Friday, December 7, 2007

Trying to Beat the Spread

In my last post, I was explaining that the spread is the difference between the bid and ask prices on a stock, and that the spread contributes to the cost of trading stocks. Is there anything we can do to reduce the trading costs due to spreads? You can try to do this with what is called a limit order (rather than the simpler market order), but results are not guaranteed.

A market order is an order to trade stock where you are saying, “just give me the best available price right now.” So, for a buy order you will get the ask price, and for a sell order you will get the bid price. Things get a little more complicated if you buy enough shares to exhaust the shares available at the current bid or ask price, but this is a subject for the next post.

A limit order is an order to trade stock where you are saying, “give me the best available price as long as it is $X or better,” where $X is a price you specify. If there is no stock available at your price, then the order is held until the stock price reaches your price. Limit orders usually expire at the end of the day if they are not filled by then.

An Example

Suppose that you want to put about $10,000 into Sapiens International Corp (ticker SPNS). As I write this, the current quote is bid $1.45 and ask $1.60, for a spread of 15 cents. You decide that you want 6000 shares. Using the same method as in my last post, you can expect your trading cost to be the commission plus a spread cost of

(6000 shares) x (1/2) x (15 cents) = $450.

Ouch! In reality, the spread cost is even higher than this because the current quote shows that there are only 2500 shares available at $1.60 (for more on this, go here). You will buy the remaining 3500 shares at a higher price. What can you do about this?

You could try a limit order to get the price in the middle of the spread. Suppose that you place an order to buy 6000 shares of SPNS at $1.52 or lower. And then you wait. Maybe your order will get filled for all 6000 shares at $1.52. Great! You have saved the spread cost. You get to feel clever for a while.

But what happens if your order is never filled? Maybe you were right that this is a good company, and no other trader is willing to sell shares at your limit price. The stock price rises a little before the end of the day, and rises a little more the next day. So, now you either abandon this stock or buy it at an even higher price than the $1.60 you could have had originally.

So your attempt to save on the spread either works or ends up costing you more than the initial spread. This doesn’t mean that there is anything wrong with limit orders. It’s just that they are not a guaranteed way to avoid trading costs caused by the spread.

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