Traders’ Torment: Bid/Ask Spread

During trading hours, at any moment, bid and ask prices for any actively traded stocks can be seen on most trading screens. "Bid price" is the price that somebody will pay for a stock at a given moment, while "ask price" is the price at which someone is willing to sell a stock. Bid/ask prices are always posted together with their corresponding bid and offered shares, often called bid/ask sizes. We can see in the figure below, for example, that the bid price for Hutchison (0013) is 98.25, the ask price is 98.5, the bid size is 1000, and the ask size is 1200.

These quotes mean that someone is willing to buy 1000 shares of Hutchison at 98.25 and that another person is willing to sell 1200 shares at 98.5. The difference between the bid and ask prices is called the bid/ask spread. In the example, the bid/ask spread is 0.25. No trades will be done unless the buyer and the seller both agree on a price for a certain number of shares.

Bid/ask spread represents the cost to the party trading a stock in addition, to trading commissions. Suppose a frequent trader can always trade stocks at bid/ask spreads of 0.25. How much impact will the bid/ask spread cost have on his trading performance? Let's suppose that he trades typical blue- chip stocks with prices of 50, and that, on average, his trades last for two days. Since there are about 250 trading days in a year, he trades 125 times a year. The total bid/ask spread cost will then add up to 125 x 0.25 = 31.25, or 62.5% (spread cost / investment capital) of his capital each year. If the trader still manages to make a profit, he makes it only after overcoming this 62.5% handicap, plus trading commissions. You can easily see, then, that bid/ask spread is the trader's formidable enemy and everlasting torment.

Demand/Supply at a Glance: Bid/Ask Sizes

As previously mentioned, bid/ask prices are always posted with corresponding bid and ask sizes, which serve as measures of the strength and depth of the bid/ask prices. They tell us about the supply/demand pressures on a stock at a given moment. We can summarize important Bid/Ask size concerns as follows:

• A large bid size indicates a strong demand for the stock.
• A large ask size shows that there's a large supply of the stock.
• If the bid size is significantly larger than the ask size, then the demand for the stock is larger than the supply of the stock; therefore, the stock price is likely to go up.
• If the ask size is significantly larger than the bid size, then the supply of the stock is larger than the demand for the stock; therefore, the stock price is likely to drop.

Because bid/ask prices and sizes change quickly in real-time, supply and demand also change quickly in real-time. Experienced traders always pay very close attention to the bid/ask sizes of a stock to monitor the supply-demand dynamic. Short-term traders usually buy a stock only when the demand is higher and sell a stock if demand suddenly becomes lower relative to supply.

One effective and widely used short-term trading strategy based on supply and demand is the following:

• Place a limit order to buy a stock at the middle ((bid+ask)/2) when you see that the ask size is small and the bid size is much larger (this strategy does not work if the stock price is quickly declining).
• Place a limit order to sell a stock at the middle ((bid+ask)/2) when you see the bid size is small and the ask size is much larger (this strategy does not work if the stock price is quickly advancing).

Example:

In a relatively quiet trading period, suppose that you suddenly notice the following:

You can place a limit order to buy 1000 shares of Hutchison at 97.75.

Now suppose you see

You could place a limit order to sell 1000 shares of Hutchison at 101.75. Most likely you will get into the trade and the momentum will soon help you make a small profit. Then you can set a stop loss order at your entry price level to protect yourself from losing the trade.

Limit, Market and Stop Orders

To buy or sell a stock, one can enter a few different types of orders to best serve one's trading goals. The following short description uses orders for 2000 shares of Hutchison to illustrate some common ordering variants:

• Limit Order-- to buy 2000 shares of Hutchison at 98: buy 2000 shares Hutchison at 98 or better (lower price). Sometimes one gets a series of partial trades (partially filled orders) at different prices all equal to 98 or better. If the market price of Hutchison moves up before the order can be executed, one may lose the opportunity and never get the trade done.
• Market Order-- to buy 2000 shares of Hutchison: buy 2000 shares of Hutchison now at whatever prevailing market price. Usually one gets the stock at the ask price of the moment when the order reaches the exchange. Sometimes, one gets a series of partial trades at (partially filled orders) different prices, with different shares adding up to 2000 shares. With such a market order, one always gets 2000 shares of Hutchison, although there is a risk of getting them at a considerably higher price.
• Limit Order-- to sell Hutchison at 101: sell Hutchison at 101 or better (higher price). Sometimes one may get a series of partial trades (partially filled orders) at different prices all equal to 101, for example, or better. If the market price of Hutchison moves down before the order can be executed, it is possible to lose the opportunity and never get the trade done at all.
• Market Order-- to sell Hutchison: sell Hutchison now at whatever prevailing market price. Usually one will get the stock at the ask price of the moment when the order reaches the exchange. Sometimes, one gets a series of partial trades (partially filled orders) at different prices, the shares of which add up to 2000. With such a market order, one can always sell 2000 shares of Hutchison, although there is a risk of selling them at lower prices.
• Stop Market Order-- to sell 2000 Hutchison at 122: sell 2000 Hutchison at the market price if the bid price hits 122.
• Stop Limit Order-- to sell 2000 Hutchison at 122 stop and 121.5 limit: sell 2000 Hutchison at 121.5 or better (higher) price if the bid price hits 122.
• Stop Market Order-- to buy 2000 at 108: buy 2000 Hutchison at market price if the ask price hits 108.
• Stop Limit Order-- to buy 2000 Hutchison at 108 stop and 108.5 limit: buy 2000 Hutchison at 108.5 or a better (lower) price if the ask price hits 108.

Bid/Ask Spread Makes all the Difference

Good execution means getting a trade done at the best price once the decision to do the trade has been made. The key to good execution has everything to do with overcoming or reducing the adverse impact of the bid/ask spread.

Experienced traders who consistently use the right tools to analyze the market and individual stocks can usually make good trading decisions that give them an insider's edge. According to our extensive historical tests, consistently applying good trading strategies can generate a return of 30% to 80% a year, before bid/ask spread costs. In reality, due to all kinds of uncertainties and inconsistent application of trading rules, it is difficult for most traders to gain an edge that consistently translates into a 30% return per year on trading capital before taking into account bid/ask spread costs. Recall that such 30% gains cannot even cover transaction costs. This explains why, in many cases, traders lose money. However, by reducing the bid/ask spread cost in every trade, the trader can then cut the per-year transaction costs down, turning a losing year into a winning year! You can see, then, that reducing the bid/ask spread can really make all the difference between gaining and losing portfolio value.

How can we consistently get the bid/ask spread down to 1/16? Here are some trading tips:

• Only trade liquid stocks that almost always trade at a lower bid/ask spread or better.
• When you buy a stock, always use Limit Order and set the limit price equal to the bid price, or the bid price plus half of the spread.
• When you sell a stock, always use Limit Order and set the limit price equal to the ask price, or the ask price minus half of the spread.
• When you sell your existing stock, use Limit Order to sell it at the bid price, or at bid price plus half of the spread to increase the chance of getting the trade done.
• When you buy a stock to cover your existing short position, use Limit Order to buy it at the ask price, or at ask price minus half of the spread to increase the chance of getting the trade done.
• For all stop loss orders, use Stop Market Orders with stop prices equal to your cut-loss level.