Monday, December 10, 2007

Trading Big Blocks of Stock Increases the Spread

In my post about trying to use limit orders to beat the spread, I mentioned that the spread between a stock’s bid and ask prices can be worse when you are trading large blocks of stock. What we mean by large here depends on the stock you are buying or selling.

When you get a quote on a stock, you get not only the bid and ask prices, but volume information as well. In our SPNS example in a previous post, the quote was bid $1.45x200 and ask $1.60x2500. This means that there were orders to buy 200 shares at $1.45 and sell 2500 shares at $1.60. If we had bought 6000 shares with a market order, the first 2500 shares would have cost $1.60 each, and the remaining shares would have cost more.

So, in the case of SPNS, a $10,000 trade qualifies as a large trade that increases the spread cost. In a quick look at Microsoft stock (ticker MSFT) as I write this, the price is a little under $34, and the bid and ask volumes are both above 3000 shares. So, even a $100,000 trade in MSFT is small enough to get the minimum spread.

This expanding spread is actually a disadvantage for rich people (although it is a problem that most of us would like to have). This is also a disadvantage for mutual funds because they are investing very large sums of money. They can’t invest in small companies without causing big increases in the stock price as they buy, and big drops in the stock price as they sell.

Smaller companies tend to have fewer people trading their shares, and these companies are difficult to make large investments in without having problems with the spread. Mutual funds are forced to stick with investing in larger companies. The larger the mutual fund, the smaller its universe of available stocks.

In the next post I will discuss how to protect yourself when you are making a trade that is large in relation to the quote volumes.