The bid and ask price is generally used while trading assets like securities, commodities and other assets around the world. In some countries such as the UK, the ‘ask’ price is also known as the ‘offer’ price.
The bid and ask price show the prices at which the market participants are willing to trade the asset.
What is Bid Price?
Bid price is the highest price a buyer is willing to buy a certain asset. This means that the bid price will always tend to be lower than the ask price, as a rational buyer would always want to buy that particular asset at the lowest price possible and so would always bargain for a lower price than the ask price.
What is Ask Price?
Ask price is the lowest price at which the seller of the asset is willing to sell the asset. Hence the seller is ‘asking’ for that price to sell the asset. The rational seller will always want to sell the asset at the highest price possible and so, the ask price always tends to be higher than the bid price.
What is the Bid-Ask Spread?
The difference between the bid price and the ask price is known as the bid-ask spread. This is sometimes also referred to as ‘spread’ in simple terms.
A high bid-ask spread indicates that the asset is illiquid as there is less competition between buyers and sellers or both to out bid each other.
A low bid-ask spread means that the asset is liquid as sellers and buyers compete with themselves to sell or buy the asset.
Why is there a bid-ask spread?
This is because the buyer and seller have different incentives. And the buyer will always quote a price higher than what the seller is willing to pay and the seller will always quote a price lower than what the buyer is willing to sell. This coupled with the supply and demand of the number of market participants willing to buy and willing to sell will determine how wide the bid-ask spread will be.
Example
How is the bid and ask price determined?
Suppose there is stock XYZ which has 3 sellers and 3 buyers, each quoting a different selling price.
Seller A – $9.00
Seller B – $9.50
Seller C – $10.00
Then the ask price would be $9.00 as it is the lowest ask price a seller is willing to sell stock XYZ.
The buyers quote the following price,
Seller D – $7.90
Seller E – $8.50
Seller F – $8.25
In this case the bid price would be $8.50 as it is the highest price a seller is willing to buy stock XYZ.
The spread = Ask price – Bid price
= $9.00 + $8.50
= $0.50
The mid price would be the price at the middle of the bid and ask price i.e. $8.75
If the spread reduced lower than $0.50, then the market could be considered more liquid than in the current situation and if the spread became more than $0.50 then the market would be considered more illiquid when compared to the current situation.
The bid and ask price always shows the ‘best’ in the market if someone wants to instantaneously buy or sell their assets.
Note: This does not mean that if you place an order for your security that you will always get at the exact same price as the bid or ask price, but rather at a relatively close price.