What is the Bid-Ask Spread?

Author: Tahir Ismail

Whether you're new to investing or have been trading in the stock market for years but want to expand your knowledge, it may be time to learn about the bid-ask spread. Paying attention to a stock's bid-ask spread can help you make purchases and trades that benefit your portfolio. Learn more about what a bid-ask spread is and how to choose the right order type.

What Is the Bid-Ask Spread?

The first part of understanding the bid-ask spread is to have a knowledge of both bid and ask. Here are the basic definitions:

  • Bid: A bid is the most that a buyer will pay for stocks and other investments.
  • Ask: An ask is the minimum price for which a seller will sell their stocks or securities.

The bid-ask spread is the difference between the bid and the ask, and it's important to know so you can trade when it's best for your portfolio. The bid-ask spread can be large or small, but no matter the size, the spread makes a difference in the final selling price of a stock. Once a buyer purchases a stock at the ask price, that stock falls in value to the bid price. Using this information, a buyer may strategize to perform quick trades that will allow them to purchase more stocks for less money.

Example of the Bid-Ask Spread

The basic bid-ask spread is a simple calculation: Subtract the bid price from the ask price. For example, if Corporation XYZ wants to sell each stock unit for $10, and buyers are bidding at $8, the bid-ask spread would be $2, or the difference between the bid and the ask. If a buyer purchases the stock at $10, the stock's value drops to $8, or the bid price, so that any buyer who purchases a stock and then sells it would be selling it for a $2 loss per unit.

Types of Orders

There are five orders to choose from:

  • Market Order: A request to buy or sell a stock at the current market value.
  • Day Order: An order that is only valid for that day's trades.
  • Limit Order: An order to buy or sell a security at a certain price or better.
  • Fill or Kill: A transaction that must happen immediately or it'll be canceled.
  • Stop Order: An order to buy or sell a stock once a certain price is reached.

Market, limit, and stop orders are the most common.

Choosing the Right Order Type

There isn't a set rule to follow when choosing an order type. Given the three most popular order types, here are some considerations to make:

  • Think about choosing a market order when you think a stock is priced appropriately and you want to complete a transaction immediately.
  • Consider a limit order when you're set on what you want the stock price to be before making a move.
  • Choose a stop order when you want to buy or sell at a specific price. Once the price reaches your stop limit, it turns into a market order and the transaction is immediate.

Investing in the stock market definitely has its benefits. As long as you invest when the time is right, you can experience long-term success.