Beginner investors can easily get confused when confronted with bid prices and ask (or offer) prices. Which one is to use if you’re buying a security? And, which one when selling the security?
Learning objectives:
- Define the concepts of bid prices and ask prices.
- Interpret bid prices and ask prices from the perspectives of investors and dealers.
Suppose that you want to trade a particular security, and you observe the following quotes posted by a securities dealer:
Bid price: $4.1. Ask price: $4.4.
If you want to sell the security, you will get paid the bid price ($4.1). Conversely, if you are interested in buying the security, you need to pay the ask price ($4.4). In general, the bid price is the highest price buyers are willing to pay. And, the ask price (or offer price) is the lowest price sellers would accept.
Interpreting bid/ask prices
Below, we offer three different interpretations of the bid prices and ask prices:
1. Bid-ask prices are quoted from the dealer’s perspective and not yours.
That is, the bid price is the price the dealer would pay to buy the security. And, the ask price is the price the dealer would ask to sell the security.
2. The dealer buys cheap and sells expensive.
The dealer’s business model is based on the spread between bid and ask prices, which is known as the bid-ask spread. In particular, dealers make a profit by buying securities cheap and selling them expensive. This means that the price they are ready to pay for a security will always be lower than the price they sell the security for. Therefore, be aware that ask prices always exceed bid prices: $4.4 > $4.1.
3. Between the bid price and ask price, you will always transact at the price that is less favorable for you.
When you are interested in selling a security, you would like to sell it at the highest price possible. Therefore, you would prefer to sell the security at $4.4 rather than $4.1. But, unfortunately, the relevant price in this transaction is $4.1, which is the price the dealer is bidding for. On the other hand, when you would like to buy a security, you would want to pay the lowest price possible. This means that you would prefer to pay $4.1 rather than $4.4. However, you need to transact at $4.4 as this is the price the dealer is asking for the security.
What is next?
This post is part of the series on trading basics. The next post in the series elaborates on what is meant by having a long position versus a short position in an asset. We highlighted the distinction between market orders and limit orders in the previous post.
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