In an earlier post , I explained that stock trading costs consist of the visible commissions and the less visible costs due to stock spreads . In the case of commissions, it is obvious who gets the money – the brokerage. In the case of stock spreads, it is less obvious where the money goes. If traders lose money due to spreads, who gets this money? You could imagine a stock trading system where potential buyers and sellers each submit a price and a number of shares, and a computer tries to match them up. This sort of system might work well for a very liquid stock that trades millions of shares each day, but it wouldn’t work as well for thinly-traded stocks. Suppose that you are looking to sell 100 shares of little known XYZ stock, and for three days running there haven’t been any reasonable bids to buy the stock. You would be quite unhappy. To make the system run more smoothly, each stock has one or more market makers whose job is to create a market in that stock. Market ma...

In an earlier post I discussed how using a limit order to beat the spread doesn’t really reduce spread-related trading costs. Does this mean that investors should always use market orders when buying or selling stocks? Definitely not. Let’s continue with the example of SPNS that had a quote of bid $1.45x200 and ask $1.60x2500, and we wanted to buy 6000 shares. In the earlier post we put in a limit order at $1.52. But there is a significant risk that this order won’t be filled. Maybe we really want to own this stock. (Please note that I don’t own SPNS, and I don’t know anything about it other than its quote worked well for my example.) We could just put in a market order and see what happens. One possible result is that we get 2500 shares at $1.60, and the rest at $1.61. Great. We get all the shares we want at a reasonable price. But what if we get the first 2500 shares at $1.60 and then 500 at $1.70, 1000 at $1.95, and 2000 at $2.40? This works out to $11,600 when we expected to p...

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 en...

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 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 ...

In my own portfolio, I choose to own several individual stocks. Even though I think that most people would be better off in index funds , I’m not against direct ownership of stocks. I happen enjoy tracking the progress of the businesses that I own, and I’m hopeful that I will prove to be slightly above average at stock picking.  ( Rereading this nearly 12 years later, I no longer own any individual stocks, and I realize that being above average doesn't mean being better than my neighbour; it means being better than most investment professionals. ) If you are not interested in analyzing businesses, and the time you spend following stocks consists mainly of checking current prices, then owning individual stocks probably isn’t for you. Over the long term it is the sales and profits of the business that determine your profits. Predicting the long-term future of a stock is best done by trying to predict the future success of the business rather than looking at wiggles in the chart of ...