One misunderstood aspect of buying and selling stocks is the “bid” and “ask” price. When you see stock prices scrolling across your TV screen, is it showing the bid or ask price? Why do “bids” and “asks” matter? Let us begin with some basic definitions:
Bid: $32.00 (20 potential buyers)
Ask: $33.00 (15 potential sellers)
In the above example, there are 20 people trying to buy shares of XYZ, and the high roller of the crowd is willing to pay $32.00. Of the 15 people wishing to sell, the person asking the lowest price is asking for $33.00.
Gridlock. No deal, right? Until someone budges….let me explain by comparing a stock transaction to something most everyone is familiar with: buying a car.
You are out shopping for a car at the local Toyota dealership when you run into your annoying neighbor (the one who doesn’t mow his yard). You exchange pleasantries and then discover that you both are shopping for the EXACT same car – 2011 Toyota Camry. As you try to control your teeth grinding, the competition begins and the numbers start flying:
Sticker price at Toyota Uptown: $30,000
Yard Neglector offers $22,000
You offer $24,000
Sticker price at Toyota Downtown: $29,200
Yard Neglector offers $23,000
You offer $23,500
What is the BID? It is the highest price either person is willing to pay…so it is $24,000
What is the ASK? It is the lowest price that either dealer is willing to take…so it is $29,200
We all know how this will turn out, right? The salesman will hear your offer, go talk to the “sales manager,” and after wasting a tremendous amount of your time, will come back with a counter offer. Then, perhaps, you raise your bid, he counters, etc…..until you agree on a price. The spread has to be closed.
This happens the same way in the stock market. When the bid on XYZ is $32.00 and the ask is $33.00, we are stuck…until someone bites the bullet and offers $32.75 and a seller (who needs to end the month on a high note) agrees to take $32.75.
One more example:
Bill bids $50.00 for a stock
Sally bids $50.25
Seller A offers at $51.00
Seller B offers at $50.50
The total difference between Sally and Seller B is a quarter…and as soon as one of them budges, we have a stock transaction.
Simple. Oh wait…did I buy a car on accident?