Understanding the bid/ask spread is one of the keys to successful online trading. While long term investors can often ignore the bid/ask spread altogether, most day trading strategies will be impacted by it, and some will even be based entirely around profiting from it.
Let’s take a brief look at the core concepts involved in the bid/ask spread, so that you’ll feel comfortable and confident when trading in all sorts of different markets.
Bid Vs Ask
At the core of the bid/ask spread are the two different prices available in any market: bid and ask.
The bid price is the current highest price that someone is willing to pay for one or more units of the security being traded, while the ask price is the current lowest price at which someone is willing to sell one or more units.
The ask price will always be higher than the bid price because any ask price at or below the current bid price will just automatically fill existing bid orders until the lowest ask is once again above the highest bid.
The spread is the difference between the current bid and ask prices. The spread in some markets can be tiny, while the spread in other markets can be massive.
The spread is important to day traders because the moment they, for example, buy a share at the ask price, it falls in value to the current bid price. In trading strategies that are based on a large number of quick trades, the spread can quickly eliminate any potential profits and turn otherwise positive trades into losses.
The cost of having an order filled instantly is the premium paid by taking the current bid or ask price on the market. However, by using different order types, traders can potentially avoid, or even exploit, the price difference caused by the spread.
The Spread and Order Types
Day traders will feel the full impact of the current spread when they use the market order function.
Market orders are filled at the most favorable opposing price, bid for sellers and ask for buyers, until the entire quantity of the order is filled. This can often result in ‘slippage‘, which means that the market order moves the current spread higher or lower than the starting price, and the order is filled at progressively less favorable prices.
To avoid the costs involved in using market orders, day traders can employ limit and stop orders instead. Limit and stop orders set a fixed price where a trade will be transacted.
For example, a day trader can set a buy limit order for 10 shares at 10$ per share. Whenever the ask price goes down to $10, the limit order will be activated and trade with the $10 ask price sell orders until all 10 shares in the order are filled. This can even result in say 5 of the 10 share orders being filled at $10, while the other 5 remain open as the ask price heads back above $10 per share and stays there.
The cost of using limit and stop order is that day traders risk missing out on opportunities by waiting for more favorable prices to transact at.
In the previous example, if only 5 of the 10 open buy orders got filled and the price of the shares then rose to $15 per share, the day trader will only profit on the 5 shares that they bought at $10 per share. If they had bought the other 5 shares using a market order at $11 per share, for example, they would have a further $4 profit per share for the additional 5 shares.
Bid Vs Ask and Choosing the Right Order Type
Unfortunately there are no hard and fast rules for navigating the bid/ask spread and choosing the right order type.
Only through hands on experience do day traders gradually develop an intuitive sense of the best way to execute their trading strategies using different order types and minimizing their exposure to the bid/ask spread.
However, with these fundamental concepts in mind, you are now well on your way to learning to deal with the different bid/ask spreads that you will encounter in the market and ensuring that you are always using the optimal order type.
(By Warrior Trading)