Trading 101 The SpreadThe sirens song of the stock market entices many fortune seekers. With cutting edge technologies on display in stocks such as Tesla Motors, Apple and Facebook many individual investors are being drawn back into the markets following the financial crisis. As such, these stocks grace various ‘most widely held’ lists, with Google currently holding the top spot.1

Market participants trade these names frequently with new traders coming in every day. But before you jump into the fray, make sure you understand the costs involved in trading-some of which may not be apparent to beginning traders.

Keep Costs Low

Any successful trader or investor has to be mindful of keeping costs down. Over the long haul, this may be the difference between successful investing and the ‘average investor’ who actually loses money.2 For buy and hold investors, this means monitoring the expense ratios (fees paid) of mutual funds. It can also mean selecting funds with low turnover rates, reducing trading costs and tax liability.

For traders, this means minimizing commissions paid when trading stocks. Years ago, that was very difficult with the endemic high commissions charged by stock brokers. An investor would routinely pay hundreds of dollars to buy and sell a stock. With commissions today of just a few dollars a trade at many discount brokerages, that burden has been vastly reduced for many investors.

But it’s equally important for individual traders to be aware of ‘the bid-ask spread’, the other major ‘cost’ for traders.

The Spread

The spread refers to the difference between the bid and the ask prices in a stock quote. The bid represents the price someone is trying to buy the stock for and the ask (sometimes known as offer) refers to the price someone is trying to sell their stock. The best (highest) bid and the best (lowest) offer are known as the ‘inside spread’ and is what’s typically shown when you hit up a stock quote. Here’s an example:

Let’s say you want to buy 1000 shares of ABC company. First, you enter the symbol into your trading system to see the price. What gets displayed is: ABC Company $50.00 – $50.10. This is known as ABC’s  ‘market’, which shows the bid  is currently $50.00 per share and the ‘ask’ is $50.10 per share.

This ten cent difference is known as the spread. The tighter the spread (lower), the less you’ll pay when trading the stock. The wider the spread (greater) the more you’ll pay. More heavily traded stocks such as Apple have very tight spreads, just a couple pennies wide. Illiquid stocks (typically small cap, or penny stocks) will have much wider spreads.

Continuing with the example, you decide the ABC stock price is fair, so you enter your buy order. ‘Buy 1000 shares of ABC at the market…’ This “market” order will automatically go to the ask side and buy the stock being offered at $50.10. In a nanosecond, you have purchased 1000 shares of BAC at $50.10.

Let’s assume after about a minute of being an ABC shareholder, you get cold feet and decide to sell your shares. Let’s assume you enter a sell order for 1000 shares, again at the market. Assuming the market for ABC stock hasn’t moved, your order now goes to the bid side, $50, which is where you sell your 1000 shares.

Paying The Spread

With these two market orders, you’ve “paid the spread” on the trade. You paid $50,100 when you bought the 1000 shares ($50.10 x 1000 shares) and subsequently sold your shares for proceeds of $50,000 ($50 x 1000). You’ve realized a $100 loss. This also doesn’t take into account trading commissions. We’ll tack on another $20 total ($10 for each half of the trade) bringing the total loss to $120.

This is a relatively mild example of paying the spread. Here is an example of a trade from just a couple decades ago. Remember, before the stock exchanges went to “decimalization”, stock prices were quoted in fractions, and the market for a stock might have been $40 ½ – $41 ¼. Here, you’d incur a $750 loss for a round trip trade (buy and sell) of 1000 shares (3/4 or .75 spread x 1000 shares).

Decimalization was brought about by both increased regulation and technological trading advancements. As you can see, decimalization significantly reduced the trading costs for the average investor.

Decimalization was brought about by both increased regulation and technological trading advancements. As you can see, decimalization significantly reduced the trading costs for the average investor.

Old commissions were sometimes 10 cents per share (or more) so tack on another $100 for both sides of the trade. Now you’re at a $950 loss between paying the spread and commissions before you even factored in whether the stock you bought went up or down. That’s just the cost of doing the trade, with market orders, all else equal.

Never Use Market Orders

Maybe you’ve heard the old trading adage, “never use market orders”. Here’s an example where using market orders result in terrible price executions, even worse than paying the spread. On August 24, 2015, the stock market experienced head-spinning gyrations. Some called it another ‘flash crash’.3 Several securities, notably highly concentrated exchange traded funds or ETFs, were opening significantly lower for trading, following some negative economic data.

One example was the Guggenheim S&P 500 Equal-Weight ETF (symbol: RSP).4 Right after the stock’s opening price of $71.39, the price plummeted down to below $44. If you owned RSP, got nervous about the stock market and put in a market order to sell RSP within the first few minutes of trading, you likely received a calamitous price execution somewhere in the low to mid $40s, when you thought you’d receive something around $71. It happened to many investors.

This debacle was caused by a number of unusual events- halted trading in some large ETFs components, market makers who were stepping away from large size commitments and a generally panicky trading environment.

Use Limit Orders Instead

There is one easy way to avoid this kind of trading disaster- use limit, or stop orders. This is a buy or sell order but with a “cap” on the price you’re willing to buy and a floor you’re willing to sell. Using the ABC example, a buyer may have put in an order to buy 1000 ABC at $50.05, right in the middle of the spread. It may not execute immediately, but patient investors find it often does.

Limit orders are used by almost all professional traders. Too often, individual investors use market orders out of convenience and impulsivity. Echoing this sentiment, the Financial Regulatory Association (FINRA) says on its website that it’s especially important to use stop orders during periods of high market volatility.5

Some investors will put a limit order at the ask price, to avoid the outlier example of a flash crash from harming them. More price conscious investors will put a limit order just above the bid. While this type of order may not get filled since there is no actual commitment to buy or sell in the middle of the spread, if you do get executed, you’ve cut your costs by more than half.

Over the long haul, using limit orders will save traders and investors a lot of money in costs. Of course, there will be those times you’re trying to get that great deal on a stock, only to watch it continue higher, without you on board. While you may miss a couple high fliers, over the long stretch, you’ll be a more disciplined, and better trader for it.

1http://www.cnbc.com/2016/06/06/facebook-now-among-the-top-15-most-widely-held-stocks.html
2https://vantagepointtrading.com/archives/13922
3http://www.marketwatch.com/story/heres-what-may-have-caused-the-flash-crash-in-some-big-etfs-2015-08-25
4https://finance.yahoo.com/quote/RSP
5http://www.finra.org/industry/notices/16-19

 

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Trading 101: The Spread
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Trading 101: The Spread
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Trading 101: The spread refers to the difference between the bid and the ask prices in a stock quote. The bid represents the price someone is trying to buy the stock for and the ask (sometimes known as offer) refers to the price someone is trying to sell their stock.
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