There’s an insipid little game that goes on behind the scenes played by market makers that are trying their hardest to squeeze every last penny, and I do mean penny, out of your stock purchases and sales.
In this article, I will be outlining some criteria for Bid/Ask spreads and what to look for to protect yourself from getting screwed by the market makers.
Let’s Look at an Example
Figure 1 below is an example of a real-time Level II quote screen for AuthenTec, albeit when the price was significantly higher than where it sits today. This example is to illustrate the bid/ask spread, with the BID price on the left, and the ASK price on the right.
The BID Price:
Essentially, the BID is the price at which a buyer or market maker is willing to buy a security. If you owned shares in a stock, say AuthenTec, and wanted to sell, it is the current price at which someone is willing to purchase your shares.
You may not be happy with this price, especially for thinly traded Small-Cap and Micro-Cap stocks because a lot of times, these stocks are illiquid and market makers tend to create a huge discrepancy between the BID and ASK spread, so as to make more money from you.
The ASK Price:
Essentially, the ASK is the price at which a seller or market maker is willing to sell a security. If you wanted to buy shares in AuthenTec, this price would be the current price at which someone is willing to sell you their shares. Again, you might not be happy with this price, especially in lieu of the much lower BID price.
The BID/ASK Spread:
This is the difference between the highest price that a buyer is willing to pay for a security (BID) and the lowest price for which a seller is willing to sell it (ASK). Say the current bid price is $15.20 per share, if you wanted to sell shares with 100 shares beings sought out (the 1 signifies 100 share increments), if you had 100 shares of AUTH, and wanted to sell right now, someone would be willing to purchase those shares for $15.20, and your order would execute immediately if you used a market order.
If you wanted to purchase shares, there are 300 available for $15.23. So if you wanted to purchase up to 300 shares, your order would execute immediately also using a market order.
The Bid/Ask spread is only $.03, which represents about a .197% difference, statistically insignificant, so if you really wanted to get some shares, you wouldn’t mess around, and just purchase them at the ask price to make sure you got them.
What Happens If…
What happens, using the example above, if you wanted to SELL more than 100 shares? Well, this is when you might run into problems, and might have to take a lower price. One hundred of your shares would sell at $15.20, but then the next order is at $15.17 for 300 shares, meaning that your next batch of shares would more than likely fetch a lower price. You are seeing the laws of supply and demand and market economics at work!
Because the stocks that I typically deal with are thinly traded like these, you have to be careful when purchasing large blocks of shares, as the bid/ask spread becomes a factor. Likewise, if you wanted to BUY more than 400 shares of this stock (there are 2 buyers lined up at $15.23), the next offer to sell is at $15.50! Ouch…that’s a long way to go!
More than likely however, the market maker would never let the price go that far, and would step in at a price that would allow them to make some profit (they would take both sides of the trade), and not allow such a precipitous rise or fall in the stock. This is why you MUST use limit orders at all times, especially with these kinds of stocks.
It might take some time to fill, but you are protected from not getting the price you specified and prevent the market makers from dictating to you what price they are willing to buy and sell a security for.
An Extreme Case
Oh boy, this one’s a doozy! I included Figure 2, as an example, specifically since some stocks will trade like this one. You have to be extremely careful when placing your order for these types of stocks and never use market orders!
The bid/ask spread for this stock is $.12.OK, you say, that’s not a big deal right? Yes, it is!
You see, this stock is trading at $.40-.52 per share! A difference of $.12 represents a spread of 30%! Some stocks don’t gain 30% in value in 1 year, let alone giving up that much in one trade! If you weren’t careful, the market makers would take you to the cleaners on this stock and you’d be left holding essentially a huge loss.
If you wanted to turn around and sell those shares back on the same day, you’d have to sell them to the market maker for $.40 per share after you had bought them for $.52 per share! That means if you spent $1000 buying about 1,923 shares at $.52 per share ($1000/.52 = 1923 shares ($999.96 total cost)), then sold them back to the market maker on the same day (1,923 shares x $.40 = $769.20), you would lose ($999.96 – $769.20) $230.76, or a whopping 23% on your money in one fell swoop!
I don’t have to tell you how dangerous this can be. Don’t be fooled by the penny stock increments and thinking that a few pennies doesn’t make a difference because it does! When a stock gets around $5 or less, these spreads start to really mean something, so please be careful and always use limit orders!
So What Do I Do?
Simple: You exercise patience and caution. Here are some steps to take to make sure you get a fair price when placing an order for a stock:
1. Enter a LIMIT order, and specify the price you want for the shares:
Usually the market maker will come in and fill your order and satisfy demand on both sides, provided they can make a profit on the transaction by buying and selling shares from one side to another, that’s how they make their money.
2. Choose a price roughly in the middle of the current bid/ask spread:
This is easier said than done sometimes, so be careful. For instance, if a stock is above $5 per share, choosing the middle is usually a good idea and will get your order filled just fine. But in the case of a penny stock, like the example above, odds are that you are going to have to actually place your limit order closer to the actual ask price and skew it towards the higher end, otherwise your order might sit there and never get filled. Try the middle first then you might need to adjust your order accordingly.
3. Stay patient:
It might take awhile to fill your order, especially with low volume or illiquid stocks. Place your order, and be patient.
4. Be prepared to move your limit price:
Sometimes the order just simply won’t get filled. As in the example above, placing your order between the bid and ask simply isn’t good enough. The market makers aren’t dumb either and neither is the software they use to calculate profit and loss on any one trade. You might need to move the needle somewhat, and take a little bit of a hit in terms of your price outlay, and pay a slightly higher premium to make sure you get shares. In fast paced markets, don’t be surprised if your order is ignored and not filled and you have to go in and change the order to get it filled.
5. Don’t be a penny-pincher:
If you buy a stock at $15, and it rises to $30, do you really even care that you “could” have bought it at $14.50 but the stock was rising and you decided just to get in? Set some standards for what you will pay, usually around 5% or so from where thought that the stock was a good buy, and just get in, don’t penny pinch. We are long term investors, not traders. A few cents won’t matter in the long run.
6. Don’t use All or None orders:
These are types of limit orders that specify that either all the shares you are selling or buying get transacted, or none of them do. This is good to do for larger volume companies, but in smaller ones, it will prevent you from at least getting a few hundred shares at the price you did want because there will rarely be someone there to take out all of the shares you wanted to buy or sell.
7. Just take the ask price:
Assuming you want a minimal amount of shares, just take the ASK price if the Bid/Ask spread is not too large (around 1-2% or less) and assure yourself of getting your order filled.
The buying and selling of penny stocks, or low volume stocks can be dangerous for those that are not aware of what’s going on. Wall Street market makers are in this to make money, not give you stock at the lowest possible price.
Learn to protect yourself with the information in this article and ensure that you aren’t caught off guard be the sometimes nefarious practices of these entities. Armed with this information, you can now make sound decisions about what price to pay for a stock, and more importantly, get in on a great opportunity when it presents itself without being burdened with the details of how to get the best price.
Chris Fernandez is the founder of PeakStocks.com, a recommendation blog, where he focuses on Micro-Cap and Small-Cap stocks since those are the types of stocks that he believes will earn you the highest return on investment over the long haul. To read a more detailed explanation of his investing style, please visit: PeakStocks.com