Stock trading beginners often have questions about how the market works, best practices for investing, and important terminology to know. Armed with a little knowledge, you can confidently invest your money to earn solid returns and build a sound financial future. Learn a few stock market basics and facts about bid-ask spread to get started on a successful and lucrative stock trading journey.
Stock Market Basics
The stock market operates on a system of supply and demand. Investors purchase shares of stock in a company, which provides them an equity share in the business with which they can vote on business measures and provide other types of input. The business gets the cash from the stock purchase to invest in operations and company growth. Shareholders can then sell their shares to other interested investors if they choose. Market exchanges like the New York Stock Exchange and other similar entities oversee the sale and purchase of stock shares, and several governmental agencies also ensure fair trading for individual investors.
What to Know About Bid-Ask Spreads
A bid is the price a buyer is willing to pay for a stock, while an ask is the price a seller is willing to accept for a stock. The difference between bids and asks are known as bid-ask spreads. Here are some key facts about bid-ask spreads to help you better understand them:
- The ask price is almost always higher than the bid price.
- The underlying stock’s liquidity impacts whether the spread is small or large.
- Popular stocks that trade frequently often have a small spread, while lesser traded stocks have a larger spread.
- The bid-ask spread usually goes to the broker who manages the trade as payment.
- Bid-ask spread applies to options trading in addition to traditional stock trading.
- Bid-ask spread is only one of a number of metrics investors can use to evaluate a possible purchase or sale.
How to Calculate Bid-Ask Spread
Calculating the bid-ask spread of a stock trade will help you know exactly how much the trade will cost and how much money you’ll lose in the spread. You can evaluate bid-ask spread by dollar amount or by percentage.
To calculate the dollar amount, simply subtract the bid price from the ask price. This will tell you the spread amount per share. Multiply that number by the total number of shares you intend to buy or sell to see the full dollar amount.
To calculate the bid-ask spread’s percentage, known as margin percent, of the total transaction, use this formula:
margin % = (ask – bid) / ask * 100%
For example, say you’re interested in a stock with a bid of $19 and an ask of $20. Using the margin percent formula:
5% = (20 – 19) / 20 * 100%
The bid-ask spread is 5% of the overall cost of the transaction.
Understanding bid-ask spread and how to calculate the margin percent can help you make smart decisions with your money when buying and selling stocks or options contracts. Use this metric to help you evaluate potential trades.