The Real Stock Price: Ask, Bid and Maximizing Profits

This is just a little primer on stock trading for the beginner. I want to relay my own mistakes in my early days of trading. In particular, the "price" you see for a stock does not mean you can buy and sell that price. It only means what the stock sold for in the last trade. Your price has at least a 50% chance of being worse than that. Let me explain.

Along with dozens of other commonly kept statistics about each listed stock, there are two very significant items: bid and ask. These are the two items you need to know when trading. They determine what the next stock "price" will be.

The bid price is the highest price that anybody is offering for the purchase of the listed stock. It is usually less than or equal to the last sale "price". For example, if the last price was $50.25, the bid might be $50.24 or it could be $50 or even much less.

The ask price is the lowest price that anybody is willing to sell the listed stock. It is usually equal to or greater than the last sale price. For example, if the last price was $50.25, the ask might be $50.25, $50.26 on up to any number.

Typically, the more heavily traded (higher volume) stocks don't have much of gap between bid and ask price. The lower volume stocks might have significant gaps. Trading in lower volume stocks was my first painful lesson the stock market.

The mistake one is tempted to make in trading stocks is looking at the last sale price only. Maybe you'll see a pattern in a stock of flip flopping in sale price in significant percentages. For example, say there is a low volume stock that seems to go up to $11 one day and back down to $9 next day, repeatedly. One might be tempted to jump in at $9 and sell at $11.

So, you take the plunge. You place a "market" order to buy the stock when it is close to $9. That was your first mistake. A market order means you will buy the stock at the lowest asking price, which could be much higher than the last $9 sale price. Even though the trade before yours went for $9, there might not have been any $9 asking prices left, so you are stuck with $10 stock.

Next day you see the stock go up to $11, so you decide to sell it, again at the market price. This means you will take the highest bid, which could be $9.50. Now you've lost $0.50/share, which incidentally was the loss I took on my first stock trade. It may not seem like but if you multiply it by, say 500 shares, it's a lot of cash to blow with 10 seconds of market action.

So what's the solution? Again, don't look at the last sale price. It's a good indicator of what people are trading at, but it's not a good indicator of what you can buy or sell your stock for. Instead of placing market orders, place a "limit" order.

When you place a limit order, you are now setting one of those bid or ask prices. If you place a limit order to buy a stock at $50, you will not pay a penny more than $50/share. Now you control the cost; but there is a caveat: possibly nobody wants to sell you that stock at $50.

Same goes for selling the stock with a limit price. You could place a limit order to sell your stock at $51/share. This means you will not sell your stock for LESS than $51/share. Again, same risk, that nobody wants to buy your stock at $51, so you will hold onto the stock, even if the price drops down to $20/share, you're still holding onto your stock and trying to sell at $51, which nobody will pay unless the market makes a big change.

One thing I do these days is look at the gap between ask and bid prices. If there is not much difference, say a few pennies, I usually just trade at the market price rather than risk missing the current prices.

If the gap is bigger, I make a limit order such that my trade should be next AND I maximize my profits. For example, if the bid is $10, the ask is $11 and I want to buy the stock, I will bid just over the highest bid (say $10.05). That way, the next person that places a market order to sell the stock will be selling to me. I will make the market price change to $10.05.

In the above scenario if I were selling the stock, I would make a limit sale order of $10.95. Then my price is the best in the market and the next person that buys the stock will pay my price. So in this scenario, I've paid $10.05, sold for $10.95 and made $0.90/share profit minus the broker fees. That's close to a 9% return on investment. Deals like this are rare and it's only here for an example.

The point is, pay attention to the bid and ask price. They determine the next price. The last sale price is yesterday's news.