Question

Explain the difference between a bid price and an asked price and also explain why the prices are different.

Answer 1

Solution:-

Let's understand these concepts with a normal everyday example before we go to financial markets.

Let's say that a person (seller) wants to sell his car and he has put a price of $10,000 for the car. A buyer comes up to him and offers $9,000 for the car. In this case, the seller is asking for $10,000 and thus the ask price is $10,000, whereas the buyer is bidding $9,000 and therefore the bid price if $9,000. Now, since there is a difference between the two the trade can't happen and the car can't be sold unless either the seller reduces his ask price or buyer increases his bid price or a new buyer shows up with a higher bid price. Let's say a second buyer shows up the next day and offers to pay $10,000 for the car. In such a case, the seller would sell his car since the bid matches his ask. Therefore, the trade would go ahead and the car would be sold.

The same concept applies in financial markets. The price that buyer is ready to pay for a stock is called bid price and the price that a seller is ready to sell the stock for is called ask price. The reason that these prices could be different is because the prices at which a buyer wants to buy something and the price at which the seller wants to sell that thing could be different. The sellers obviously desire as high a price for their shares and the buyers would obviously like to pay as little as possible to make their purchase. Both parties are trying to get best possible deal for themselves and this may result in a discrepancy between the two prices.

However, it is not a rule that the two prices have to be different. When they are same (Like the second buyer of car in example above), the trade gets executed immediately on the stock exchange. In cases where there is a difference between the two prices, either the ask price must come down or the bid price must go up for the trade to get executed.