about to place your order.  You select how much you want to buy – whether in dollars or number of shares – and then execute the transaction.  What you may or may not have been paying attention to, however, is something else that it said on the screen before your transaction went through.  In particular, the trade summary (or whatever your broker/platform calls it) probably gave you an “estimated” quantity of either shares or the price before the transaction executed.

Say you went to purchase 100 shares of XYZ and it was trading around $50 per share.  Before you hit “confirm” (or the equivalent), the screen probably said estimated price $5,000.  Or, you wanted to purchase $5,000 of XYZ and it said estimated shares: 100.  Why did it say “estimated?” you ask.  Well, the bid/ask quote is why.

Just a guess, perhaps?

As you’re probably keenly aware, the stock market is a dynamic system, meaning that it’s constantly moving due to nearly innumerable variables that impact the price of a given share of stock at a given moment.  Purchasing a share of stock is not like going to the grocery store where you see a stated price for an item and can purchase all they have of that particular item at that price.

Rather, stocks operate more like a market where you have to haggle for the price of everything you want to buy.  When you place an order for a trade, you’re not purchasing a specific share of stock at a specific list price.  Instead, you’re actually placing a “bid” to purchase the share(s) of stock.  At the same time, people trying to sell their shares are doing almost the same thing.  They’re listing their shares for sale at an “ask” price.

I’ll explain more below how different types of orders (market, limit) impact how your request to buy/sell is filled, but for now, let’s stick to the basics.  When you place a buy order, your online broker essentially puts out your “bid” and the market matches you with an “ask.”  Once it finds a match, the market executes the transaction.  When you place your order for 100 shares of XYZ and bid $50 per share, the market finds an ask of $50 per share for those 100 shares, and completes the buy/sell transaction.  Having the market do this for you saves the trouble for the buyer and seller of two things: (1) trying to find each other; and (2) having to haggle over the price.

After your buy order is executed, you typically see in your “recent transactions” folder that you purchased 100 shares of XYZ that “filled” at $50 per share.  This means that the market was able to match your bid for 100 shares at $50 per share with an ask price of $50 for 100 shares.

Transaction Complete

In reality, it’s a little more complicated than this, as you might expect.  When trading in real life, it’s unlikely that the bid/ask quotes will match exactly, which is why this topic is relevant.  Far more likely is that after a trade is executed, you’ll see a slight variation in the price at which the transaction was executed, even in a liquid market.  More common in the scenario above is you’ll see that maybe 75 shares of XYZ were filled at 50.01203791 per share and 25 shares were filled at 50.0342128 per share.  The fraction of a cent difference would reflect that the first 75 shares of your order were filled at one ask price, while the remainder were filled at the next best ask price.

The opportunity for this variation explains why, when you place a trade order, the transaction details will show an “estimated,” rather than an actual price.  It’s estimated because, while the market will try to match you with the best price it can, it won’t necessarily be precise.  As the market is constantly moving, bid/ask spreads go up and down in incremental amounts, and that’s how this comes to be. 

The same thing happens when you sell, except that this time, you’re the “ask” instead of the “bid.”  The market tries to match you with the closest “bid” to your “ask” price.  What ends up happening is that there may be a difference between the total amount you receive for your shares and the price that you saw when you entered the sell order.  You may also end up receiving different prices for different shares in the same sell order.

Most retail investors who trade well-known stocks and ETFs will not give much consideration to bid/ask spreads.  Large companies trading on the Dow and Nasdaq often have significant liquidity, which results in minimal bid/ask spreads.  Contributing to this is the fact that many of the shares traded throughout the day are at the hands of trading algorithms and professional traders, which constantly keep the prices moving and reflective of real-world conditions.  The end result for the retail trader is that it is fairly easy to enter and exit positions because there are plenty of willing buyers and sellers.  Placing an order will likely match you up with a buyer or seller within a fraction of a second for a price that’s very close to what you saw quoted when you placed the order.

Realistically, the bid/ask spread becomes relevant when you’re looking at securities that don’t have as much liquidity or if you’re trading in the off-hours.  When there are fewer people trading or when the securities are not as well-known, the bid/ask spreads can actually make a meaningful difference in the price at which a trade is executed.

Things are different in the dark

Market vs. Limit Orders

The type of order you place impacts how the system treats your “bid” or “ask” price.  When you place a “market” order, you place an order for a set number of shares (or a specific total dollar amount) and the exchange fills your order at the next available price.  If you place a market order to buy shares, you don’t really have a “bid” price; rather, the exchange fills your order at the next available “ask” price.  The bid/ask spread really only becomes relevant if you’re trying to figure out the most likely price at which your order will fill.  If you’re buying, you can review the current “ask” prices, and if you’re selling, the current “bid” prices.

Placing a market order is how you end up with the example above where 75 shares of XYZ fill at $50.01203791 per share and 25 fill at $50.0342128.  The exchange matched you first with those 75 shares at the best price it could find, then filled the remaining 25 shares at the next best price. 

A “market” order contrasts with a “limit” order, in which you set the maximum price you’re willing to buy or the minimum price at which you’re willing to sell.  A “limit” order is where you truly place a bid or ask price.  If you place a limit buy order for XYZ, you might still place one for 100 shares at $50 per share, except that in this situation, you’re saying that $50 is the most you’ll pay.  The exchange will try to match you with sellers with an “ask” price of $50.  If there’s no match, your order will stay open until it expires (which is typically a time frame you can set).

If a seller comes around with an “ask” of $50 for 50 shares, the market will execute your order for those first 50 shares and keep the remainder open until it can find another seller with an ask of $50 for the remainder.  (Note: there are options to set your order only to execute if the market can find the full number of shares at once).   

When you place a limit order, the bid/ask becomes relevant.  If there is a spread between the bid/ask prices, it may mean that your trade won’t get executed unless you either wait for the other side to adjust their number or you adjust yours.  If you place your limit order to buy 100 shares of XYZ for $50 and the order doesn’t execute, you may have to adjust your price upward so that you’re matched with a seller.  The way to know how much to raise your price is by looking at the current “ask” prices to see where you’ll get matched.

All that movement does mean something

The way the market is moving affects whether buyers or sellers have the upper hand.  If the security is performing well and prices are moving up, then the sellers will try to set a higher “ask” price.  This moves the price of the security higher as buyers have to bid more to purchase the security.  If the security is not performing as well, then buyers will set a lower “bid” price that forces sellers to accept less to sell their shares, moving the price of the security lower.

On the big exchanges, most of this happens in milliseconds by computers and algorithms rapidly executing millions of trades.  When a retail investor enters the market, the shares you buy and sell happen in the midst of computers rapidly trading back and forth.  Only when you hold a significant number of shares does your bid/ask have a meaningful impact on the price.  For most FIRE investors or retirement savers, you probably won’t get to the point where you hold enough shares of any particular security to make a meaningful difference in the bid/ask spreads.

When you’re trading a liquid security on a big exchange, you’ll likely never see the impact of any of this, especially if you place market orders that fill at the next available price.  But if you happen to delve into other types of markets, or after-hours trading, the bid/ask spread becomes much more of a factor.  

For example, if you’re trading after-hours and want to purchase 100 shares of ZZZ at $50, you’d be wise to check the prevailing bid/ask before you place a market order.  And you should do so even if ZZZ closed around $50 during the trading day because you can’t assume the price will carry over to the after-hours trading session.  You might see that the lowest ask for that many shares of ZZZ is $55 per share.  If you had simply placed a market order, those 100 shares would cost you $500 more than you thought ($5 more per share, at 100 shares).  Or, if you placed a limit order at $50, it wouldn’t fill unless you adjust your bid price.  

While bid/ask spreads may not impact you if you’re trading during the day on major markets, it’s important to understand given its impact on the price at which you buy and sell stocks.  If you wade into markets other than the major exchanges, remember to consider the bid/ask spread before you execute trades.