Recent sharp declines on the Australian share market have highlighted one of the most common misconceptions when it comes to trading shares: that heavy selling alone contributes to the price of a stock going down. It sounds as plausible an explanation as the reverse – that intense buying activity in a stock will push its price up.
Arguably, these explanations are good enough for the casual share market observer, who probably does not stop to think that for every share whose price is falling there still has to be a buyer.
But for serious traders, it’s critical to realise a lot more is going on in the buy-sell dynamic.
One of the fundamentals of that dynamic is the bid-ask pricing equation, which reflects the different valuations that individual market participants ascribe to a given stock. More specifically this is the difference between the highest price buyers are willing to pay for a stock – the bid – and the lowest price sellers are willing to sell at – the ask. The difference between the two is commonly known as the bid-ask spread, and, during normal trading, the ask is always higher (though not by the same amount) than the bid.
Bid-ask pricing is very much tied up with the familiar concept of supply and demand, and to many newcomers to the share market it can be something of a surprise to learn that stock prices are actually set by the buyer and the seller.
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It’s less like a retail store where the buyer is simply told the price by the seller, and more like the most ancient forms of market haggling, where both buyer and seller determine the eventual price at which the transaction is struck.
So why are bid-ask spreads different when it comes to different stocks?
As in any marketplace, one of the most influential factors on pricing is how plentiful or scarce are the number of buyers, sellers as well as the volume of shares being traded. If a stock is illiquid, that is, it is not traded very often – and therefore can’t be sold to convert to cash easily and quickly – the bid-ask spread is likely to be wider. By contrast, narrow bid-ask spreads are generally observed in shares that trade in greater volume essentially reflecting the increased likelihood that there will be buyers and sellers available across the range of price levels.
Volatility is another key determinant of the bid-ask spread. In more volatile stocks, bid-ask spreads tend to be wider reflecting the greater range of possible share price valuations.
A further factor contributing to the range of a bid-ask spread is the degree of market transparency and information symmetry of company information for each individual stock. Stocks in larger companies which are generally perceived as offering greater transparency and symmetry of information (i.e. where market participants have close to equal knowledge), will generally have a tighter bid-ask spread as accurate share price valuations are more readily obtained and there is less disparity in valuations where buyers and sellers have access to the same information.
In summary then, the size of the bid-ask spread of a stock will vary depending on several factors including the differing valuations ascribed by individual investors, the number of buyers and sellers and the volume of shares traded, stock price volatility and the degree to which information about a company’s performance and prospects are available to all market participants. Based on these factors, the bid-ask spread is usually greater for small cap stocks whose shares may be tightly held and infrequently traded, for whom pricing volatility is also more pronounced and where the level of information transparency and symmetry is comparatively lowest.
Disclaimers: The views expressed in this article are not intented to be construed as either general or personal advice.