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Given the avalanche of books on trading and investment, how strange that it should be impossible to find one devoting a single chapter to trade execution! Certainly, this area is most important for frequent traders, because good or bad execution can make all the difference in transaction outcomes! Below, you'll find some helpful tips on Execution Skills.
Traders’ Torment: Bid/Ask
Spread
During trading hours, at any moment, bid and ask
prices for any actively traded stocks are posted by market makers.
The prices can be seen on most trading screens. You can find them, for example,
on Tradetrek.com's Gold Version of our Trade Panel and
Portfolio Panel. "Bid price" is the price that somebody will
pay for a stock at a given moment, while "ask price" is the
price at which someone is willing to sell a stock. Bid/ask prices are
always posted together with their corresponding bid and offered shares, often
called bid/ask sizes. We can see in the figure below, for example, that
the bid price for IBM is 120 3/8, the ask price is 120 1/2, the bid size is 1000,
and the ask size is 1200.
| Ticker |
Bid
Price |
Ask
Price |
Size
(Bid x Ask) |
| IBM |
120
3/8 |
120
1/2 |
1000
x 1200 |
These quotes mean that someone is willing to buy 1000 shares of IBM at 120 3/8 and that another person is willing to sell 1200 shares at 120 1/2. The difference between the bid and ask prices is called the bid/ask spread. In the example, the bid/ask spread is 1/8. No trades will be done unless the buyer and the seller both agree on a price for a certain number of shares.
Bid/ask spread represents the cost to the party trading a stock in addition, to trading commissions. If the transaction is made online, the commission is a small fixed cost, usually about $10 per trade. In today’s very liquid and dynamic market environment, stocks are usually traded at a bid/ask-spread cost of 1/8 of a dollar or even lower. Of course, one should avoid trading illiquid stocks that consistently show bid/ask spreads higher than 1/8. Suppose a frequent trader can always trade stocks at bid/ask spreads of 1/8. How much impact will the bid/ask spread cost have on his trading performance? Let's suppose that he trades typical blue- chip stocks with prices of 50, and that, on average, his trades last for two days. Since there are about 250 trading days in a year, he trades 125 times a year. The total bid/ask spread cost will then add up to 125/8 = 15.625, or 31.25% of his capital each year, a number that doubles if he uses the typical 50% margin! If the trader still manages to make a profit, he makes it only after overcoming this 31.25% handicap, plus trading commissions. You can easily see, then, that bid/ask spread is the trader’s formidable enemy and everlasting torment.
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