How do bid and ask prices work in stock and other markets?

In financial markets, bid and ask prices play a fundamental role in determining the price at which an asset is bought and sold. If you are new to trading, it is crucial that you understand what bid and ask prices are and how the market dynamics influence them. They help traders gauge the market sentiment, identify potential entry and exit points, and manage their trade effectively.

Understanding bid and ask prices

Bid and ask prices are the best price at which a buyer or seller is willing to transact an asset in the marketplace. The bid price is the highest price a buyer is willing to pay for a security in a given price movement, and the ask price is the lowest price at which a seller is willing to sell a security. Hence, you must also know the difference between bid vs. ask options.

To initiate a trade, an investor must place an order with the broker, after which the broker places an offer on the stock exchange that includes the number of shares to be purchased and the price at which they are willing to purchase. The highest proposed price is the bid price, which is the demand side of a stock. 

On the other hand, each offer to sell includes the number of shares you are willing to sell and the price. The lowest proposed price is the ask price and the supply side of the stock in the market. As a beginner, you must narrow your investment choices and understand the basic terms if you want to make informed decisions and effectively manage your portfolio. 

How are bid and ask prices determined

Two factors determine the bid and ask price of an asset: 

• Supply and demand: Bid and ask prices are influenced by demand and supply dynamics. In order words, they are determined by the people and institutions willing to buy or sell the asset. So, just like in any other market, the bid and ask price will rise if the demand exceeds the supply. Conversely, bid and ask prices will move downward if supply exceeds demand.
• Market conditions: Market conditions such as volatility, economic indicators and geopolitical events can impact the bid and ask prices. During situations when the market is very volatile or uncertain, the spread may widen as institutions and brokers adjust their processes to manage risk. 

Understanding bid-ask spread and what it tells you about the market

As mentioned earlier, the bid-ask spread is the difference between the highest price a buyer is willing to pay for a security and the lower price a seller is willing to accept. The bid-ask spread helps determine the liquidity of a market in the following ways.

• Wide market: A wide market refers to a market with a large bid-ask spread, meaning there is a significant difference between the prices at which buyers are willing to buy and sellers are willing to sell. This situation arises in a market with low liquidity or during periods of low trading activities. For example, if a bid price for a stock is $10 dollars and the ask price is $11, the spread is $1, indicating a wide market.  
• Thin market: A thin market refers to a market with a narrow bid-ask spread. This means that there is a minimal difference between the price at which the buyer is willing to buy and the seller is willing to trade. A thin market is a phenomenon of highly liquid markets or active trading periods. For example, if the bid price is $10 and the ask price is $10.10, the spread is only $0.10, indicating a thin market. 

Conclusion

The bid and ask price tells you a lot about market liquidity and the demand and supply of an asset. Understanding these basics will help you build a strong foundation and effectively manage your portfolio.

Read more: ‘Big red flag’ waving for stocks.