Understanding the Bid-Ask Spread: A Key Factor in Securities Trading

When entering the world of trading and investing, one of the things that often confuses new investors is the bid and ask prices. This phenomenon relates to a fundamental understanding of how financial markets operate. In this article, we will explain these concepts in depth and how professional traders leverage price movements.

Bid Price: Market Demand

The bid price, also known as Bid, refers to the maximum amount of money a buyer is willing to pay for a product or security. This bid reflects the demand characteristics of buyers in the market. The higher the demand, the higher the bid price will be.

When investors want to sell shares or any assets, they need to know how much someone is willing to pay for that asset. This information is obtained by looking at the bid prices available in the market. Generally, the bid price is always lower than the ask price because buyers usually want to pay less than the seller’s asking price.

Bidding can be done both online and offline through intermediaries or brokers, involving two parties. Every time a trade occurs, the bid and ask prices will change according to market supply and demand.

Offer: Selling Price Proposed by Sellers

The offer is the selling price or the asking price set by the seller. An offer is the amount of money the seller is willing to accept for their securities.

When investors want to buy shares, they consider how much someone is willing to sell for. The ask price indicates the lowest price the seller is willing to accept. If a buyer wants that asset, they must pay the ask price; they cannot pay less. Investors need to place a buy order in the market to purchase at the current ask price.

Fundamental Differences Between the Two

Understanding the difference between bid and ask prices is crucial for any trader aiming for success in the market.

Ask Price is usually higher than Bid Price. This is because sellers expect to receive more for their assets, while buyers try to pay less. This difference is called the (Bid-Ask Spread), which is an implicit cost of trading.

Supply and Demand Drive Price Direction

Changes in bid and ask prices depend on market supply and demand. When demand exceeds supply, both prices tend to rise, indicating that buyers are willing to pay more and sellers expect higher prices.

Conversely, when supply exceeds demand, both prices tend to fall. Buyers want to pay less, and sellers lower prices to find buyers.

Benefits of Bid-Ask in Trading

Some may think that the difference between Bid and Offer is insignificant, but in reality, this information is extremely valuable for trading decisions.

Firstly, these prices help us understand market liquidity. A highly liquid market will have a narrow spread, while a less liquid market will have a wider spread.

Secondly, bid-ask prices are used to determine entry and exit points for trades. Experts can identify buy and sell orders, but cannot guarantee exact prices because market orders will close near the Bid or Ask prices.

Thirdly, these prices are useful for placing limit orders (Limit Order) and stop-loss orders (Stop Loss), which are essential tools for risk management.

How Traders Use Bid-Ask Data

Correctly reading the Bid-Ask is a vital skill. Professional traders use various patterns of Bid-Ask to predict price movements:

1. Narrow Bid and Narrow Offer: Indicates market consolidation but with low trading volume. If buying continues steadily, monitor closely. As trading volume increases, prices are likely to move further.

2. Narrow Bid and Wide Offer: Suggests large investors are preparing to place buy orders, waiting for the right moment to cancel sell orders. The Offer price may gradually increase.

3. Wide Bid and Narrow Offer: Usually appears at the final stage of a trend, indicating a slowdown in movement.

4. Wide Bid and Wide Offer: Represents a period of high trading volume. If this occurs at the start of a trend or breakout, prices may surge further. If at the end of a trend, it’s best to avoid.

Advantages and Disadvantages of the Bid-Ask System

Advantages

Buying:

• Helps sellers understand the true value of their securities. A high bid indicates a good stock.
• In bullish markets, buyers are willing to pay higher prices, believing they can sell later at a profit.
• In bearish markets, buyers accept lower prices, making it easier for sellers to find buyers or sell assets.

Selling:

• Can be used in stock markets, bond markets, derivatives, and foreign exchange markets.
• From the seller’s perspective, the Ask price indicates their desired selling price, reflecting willingness to sell.

Disadvantages

Buying:

• The Bid price is always lower than the Offer price, sometimes hindering transactions if sellers refuse.
• Cannot determine the true value of securities due to investor confidence and market fluctuations.
• In modern electronic systems, millions of transactions occur daily, making it impossible for buyers and sellers to meet directly.

Selling:

• The Offer price is often above the current market price, increasing purchase costs.
• New investors often misunderstand the difference between Offer prices and market prices, leading to poor decisions.

Example Case Study

Suppose Somsak is a retail investor wanting to buy shares of Security A. He notices the current price is $173 and decides to buy 10 shares.

Calculation: $173 × 10 = $1,730

However, upon executing the purchase, Somsak finds he must pay $1,731. He feels confused.

The truth is, the $173 he sees is the last traded price (Last Trade Price), while the actual price he pays, $1,731, (173.10 per share), is the current Offer in the market. The $0.10 difference per share is the spread.

Another Example: Price Competition

Consider a scenario where Bidder A offers 5,000 Baht for an item, while Bidder B offers 5,700 Baht for the same item.

The seller decides to sell to Bidder B for the higher price. The highest bid wins, which benefits the seller by pushing the price upward.

Summary

Understanding Bid-Ask is essential for anyone aiming to succeed in trading and investing, especially when dealing with assets that have low liquidity.

Highly traded assets like large-cap stocks may have almost invisible spreads, while small-cap stocks or certain bonds may have noticeable spreads expressed in percentages.

Investing in the stock market has proven to be an effective way to generate income. Returns can help you achieve both short-term and long-term financial goals. Therefore, studying the Bid-Ask deeply is a necessary step into the world of investing.