Bid-Ask Exercise
If you're still confused with bids and offers, don't feel bad. The concept throws many new (and even advanced) investors. Here's a little workshop that walks you through how the quotes get posted and hopefully brings you a new level of understanding.
Let's start by assuming I am the market maker for ABC stock. I post bids to buy the stock and offers to sell the stock. If you wish to buy or sell, you can either put in a "market" order or a "limit" order. If you're not familiar with market and limit orders, don't worry. We'll cover those in detail in the next course. All you need to know for now is that market orders are guaranteed to execute, which means you will likely buy at the asking price or sell at the bid price. If you want to try for a better price, you can enter a limit order. With a limit order you specify the price, but your order will not execute unless you can be filled for that price (or a more favorable price).
The Day Begins
The market has just opened and I have no customer orders on the books. Let's assume that I'm willing to buy up to 500 shares at $30 and I'm willing to sell up to 500 shares for $30.50. Notice how the price I'm willing to pay is less than the price at which I'm willing to sell them. This is analogous to a car dealer who buys used cars at wholesale and sells them at retail, keeping the difference as profit.
I start the day by entering quotes into my system and posting a bid of $30 and an asking price of $30.50.
You log online and get a quote for ABC stock. Your screen looks like this:
| ABC STOCK | |
| BID $30 | ASK $30.50 |
| SIZE 500 X 500 | |
The "size" field shows the number of shares available at the bid and ask prices respectively. This would be read as "500 by 500" and means that 500 shares are on the bid and 500 are on the ask. Most quote systems give this information but, if not, your broker will certainly have it.
Now let's see what happens as orders come to me from retail customers. We'll show how they affect my books as well as the quotes you're getting online. Let's start by assuming you have some shares you'd like to sell.
Order #1
You have 200 shares but do not want to sell at my bid price of $30. You decide to put in a sell limit order at $30.40, which is in between the bid and ask prices.
At this point, I see your order and realize that it is more competitive than my offer (you are willing to sell for less than $30.50) so I must do one of two things: either fill it at $30.40 (or higher) or display it so that other investors may see it.
 | Key Points |
Any time a limit order is placed in between the bid and ask, that limit order is a more competitive price. That's because, by definition, it must be a price that is higher than the bid and lower than the ask, which are both more favorable to the market.
Let's say I decide to not fill the order.
The quote you're watching will change to reflect the lower asking price. The quote you get from your broker or online is called the "inside quote" and reflects the best bid and offer. Your screen now changes to this:
| ABC STOCK | |
| BID $30 | ASK $30.40 |
| SIZE 500 X 200 | |
Notice how the asking price is reduced from $30.50 to $30.40 (that's your order) as well as the size. Your order is only good for 200 shares, so the size of the offer falls from 500 to 200.
Any time an order is placed "in between" the bid and ask without it being filled, it will result in a changing of the quote!
Because I am the market maker, I must keep track of all quotes even though I only show the best bid and offer. My computer software will show this:
| ABC STOCK | |||
| BIDS | 500 | $30.50 | |
| 500 | $30 | 200 | $30.40 |
| | OFFERS | ||
Basically all that happens is that the bids or offers that are "away" from the market get shifted. When we say "away" from the market, we mean that they are not as favorable a price. In this case, my offer of $30.50 (shown in red) is shifted higher and your order takes its place.
Notice too how your quote system online only shows the one row of my book (in blue). That is all you will ever see even though there are many quotes above and below that. Once again, this is because the market is really only concerned with the highest bid and lowest offer (the inside quote).
Let's run through a few more examples so we can get some orders on the books. Then we'll look at how to fill orders based on the book.
Order #2
Another investor comes along and enters an order to buy ABC stock. He thinks it will fall a bit first and places a limit order to buy 400 shares at $29.
Once again, I get this order and notice that it is not as competitive as my bid of $30, so I just move that order out in the "wings" hopefully to be filled at a later time. In other words, because this new order is not in between the bid and ask, it is therefore less competitive and just gets pushed aside for now. My system now looks like this:
| ABC STOCK | |||
| BIDS | 500 | $30.50 | |
| 500 | $30 | 200 | $30.40 |
| 400 | $29 | OFFERS | |
The lower bids (worse for the market) get moved lower and the higher offers (worse for the market) get moved higher. Remember, the market is only concerned with the highest bid and the lowest offer. All others get "swept aside" for the meantime. This practice always keeps the best bid and offer in the middle of my screen.
Order #3
A new order comes in to buy 100 shares at $28.50. This is the weakest of all bids (the lowest) so it gets moved to the very bottom. My system now looks like this:
| ABC STOCK | |||
| BIDS | 500 | $30.50 | |
| 500 | $30 | 200 | $30.40 |
| 400 | $29 | OFFERS | |
| 100 | $28.50 | ||
Notice how the "buy" orders are always placed under the "bid" column and the "sell" orders are always under the "offers." This is in line with what we said earlier in that the bid price represents buyers and the offer price (asking price) represents the sellers.
Order #4
Hopefully you're getting the idea of how this works, so let's go ahead with several orders. Assume the following orders are received:
- Sell 300 shares at $30.75
- Sell 150 shares at $30.45
- Buy 250 shares at $29.50
The first order to sell 300 shares at $30.75 is the highest of all current offers, so it goes to the very back of the line:
| ABC STOCK | |||
| BIDS | 300 | $30.75 | |
| 500 | $30.50 | ||
| 500 | $30 | 200 | $30.40 |
| 400 | $29 | OFFERS | |
| 100 | $28.50 | ||
The next order is to sell 150 shares at $30.45. It is higher than the best offer of $30.40 but it isn't the worst one either. It gets wedged between the offers of $30.40 and $30.50 as shown below. The same idea applies to the last order to buy 250 at $29.50. They get wedged between the orders to buy 400 at $29 and 500 at $30:
| ABC STOCK | |||
| BIDS | 300 | $30.75 | |
| 500 | $30.50 | ||
| 150 | $30.45<-- | ||
| 500 | $30 | 200 | $30.40 |
| -->250 | $29.50 | OFFERS | |
| 400 | $29 | ||
| 100 | $28.50 | ||
This process continues, and all bids and offers are placed in descending order. If an order comes in that is the most competitive bid or offer, it will be placed at the very front of the line. Otherwise, the order takes its appropriate place in line.
Let's do one more like that to be sure you understand.
Order #5
An order comes in to buy 100 shares at $30.20, which is in between the current quote of $30 to $30.40. Therefore, the order jumps to the front of the line as shown. In other words, because they are now the highest bidder, they move to the front of the line. The only way to get moved to the front of the line, whether buying or selling, is to place a limit order in between the bid and ask. My computer screen now looks like this:
| ABC STOCK | |||
| BIDS | 300 | $30.75 | |
| 500 | $30.50 | ||
| 150 | $30.45 | ||
| 100 | $30.20 | 200 | $30.40 |
| 500 | $30 | | |
| 250 | $29.50 | OFFERS | |
| 400 | $29 | ||
| 100 | $28.50 | ||
Once again, the inside quote has changed (the bid is higher), so your computer screen will now show this:
| ABC STOCK | |
| BID $30.20 | ASK $30.40 |
| SIZE 100 X 200 | |
Filling Orders
Now let's look at some orders that actually get filled. The reason that none of the orders got filled in the first examples is because none of the buyers accepted the offer price (called "taking the offer" in trader's jargon) or sold at the bid (called "hitting the bid"). All orders were either "in between" the bid and ask or away from the market. Now we're going to focus on what happens when orders actually get filled.
Order #1
An order comes in to buy 200 shares "at market."
Because those investors listed in the "offers" column are sellers, I know I can match this buy order with the person there and fill the order. The trade "200 at $30.40" is removed from my books and all the offers are now shifted down. The best offer is now $30.45:
| ABC STOCK | |||
| BIDS | 300 | $30.75 | |
| 500 | $30.50 | ||
| 100 | $30.20 | 150 | $30.45 |
| 500 | $30 | | |
| 250 | $29.50 | OFFERS | |
| 400 | $29 | ||
| 100 | $28.50 | ||
Of course, your screen will reflect this change as well. You will now see:
| ABC STOCK | |
| BID $30.20 | ASK $30.45 |
| SIZE 100 X 150 | |
The buyer receives a confirmation from his broker that he bought 200 shares at $30.40, and the seller receives a confirmation of the sale of 200 shares at $30.40 as well.
Order #2
An order comes in to buy 350 shares at market. Market orders must be filled, so I look at my books and will have to split some orders. I will give the person 150 shares at $30.45 and 200 shares from the order above it at $30.50 as shown by the arrows:
| ABC STOCK | |||
| BIDS | 300 | $30.75 | |
| 500 | $30.50 Only 200 shares get filled from here | ||
| 100 | $30.20 | 150 | $30.45 We'll use all 150 of these |
| 500 | $30 | | |
| 250 | $29.50 | OFFERS | |
| 400 | $29 | ||
| 100 | $28.50 | ||
After that order is filled, my screen looks like this:
| ABC STOCK | |||
| BIDS | 300 | $30.75 | |
| 100 | $30.20 | 300 | $30.50 |
| 500 | $30 | | |
| 250 | $29.50 | OFFERS | |
| 400 | $29 | ||
| 100 | $28.50 | ||
The person who had the order to sell 500 shares at $30.50 will receive a confirmation from his broker that 200 shares were sold at $30.50 and he will still have an open order to sell the remaining 300 at $30.50.
The investor who placed the order to buy 350 shares at market will also receive partial fills. Their broker will inform them that he bought 150 shares at $30.45 and 200 shares at $30.50. This explains why it is not uncommon to see "partial fills" on your account!
Your screen now reflects the new inside quote and size:
| ABC STOCK | |
| BID $30.20 | ASK $30.50 |
| SIZE 100 X 300 | |
Order #3
See if you can handle this next order. An order comes in to sell 700 shares at market. How would you fill it? Look at the chart below. See if you can figure it out, then continue reading to see if you have the correct answer.
| ABC STOCK | |||
| | |||
| BIDS | 300 | $30.75 | |
| 100 | $30.20 | 300 | $30.50 |
| 500 | $30 | | |
| 250 | $29.50 | OFFERS | |
| 400 | $29 | ||
| 100 | $28.50 | ||
The market order must be filled so we find some buyers (bidders) to match up to this seller. Specifically, we need 700 shares. We look in the bid column and will fill:
- 100 shares at $30.20
- 500 shares at $30
- 100 shares at $29.50
Now, in reality, the market maker will usually step in and provide some liquidity. For instance, I could decide to fill 100 shares at $30.20 and 600 shares at $30 thus giving up 100 shares from my own account. It is not required, but is usually done to provide for more liquid markets. For now, let's assume that the order is filled as we originally stated in the bullet points above. My books now look like this:
| ABC STOCK | |||
| | |||
| BIDS | 300 | $30.75 | |
| 150 | $29.50 | 300 | $30.50 |
| 400 | $29 | | |
| 100 | $28.50 | OFFERS | |
| | |||
| | |||
And your quotes will now show:
| ABC STOCK | |
| BID $29.50 | ASK $30.50 |
| SIZE 150 X 300 | |
Notice how the spread -- the difference between the bid and ask -- has widened to $1. At the very beginning of this exercise, the quote was $30 to $30.50, which is only a half-point spread. The spreads will generally widen if the market maker only fills orders based on the book like we've been doing in these examples. This is why market makers usually step in and provide some liquidity to keep an orderly market. If they didn't, the spreads would just keep getting wider and wider as orders were filled.
Hopefully this exercise sheds some light on what happens with the bids and offers and how the orders are handled. More importantly, you just need to be aware that when your broker quotes you a bid price, that is the price of the highest buyer and, consequently, the price where you can currently sell. Likewise, if you get a quote on the ask, that is the price of the lowest selling price and, consequently, the price where you can currently buy.
This system of providing the best bid or offer is used by the stock and options markets. It is not, however, used by the futures markets. If you are looking at a futures quote of $30 to $30.50 and place a limit order to buy at $30.20 (in between the bid and ask), you may not get filled; and it is possible that your better purchase price will not be disseminated to the market. However, it is still important to understand how the system works for stocks and options as many of your futures trades will be combined with these other assets.
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