Following on from the previous post, the general process of trading stocks on an exchange is that an order comes through a broker or online platform. That broker then posts to the exchange at what price he wants to buy (bid) or sell (ask) the stock. If another market participant is willing to accept the other side of the transaction the exchange will facilitate that process and “match” the order (all done by computer).
The current price is the highest price any buyer is willing to pay and the lowest price someone is willing to sell. The price difference between the buy and seller is called the spread. In busy markets the spread might be very small, in slow markets that gap between buyers and sellers could be quite large.
Let me give you a simplified example of the matching process that the exchange uses to match buyers and sellers. Assume I have 20 shares of a rarely traded stock, let’s call it Hypothetical Industries (HPI). Yesterday a single share was sold for $100.
Because it’s rarely sold, there will be many buyers offering different amounts depending on how much they want the stock. Someone might offer to buy 10 shares at $80. Someone else might offer to buy 10 shares at $90. There is also someone hoping to sell their 10 shares at $150.
I decide to sell my shares, but won’t accept anything less then $120.
At the moment, the exchange order book – or list of buyers and sellers – consists of 4 items. Two buy and two sell. The spread is currently $120 – $90 = $30. No transactions will happen because no pair of traders have yet agreed on the same price.
Someone now tells their broker to buy 25 shares of HPI at any price. Because I’m selling at $120, the exchange will immediately match me and the new buyer. I’ll sell all of my 20 shares at $120. Because the buyer wanted 25 shares, they will then be matched by the exchange to the next highest price and pay $150 for the remaining 5 shares. This matching of different prices is called slippage and considered a cost of doing business on the exchange.
You might have seen this when reading some stock recommendation: “Buy HPI up to $110.” Which means buy it now, as long as you don’t pay more than $110 per share.