The stock market is a continuous, two-way auction process.

If you want to sell, you can ask for any price you want, and the transaction will occur when a buyer is willing to pay your asking price.

If you want to sell instantly, you have to accept whichever is the highest price that a buyer is offering at that time.

Vice versa for the buy side of the equation. 

In the stock market, we call offers to buy “bids” and offers to sell “asks.”

You might hear traders talk about the bid/ask and get confused, but all it really refers to is the highest price a buyer is currently willing to pay, and the lowest price a seller is willing to sell for.

What is the Bid and Ask in the Stock Market?

A bid is simply a buyer’s offer to buy at a specific price. An ask is a seller’s offer to sell at a specific price.

Every stock has an order book, which tracks all of the open orders, both buy and sell, for the stock. I’ll draw out a hypothetical order book: 

XYZ Stock: Order Book

 

As you can see, on the left side, there is a set of bids from the buyers, and on the right side is a set of asking prices from the sellers. You can see at which prices buyers and sellers are willing to transact at, and how many shares they’re willing to buy/sell. 

The Force That Dictates the Bid and Ask: Supply and Demand

The question of whether or not to transact on the bid or ask comes down to the most fundamental concept in economics: supply and demand. 

We’ll use real estate as a tangible example we can all relate to. At the time of writing in 2021, the US housing market is really hot. If you ask a real estate agent about the market right now, they’ll tell you that it’s crazy, and now is the time to sell and not buy. 

Houses are regularly getting several cash offers for more than the asking price.

Open houses are packed, and many cities are experiencing what San Francisco homebuyers have internalized as a part of their life: having to compete to earn the right to buy a house. In many cases, buyers are having trouble buying a house, even if they’re willing to pay the total asking price, because there are so few houses in comparison to how many buyers there are. 

So given the fact that US homebuyers are currently paying any price, even to the point of writing offers in excess of the asking price, what do you think would happen if you lowballed a seller right now?

If a house was listed for $300,000, and you submitted an offer for $270,000. That’s right, you’d get ignored, only for your realtor to tell you that the home ended up selling for $310,000. 

On the other hand, when the US housing market crashed in 2008, real estate investors had loads of inventory that they just couldn’t unload. They were overleveraged and desperately needed to sell to recoup any cash they could, or even just to reduce their debt load with the bank.

I’ll give you the same question. If you wanted to sell your home during the crash, and you listed your 3 bedroom, 2 bathroom house for $200,000 when equivalent homes are going for $150,000, what do you think is going to happen?

Right again, nobody will call your realtor, and you’ll waste their time while they play on their phone at your empty open house. 

This is basic supply and demand.

Supply and Demand in the Markets

If there is more demand than supply, prices will go up, and you can’t negotiate many terms because there’s always a buyer standing behind you, willing to pay the asking price with no questions asked.

If there’s more demand than supply, then a buyer can negotiate and be choosy. There’s little rush because few people are buying and sellers have to take the offers they receive because another buyer might not come around for a long time.

The concept is the same in the stock market. When shares of a stock are flying off the shelf, you can’t play hardball and start trying to bid low. The stock will run away from you and you’ll never get your chance to buy unless it crashes. If you want the stock, you have to pay up or get left behind.

One caveat, of course, is that the dynamics in real estate are very different from the stock market. In real estate, you can be one of a few people interested in the house and therefore your individual influence is very high.

You can establish a relationship with the seller (or buyer) and that can get you a better deal. The stock market has millions of participants at any given time and it’s completely impersonal, so it doesn’t care that you want to buy at a low price.

On the other hand, if you own a stock that is crashing, there are few buyers in sight, while tons of owners of the stock are rushing to sell because it’s crashing. If you want to sell, it’s going to be hard to ask for a high price when every successive transaction lowers the best asking price.

So, generally, in a “buyer’s market,” you can be choosy and try to fish for a good deal as a buyer. In a ‘seller’s market,’ the seller makes the rules and that means buyers are paying up or getting left in the dust. 

With this information in mind, how do we use these concepts to get a better deal in the stock market? The answer isn’t so clear.

There’s no human-to-human negotiation involved in stock trading, so no amount of sales skills will get you a better deal. It’s more about tactically placing orders at good prices and hoping the market approaches your price.

Orderflow

Understanding the bobbing and weaving of the stock market “order flow” as it’s called is an artform in itself and many traders make their living by reading it.

They’ve learned to identify when a big buyer or seller has entered the market, or when the energy of the market picks up. In other words, they can read a weak or strong hand. 

However, order flow analysis is the type of trading style that you not only have to know what to look for, but you need hundreds of hours of experience staring at the order flow to get that intuitive sense and apply your knowledge effectively.

That’s not to discourage anyone, only to tell you that there’s no quick and easy trick to forecast where the price will go in the next few minutes in a short article. 

Instead, we’ll give you some rough guidelines which you can supplement your current trading strategy with and understand the type of market you’re in, and what to expect when submitting orders to said market. 

As we’ve said, there are no hard-and-fast rules here. This isn’t a game that’s been ‘solved’ and you can find an optimal answer to. We can, however, use the basic principles of supply and demand as a starting point. 

Before we move on, you should give consideration to the type of brokerage account you have.

If you have a brokerage account with direct market access, meaning you route the orders directly to specific market venues, then you typically will pay fees directly to the exchanges you trade on.

And most exchanges give traders who “provide liquidity” (send orders to the market that don’t immediately get executed, i.e. send an bid to buy at a price lower than the current ask price) a rebate on those exchange fees.

The question of whether or not to trade on the bid or ask is definitely affected by those fees, so if you have a DMA brokerage account, definitely consult with your broker’s pricing table. 

Passive Trading: When to Buy on the Bid or Sell on the Ask

Buying on the bid is a passive trading tactic. You’re sending an order that doesn’t immediately get filled, because there isn’t currently a seller willing to sell you the stock at that price. You’re willing to sacrifice the immediate execution of your order in exchange for the chance to buy the stock at a lower price. 

This concept applies equally to selling on the ask, or above the ask. In a rapidly rising market, demand is outweighing supply and therefore you’re in a unique situation as a seller and can often get a better price if you wait it out.

Generally, passive trading tactics are most favorable as a buyer in a buyer’s market.

Going back to the real estate example, if there was just a housing crash and you want to buy a house, you might not want to pay the asking price. You can negotiate with the seller, lowball a bit, ask for more favorable contractual terms, etc.

The same stands true in the stock market. When a stock is crashing, or aggressively dropping in price, you can often afford to wait it out and fish out lowball bids to see if the stock will come to you. 

The market doesn’t have to be crashing for you to be a passive buyer or seller, though. In a ‘boring’ market where the price is moving sideways, you can often set a bid slightly below the price (or offer to sell slightly above the price) and get it filled, so long as it’s within the range of prices that the stock is bouncing between.

As a generality, traders who employ a “mean reversion” (buying things that have gone down a lot, or shorting things that have gone up a lot) favor passive strategies, as they’re buyers in a buyer’s market and seller’s in a seller’s market. 

There are a set of traders called ‘market makers’ which make their living by simply buying on the bid and selling on the offer, collecting the “spread” between the prices all day.

These traders used to be humans trading on a trading floor, as seen in the movie Trading Places, but nowadays, most market making is automated by high-frequency traders.

Keep in mind when trying to send passive limit orders, that you’re competing with the market makers to get that better price, and their algorithms are very good. 

The decision between passive trading and aggressive trading is riddled with trade offs. While passive trading can get you a better price (and rebates if you use direct market access), the stock might never trade at your price, leaving you behind. 

Aggressive Trading: When to Buy on the Ask or Sell on the Bid

Aggressive trading is when you send an order that is available for immediate execution. If the bid is $9.95 and the ask is $10.00, an aggressive trader would buy from the ask at $10.00, foregoing the ability to set a bid at $9.95 or $9.96 in favor of the benefit of being able to buy the stock immediately.

The aggressive vs. passive question is a weighing between immediacy and price. 

Going back to the housing example, an aggressive homebuyer might think “this market is hot and I don’t see it stopping. Home prices are going up, so I’m gonna buy now and sell in a few months after prices rise more.”

They’re taking the risk of getting a worse deal but they get their house immediately. If prices rise 10% in the next six months, they’re ready to sell. They weren’t left behind waiting to get a better deal. 

In the stock market, aggressive trading typically makes the most sense in a trending stock. If you want to hop aboard a strong trend that’s already underway, you’re going to have a hard time trying to buy below the bid, or even on the bid.

The stock might run away from you while you’re trying to buy on the bid, forcing you to buy at even higher prices.

All trend traders have struggled with this at some point, and many opt to only trade with aggressive limit orders for this reason. 

Another situation in which traders might favor aggressive limit orders is in a sideways range.

Recall that we said that sideways markets are also ripe for passive trading in the previous section. So how can both be true?

It really comes down to your preferences. You might be looking at a stock in a very tight range that you will breakout aggressively. You don’t know if it will break out next week or within the hour.

So some traders make the trade off and use an aggressive order so they don’t get left behind. Their mentality is that they’re playing for such a big price move, that paying the bid/ask spread (the difference between the bid and ask prices) is negligible in comparison to potentially missing a huge win. 

Bottom Line

We’ve barely scratched the surface on the subject of trade execution and where, when, and how to submit orders to the market.

There’s an entire field of study called market microstructure which aims to answer these questions. There’s an entire swath of traders who make their living by getting clues by watching the order book, too. 

If this is all new to you, don’t get discouraged. You don’t have to be an expert in everything in trading. If your strategy doesn’t live or die on squeezing out an extra penny by trying endlessly optimize how you send your orders, thinking too hard on this question can actually be a big waste of time. 

Keep in mind that the bid/ask spreads on the most liquid stocks like SPY, AAPL, etc., is typically one penny, which is a very small percentage of the price of the stock. For many traders, this can be pretty negligible.