Why is the Bid Lower Than the Ask?

If you are struggling to grasp “bid” and “ask” prices, keep reading.

Bid and Ask Prices

When you look up the terms, you will see the following definitions:

• Ask Price: the lowest price a seller is willing to accept
• Bid Price: the highest price a buyer is willing to pay

In other words, the ask price is the price at which you can buy the asset if you wish (because there is a seller willing to accept your offer). The bid price is the price at which you can sell the asset if you wish (because there is a buyer willing to accept your offer).

Ok, that makes sense. Sellers want the highest price possible for their asset, so there is a lower limit to the price they are willing to accept. Likewise, buyers want the lowest price possible, so there is an upper limit to what they are willing to pay.

Executing the Trade

A market is a place where buyers and sellers meet. If an individual seller’s desired price is lower than the buyer’s desired price, they execute the trade and both leave happy. If not, they cannot make a deal.

This implies that the ask price (demanded by the seller) must be equal to or lower than the bid price (demanded by the buyer) — otherwise no trades would be executed.

But this is wrong! The internet is quick to inform us that the bid price is lower than the ask price. The difference between the (lower) bid and (higher) ask is called the “bid-ask spread,” and is nearly always present in liquid markets.

How is this possible? If the bid is lower than the ask, then no trade will take place because the seller is demanding a higher price than what the buyer is willing to pay.

Market Makers

To understand this conundrum, we must understand the role of market makers.

If the market were made up of only individual buyers and sellers, the marginal buyer’s demanded price would need to continuously move above the marginal seller’s demanded price in order for trades to be executed. Since this is not the case (as we just mentioned, the bid price is almost always lower than the ask price), we know that something else is going on.

Ok, so what is a market maker?

Market makers are financial institutions that facilitate trading by providing liquidity to the market. They do this by quoting both a bid and an ask price for a particular asset.

We went wrong in assuming that the “buyer” and “seller” were different entities, transacting directly with each other. In major stock, bond, and commodity markets, sellers do not sell directly to buyers, they sell to market makers, which then sell to buyers.

The Bid-Ask Spread

The market maker sets the bid price (the price at which they are willing to buy) slightly lower than the ask price (the price at which they are willing to sell). For example, if a stock is trading at $29.50 (bid) — $30.00 (ask), the market maker will buy the stock for $29.50 and sell it for $30.00.

In this case, the bid-ask spread is $0.50. Market makers make a profit by buying at the lower bid price and selling at the higher ask price, earning the difference.

Market makers continuously quote bid and ask prices, which helps maintain an orderly and liquid market. Sellers and buyers can both execute their trades promptly, because there is always a middleman ready to buy from sellers and sell to buyers.

Hedging

Of course, this job involves risk. If a market maker ends up purchasing an asset without any buyers, they could be exposed to a price drop. For this reason, market makers often hedge their positions by buying financial instruments that are negatively correlated with the assets in their inventory.

For example, imagine a market maker just bought a large amount of gold. If the price of gold drops before they can sell it at their quoted ask price, they will suffer losses.

So, they buy a “short” position on gold to profit from a potential price decline. Short selling often occurs in the futures market. They may also purchase put options that give them the right to sell gold at a predetermined price at a later date, protecting against price drops.

Definition of Bid and Ask

To sum it up, here are some clear definitions for “bid” and “ask” in markets where a middleman is involved:

• Ask Price: The lowest price at which you can buy an asset from the market maker
• Bid Price: The highest price at which you can sell an asset to the market maker

Hope this clarifies things!