DINEO TSAMELA: The price of a security is determined by both buyers and sellers
Long-term investors generally wouldn't concern themselves with the terms bid, ask and spread, but these terms are important to traders if they are to master the art of trading. Having a fine understanding of these market functions and the impact they have on your trading success is important.
To understand these words and their function in the market, we need to understand market dynamics and how the terms play out under different dynamics.
The market is driven by supply and demand. You have buyers and sellers of securities, and the relative size of each acts as a price determinant, among many other factors.
The number of buyers and sellers and the price difference are liquidity factors. The more buyers and sellers, the more liquid a security is, and vice versa.
Liquidity determines how quickly you can buy or sell a security. Liquidity matters because, as a day trader, you want to take advantage of price movements. Illiquid securities don't offer as much flexibility as those that are bought and sold frequently.
You may ask why we have a bid and ask price when a security is often given as trading at a particular price. But you'll find, as you delve deeper into it, that the price moves and that that movement is determined by both buyers and sellers.
Matched by a willing seller
What you do as a trader when you buy a stock is to put the price you're willing to pay out there. Your bid or asking price for the security will be matched by a willing seller. The same applies if you want to sell a security.
It may happen that you place a bid for a stock at a certain price and don't sell it because no one is willing to match your price - you've bid yourself outside the price range.
The difference between the bid and ask price is known as the spread. The size of the spread depends on the difference between bid and ask and is also influenced by the volume of the shares traded daily.
Let's say there's a share with a bid or asking price of R150.05 and an offer or selling price of R150.10. The difference between the two is R0.05 - the spread.
For forex traders, the spread is their main trading cost between two currencies. Traders should familiarise themselves with the concept of the point in percentages, commonly referred to as a pip - the unit forex traders use to measure their spread and calculate their profit or loss.
Pip in currency trading
A pip in currency trading pairs is the fourth decimal place. This excludes a currency pair in which one of the currencies is the Japanese yen. Here the pip is read in the second decimal place.
In a bid-ask combination for a US dollar and South African rand currency pair, the bid price may be R14.50639 and the ask may be R14.50879. The spread is R0.0024 and the pip is 4 (0.0004.)
If you want to familiarise yourself with how the bid-offer spread affects your trading, tinker around with a demo account or start small by trading equities. As we've stressed in past columns, educating yourself and playing around with the maths will help you get a much better understanding of how these things actually work.
When trading - whether in forex or equities - pay close attention to the spread. Beyond that, think carefully about how the movement affects your trading profit, and factor in all the other costs of placing a trade. You might make a profit on the movement of a share, but if fees such as brokerage eat into your profits, then you're working for nothing.