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The Bid, The Ask and The Market Maker Basics

Posted on May 30, 2009 by Penny Stocks Picker

Whether you plan on investing in or trading penny stocks you need to understand what the bid and ask prices mean and how to go about getting the best entry and exit prices.  Additionally, there would be no bid and ask price without the Market Maker so I’ll explain their roll with a touch about Level 2 quote system.

The Market Maker:  This is a firm (broker/specialist) who is authorized to deal in the securities (sell or buy shares of a stock) on an exchange at the quoted bid and ask prices.  More than one Market Maker (MM) can deal in a security.  This is the entity who will buy your shares and sell you shares.  You are not buying or selling shares directly to another trader or investor.  Market Makers must maintain an inventory of shares in the security they deal in order to supply shares as needed and be ready to buy those shares back from you.  So, that means the MM is always playing both sides of that penny stock and set the prices at what they will buy and sell a stock for (bid/ask).  It really comes down to supply and demand, if the MM has an over supply of shares the price should come down and vice versa if demand is high and supply is low, the price should go up.  However, it’s not quite so simple, it’s my opinion (or a fact) that at times the MM’s play games and hide the truth behind the supply and demand.  If they were always straight forward then you would know what’s really happening and hence you might not buy or sell that penny stock.  Look, you say that’s not possible they are honest people just making a commission.  I say….wake up McFly and be suspicious, these MM’s are not your friends, they want your money.  The MM is a real human (like you and me) and it’s his/her job to make money for his firm or he will end up without a job.  The MM is sharp, decieving and has a bag of tricks to sucker you in or shake you out.  The MM wants to buy your shares cheap and sell them for the highest price they can.  At the same time they want to keep the shares trading (more volume means more commission and bid/ask spread profits).  Your only advantage against them is to know they are cunning and you must be nimble.  If your a long term investor and have done your fundamental research then level 1 quote system is probably good enough for you.  In level 1 you will only see the best MM bid/ask  price.  If your planning on short term trading, then I highly suggest you get Level 2 quote system so you can see all the MM’s ready to buy and sell and what their associated bid/ask prices are.  In level 2 you will also see who the controlling MM is at any point in time (that is the one at the top with the best bid/ask prices).  This is just the basics, I suggest you learn all you can about how Level 2 quote system can assist your trading.  Level 2 will help provide you with clues as to what the MM’s are up to and can assist you in getting the right price on your way in and out.

The Bid:  The best bid is the highest price a MM is willing to pay you for each of your shares (the price you get if you sell at that moment).  This is not always the case, I have actually been able to sell my shares at the higher ask price or somewhere in between.  Nothing is always.

The Ask:  The best ask is the lowest price a MM is willing to sell you shares (the price you need to pay at that moment).  I have been able to bid whack and that is put my buy limit order in at the bid and purchased shares for a lower price than the ask.

The Bid/Ask Spread:  The difference between the bid and ask price is what is called the spread.  The spread is additional profit to the MM.  For example, say the bid/ask is .0002/.0004.  The MM buys shares at .0002 and sells them for .0004.  For every share the MM sells or buys, he/she makes .0002 per share for the firm (little more complicated but that’s the basic idea).  Hopefully, you understand now and realize that the MM makes money no matter which direction the stock price goes.  They just don’t care which way it goes….they only want to keep the shares trading (more volume). 

It’s important to never ever place market orders trading or investing in penny stocks.  You should always use buy or sell limit orders (unless you absolutely must get out now).  If you will not listen, then at least don’t put overnight buy market orders in, you will get hosed.  Also, take your time placing limit orders (make sure you use the correct # of decimal places…no fat finger typos).

Sometimes I just look at the chart and decide what I’m willing to pay regardless of the current bid/ask price.  For example, I may put my buy limit order price in just above the support level.  Once it’s filled, its good practice to immediately place a sell limit order just below the next resistance level.  At times when I’m trading a hot penny stock I’ll just hop on (if I catch it quick enough) and jump off as the momentum slows (In level 2 if I see lots of MMs stacked up on the best bid (ready to buy) and 1 left on the best ask (ready to sell) with volume screaming, I know I have a pretty good chance of making a quick profit while limiting my risk).  Not always, things change on a dime so you got to pay attention and be ready, have a plan and stick to it. 

Have fun, be a sponge and keep learning something new everday.