WHEN LOOKING AT a stock — or any security, for that matter — most people are content to focus on the price at which it last traded. And for investors with the patience to wait for a really big move, that’s generally sufficient.
But in reality, there are three prices in any given market. Market makers — those who make a living buying and selling at lightening-quick speeds — succeed or fail by looking not at stock XYZ’s last trading price, but at where it is bid and offered right now.
A quick refresher: The “bid” is the highest price to buy at any given moment; the “ask” is the lowest price to sell. So if the Dow Jones Industrial Average futures contract is quoted at 8838 bid, 8848 ask, it means the lowest offer to sell (the “ask”) one contract is 8848. If you entered a market order to buy (as most of the public does), you’d most likely be filled at the “ask.” The same applies for a market order to sell, which in this case would likely be filled at 8838.
The bid/offer is critically important to market makers because they don’t bet on direction. Unlike investors or discretionary traders, market makers profit merely by adding liquidity to a market. They bid at the bid (or slightly better) and offer at the offer (or slightly lower) and hope someone will trade with them. They aren’t out to find the next Cisco (CSCO) or Microsoft (MSFT), but rather to consistently buy and sell small price fluctuations. They want to make the spread, or the difference between the bid and the ask. In the Chicago futures pits, this is called the “edge.” (more…)