In financial markets, just like in any other market, we often see buyers and sellers in a constant tug of war. It is always sellers verses buyers, highest verses lowest price. Both parties try to pull the rope to their side. Efficient markets are pretty good at helping buyers and sellers in reaching a compromise, whereas less efficient markets may not be so good in bridging the gap. This gap between what the buyer is willing to pay and what the seller is willing to accept is often referred to as “bid-ask spread”.
Johnny: Jinny, can you explain a little bit more; what does this term “bid-ask spread” really signify?
Jinny: “Bid-ask spread” signifies the progress of negotiation between buyers and sellers. To start with, a buyer may quote the bid price, the price at which he is willing to buy, and the seller may quote the ask price, the price at which he is willing to sell. The difference between the bid price and the ask price is known as “bid-ask spread”. In financial markets, where most of the trades now take place electronically, it is not necessary for buyers and sellers to directly quote their price to each other. In fact, buyers and sellers quote their bid and ask price independent of each other. Most often the same person, a market maker or broker, may be separately quoting both the bid and ask price for the same instrument. So whenever you ask for a quote of any instrument you get separate quotes in which quote for buy is higher than quote for sell.
Johnny: But if buyers and sellers are not quoting their prices directly to each other, then how does the negotiation ultimately take place? How are they actually able to buy and sell?
Illustration: Jayachandran / Mint
Jinny: Indirect negotiation takes place between the buyers and sellers. I will explain by taking a hypothetical example. Suppose there are only two traders, A and B. A wants to buy instrument ‘I’, for which he is willing to pay a maximum of Rs80, his bid price. B wants to sell the same instrument ‘I’, but at a higher price of Rs100, his ask price. Now both the parties are quoting different prices; in fact, the “bid-ask spread” in the present case is Rs20. Had they quoted the same price, the matter would have amicably resulted in a transaction of buy and sell. However, both sides want to deal at what they think is the right price. But both A and B can’t be right at the same time.
Johnny: Yes, Jinny. Maybe the price quoted by A is right or maybe the price quoted by B is right. But the problem is, who will decide?
Jinny: Both A and B feel, let the market decide. For the time being, they are not negotiating with each other. Both of them wait for other buyers or sellers. After some time, C enters the market as a seller and sees that A is ready to buy at Rs80. At this stage C has two options: He can go to A and sell at Rs80 or he can quote his own price and wait for another buyer. C thinks he can wait for a better deal. But another seller, B, is already sitting there with an ask price of Rs100. C decides to ask a lower price of Rs90.
This will force B also to revise his asking price, narrowing the “bid-ask spread” to Rs10.
Johnny: Yes, that seems logical but what’s the point?
Jinny: The point is that more sellers entering the market would push the asking price downwards, whereas more buyers entering the market would push the bid price higher. Ultimately, both bid price and ask price come closer to the price reflected by the actual demand and supply. Finally, another buyer, D, entering the market would find that the bid-ask prices are narrowly close. Maybe the bid price is Rs89 and the ask price is Rs90. Ignoring the Re1 “bid-ask spread”, he straightaway goes to sellers and buys at the ask price. Likewise, somebody else who is willing to sell straightaway goes to buyers and sells at the prevailing bid price. So in a highly liquid market where the number of buyers and sellers is sufficiently large, you would observe that the “bid-ask spread” remains in a very tight range.
The presence of “bid-ask spread” acts as an inducement for market makers or brokers to enter the market as middlemen by simultaneously quoting both the bid and ask price. The bid price quoted by market makers is lower than their ask price, which means that market makers earn money by buying at low and selling at high. Just like a junk dealer who buys something from you at a lower price and sells it to someone else at a higher price.
Johnny: I think the role of market makers requires greater scrutiny, Jinny. Maybe I will ask about their role some other day.
What:The difference between the price a buyer is willing to pay and the seller is willing to accept is called ‘bid-ask spread’
When: ‘Bid-ask spread’ is very high when there are not enough buyers and sellers
How: ‘Bid-ask spread’ gets reduced by virtue of indirect negotiation between a sufficiently large number of buyers and sellers
Shailaja and Manoj K. Singh have important day jobs with an important bank. But Jinny and Johnny have plenty of time for your suggestions and ideas for their weekly chat. You can write to both of them at email@example.com