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Bid vs Ask Price Explained
Luis Clark
Luis is a personal finance expert who has been passionate and writing about crypto for more than five years.
Stepping into the world of finance involves navigating a maze of complex financial jargon and terms. A notorious example of such unnecessary complexity is the concept of “Bid vs Ask”. This is perhaps one of the most deceptively simple concepts that many novice traders struggle with.
But fear not! In this article, we will provide an elementary explanation of the bid price and ask price, which should be sufficient for you to understand how the financial markets work.
What are Bid Price and Ask Price? What's the Difference?
In the financial markets, the terms “bid” and “ask” refer to the different prices at which a security, such as a stock or a currency pair, can be bought or sold. These two prices are essential for understanding how trading works and how prices are determined in the market.
In the simplest form of definition, “bid” is the price a buyer is willing to pay for an asset, while “ask” price refers to the money the seller is willing to accept. But of course, there is much more to it. Let’s take a closer look.
Imagine you’re at a flea market searching for a collectible toy. You come across a vendor willing to sell that toy for $15. You can think of this $15 as an “ask price”—the minimum price of the toy. Upon more searching, you bump into another buyer willing to pay $10 for the same collectible. Think of this as the “bid price”—the maximum price being offered for the toy.
The main lesson to be learned from this example is that there is a clear distinction between these two prices. This is known as bid-ask-spread, and the gap represents the extra amount of money you would need to purchase an asset or give up on to sell it off. It keeps the market running and allows people to trade with each other. Let us see how.
Bid vs. Ask Spread
The most basic definition of bid vs. ask spread is the difference between the highest price a buyer is willing to pay bid) and the lowest price a seller is willing to accept (ask). Although to a novice investor, this might be a meaningless margin, to the experienced eye, the spread represents an enormous amount of information.
One important concept you must know of is Market Liquidity.
Market Liquidity
Market Liquidity of an asset refers to how easily it can be bought or sold without a significant impact on its price. It stabilizes an asset’s price and ensures easy entry/exit from the market without substantial financial consequences. A slim bid-ask-spread reflects that the market is highly liquid, with no shortage of either buyers or sellers.
The Impact of Bid vs Ask Spread
When trading in the financial market, a narrow spread is more profitable than a wider spread; here’s why. A narrow spread reflects low transaction costs, the asset only needs to rise in value by a small amount from the current market price to close the gap between the previous bid-ask-spread and make a profit on your investment. Therefore, making a profit on assets with wider bid-ask spreads is relatively tricky. Let’s put things into perspective for better understanding.
Product Analysis
Let’s suppose that there are two products available in the market, A and B:
Product A:
Ask Price: $10
Bid Price: $8
Bid-Ask Spread for A = Ask Price – Bid Price = $10 – $8 = $2 (narrow spread)
Product B:
Ask Price: $100
Bid Price: $80
Bid-Ask Spread for B = Ask Price – Bid price = $100 – $80 = $20 (wider spread)
Now picture this, you buy 1 of each A and B for their given ask price. After some time, both products experience an equal increase in ask and bid prices, i.e. $5 each. At first glance, it looks like you’ve made a $5 profit on each of your investments, which is somewhat valid. But if you’d like to sell both of these immediately for a profit, you wouldn’t gain much with the sale of product B since its new bid price is still $85, which is much less than the original $100 you purchased it for. For A, selling it for $13 gives you a $3 profit since it was initially purchased for $10.
However, please keep in mind that this example is more relevant for short-term gains. In the long term, there are more chances that the market price will fluctuate to a higher degree, so even a wider spread can be lucrative. Regardless, a narrow spread is still deemed more profitable.
How are the Bid and Ask Prices Determined?
Several factors influence the price of a good, but we will concentrate on the most crucial factors in play here: supply and demand. At its core, an asset’s buying and selling decisions determine the bid-ask spread. When there is high availability of an asset, meaning more people are willing to sell the asset compared to the number of people ready to buy it, then the ask price is likely to fall.
In contrast, if too many buyers are seeking an asset, but there are not enough sellers, the bid price will likely spike. This is because the stock price follows a system called competitive price, where buyers contend with each other to score a winning bid to purchase an asset. Higher bids mean more odds are in favor of securing an asset.
Similarly, the ask price depends on the supply-side factors of the sellers. The sellers compete with each other to sell an asset, thereby lowering the ask price. If there are fewer people willing to sell an asset, the ask price will tend to rise, given that there is enough demand. Other factors include investor sentiments, inflation rate, history of stocks, future prospects, government policies, and market liquidity. If you wish to learn more about how the market price is set, you can refer to this blog.
Who Benefits from the Bid-Ask Spread?
Two parties stand to gain the most from these the difference between the bid and ask prices, or the bid-ask spread: the market maker and the broker. Let’s see why.
Market Maker
The Market Maker is perhaps the most significant stakeholder involved in the sale or purchase of an asset. This person/company basically owns a lot of a particular asset, which they are willing to sell for the ask price (higher), and at the same time, they are also willing to pay for the same asset at the bid price(lower), providing the market with liquidity.
Broker
Another party who benefits from this deal is the broker, although they have much less at stake. These intermediaries help the average investor secure a trade. They match up two parties, offering the buyer the ask price (higher price) and the seller the bid price (lower price). The difference between the two prices is their commission.
Knowledge is Crucial
Knowing the difference between the bid price and ask price is crucial for several reasons, especially for anyone involved in trading or investing in financial markets. Understanding this difference provides valuable insights and helps make informed decisions.
In a nutshell, bid vs. ask price refers to the two sides of the same coin. One represents the selling price (which is higher), while the other the buying price (which is lower). Knowing the bid and ask prices allows traders to determine the best price at which to execute their trades. It helps them to gauge market conditions, manage costs, and assess the liquidity and sentiment surrounding an asset, leading to better overall trading outcomes. The phenomenon allows for the existence of a functional economy, encouraging people to invest and participate in the financial market.
FAQ
Most frequent questions and answers
It means the asset has higher transaction costs, a volatile market, and not enough market makers to stabilize the market.
Typically, customers buy at the ask price and sell at the bid price.
It is possible, but this rarely happens. It depends on the market order, and is usually not possible, unless you are the market maker.
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