## Thursday, December 6, 2007

The buying and selling of stocks is a kind of auction. At any given moment, people are offering to buy a given stock at various prices, and others are offering to sell that stock at various prices. If a buyer and seller have the same price, then they get matched up, a trade occurs, and they leave the system. What is left is a list of buyers who are offering less than what the list of sellers are willing to accept.

The highest price offered by the buyers is called the bid price, and the lowest price asked for by the sellers is called the ask price. The word “price” is often dropped, and people talk about the bid and ask on a stock. The difference between these two prices is called the spread.

Let’s look at a real life example. As I write this, Microsoft (ticker MSFT) has a bid of \$33.49 and an ask of \$33.50. The spread is quite low at 1 cent. Such a small spread is typical of stocks that are traded a lot. So, if you want to buy Microsoft stock, someone is out there who will sell it to you for \$33.50 per share. If you have Microsoft stock you want to sell, there is a ready buyer at \$33.49.

Suppose that someone is crazy enough to simultaneously buy and sell shares in the same company at the price the market is currently offering. Then this person would lose the amount of the spread, or 1 cent per share (plus commissions). Another way to think of this is that on each trade you are losing an amount of money equal to half of the spread.

So, if I buy 100 shares of Microsoft, I should think of my trading costs as the \$10 commission (this is what my brokerage charges me) plus

(100 shares) x (1/2) x (1 cent) = 50 cents for the spread.

For heavily traded stocks, the cost of the spread is not too painful, but this changes for more obscure shares. The current quote on Oxford Bank Corp (ticker OXBC.OB) is bid \$34.30 and ask \$34.70 for a spread of 40 cents. So, on a buy of 100 shares, the cost is a \$10 commission plus

(100 shares) x (1/2) x (40 cents) = \$20 for the spread.

This shows that the cost of the spread can easily exceed the commission cost, especially if you are trading more than 100 shares. Things are even worse when trading stock options where spreads are often more than 10% of the ask price.

Some people try to beat the spreads by making what is called a “limit order”. I’ll have more to say about this in the next post.