Finance: Bid/Ask spread helps lower-priced stocks?

My understanding is that any time a transaction takes place, there is a spread between the selling price asked and the buying price bidded. The transaction always occurs at a slightlyhigher price than the current market price. On top of this, the market makers on the floor take a slice of this, which pushes the transaction price up a little more (am I right about this last part or do they take a slice off the existing transaction price?).

Theoretically, shouldn’t a stock with a lower per share price benefit more from these small increases, since the increases are a larger percentage of the market price?

Is the bid/ask spread smaller for lower priced stocks?

You make (or lose) money by buying low and selling high. It’s the difference between the buy and sell price that matters – the absolute value of the price is “almost irrelevant” from a trading perspective.

Actually, the spread is usually higher since there’s more risk involved – lower priced stocks usually reflects companies in not exactly perfect shape. Plus, there’s just less people trading the low priced stocks (lower volume).

For a comparison, go to www.island.com and take a look at the books for EBAY ($78 per share) and AKAM ($1.40 per share) (type the symbols in the upper left hand corner of the page).

You are not understanding when I say benefit. I mean, couldn’t a stocks’ returns be 10% for the year due to the normal market conditions and 5% for the year due to the millions/billions of transactions that went through at a slgihtly higher price than the market quote?

Maybe the market adjusts the price to not let this spread affect the price?

If I buy one share of stock or ten shares, and the current quote is $20 and the transaction goes through at $20 1/16, and then i buy another ten shares two seconds later, with the current quote being $20 1/16 and it goes through $20 1/8 and if I do this again 1 million times within the day, the stock price will be $62,520!!! What I am asking is, what type of adjustment is made for this?

Summary: Does the bid/ask spread and the market makers’ take affect the stock price? I am a Finance major so I won’t have much use for basic explanations about the market, just specific transaction info.

Thanks.

The adjustment is that YOU had to keep being irrational and buying for more and more. If a buyer will keep buying at higher and higher inflated prices, then the price of the share needs to go up, to reflect all the demand. In real life, the subsequent prices are just as likely to be LOWER on a subsequent transaction versus higher. Also, the market uses cents now instead of eighths and sixteenths, so that probably explains half of it for you. Good luck in school.

One more thing: there’s probably some truth to what you are saying for the first couple of trades (percentage-wise), but investment opportunities are accurately measured in absolute reutrn, not percentage return. For example, would you rather make a 100% return on $1 or make a 5% return on $100?

The bid-ask spread as a proportion of the price is proportionately greater for lower-priced stocks. For a stock ‘worth’ 1.00, you buy for 1.01 and sell for 0.99, the b-a spread will take about 2% off your return, exclusive of commissions. This is how most brokers make money, not from commissions, but from this ‘spread’, which they will tell you is for providing a liquid market and bearing risk, but others will say is for having some market power (especially floor specialists on the NYSE).

Note that if the price at close bounces from bid to ask, 0.99 to 1.01, the daily returns would be +2.02% and -1.98%, for a daily average>0, even though, by assumption the price hasn’t moved. This is why you should always use geometric averages instead of arithmetic averages. It can make a big differences for really high frequency (> once a week) trading strategies.

That’s what I was wondering about. So you and Daniel are in disagreement?

Daniel, I always thought the transaction always went through at a higher price than the current quote, even if there is selling pressure, is this not true?

Also, it doesn’t matter how opportunities are measured, it’s how they are realized. If I own a stock that is priced at $30 and it splits 2:1 twice, then the price is $7.50. Now that it’s $7.50, i have four times as many shares and any bid/ask spread will benefit me 4x as much. Now, let’s say the trading volume was 1M for the day… that’s a lot of bid/ask spread benefits, equalling say 2% on maybe, which would raise my realized gain if i were to sell. Do you agree?

Mainly I am asking this question because i was wondering if having a really high priced per share stock hurts returns. I know that a high price causes the stock to be less attractive to small investors and large mutual funds, but i am talking about technical issues here. I am assuming there is a mechanism that prevents this kind of price manipulation, i am just asking what it is.

This is incorrect. The transaction will occur at exactly the same price point for both sides. When you try to buy a stock using a market order, your order will usually be executed at the current asking price. However, you have an option of placing a limit order inside the bid/ask spread and not settling for the asking price.

Let me know if you are interested in specifics of order handling, as they differ between NASDAQ and NYSE.

There are no small increases. Bid/ask spread is usually larger in percentage terms for lower priced stocks.