In everyday life, you face only one-way prices, either to buy or to sell. Be it buying groceries, or selling old newspapers, you get just one price.
You can haggle on the price, but you cannot sell groceries to the kirana shop or buy old newspapers. Yes, you might find both buy and sell rates in a jewellery shop, which sells gold at Rs4,900 and buys old gold at Rs4,300.
But, in the world of finance, you will get both buying and selling prices at the same time. These are called ‘bid-offer’ (B&O) prices.
ACC shares - Rs1,890 – Rs1,910
1 month interest rate – 2.28% – 2.34%
Option premium – Rs4.45 – Rs4.80
Which is which?
A simple rule: Whichever you want to do, buy, or sell, you will get the worse of the two rates.
If you are buying ACC shares, the better rate for you is Rs1,890. Sorry, you will have to pay Rs1,910.
If you are selling, you will get the worse (for you) rate – Rs1,890.
If you are borrowing, you will pay 2.34%, if lending you will earn 2.28%.
The difference between the two rates is called the spread.
The gold prices in first para have a spread of Rs600, a huge 13%. In the international market, spreads are tiny.
A pound/dollar rate of 1.3815-16 means that the bid-offer rates are Pound 1 = Dollar 1.3815 and 1.3816.
Here the spread is just 0.0001, commonly called one pip.
One more thing to remember.
The left-side price (never mind what it is called) is ALWAYS lower, and the right-side price is higher.
If the RHS bid seems lower than the LHS bid, that is not so. For example, the ACC quote of Rs1,895-05 does not means 1,895-1,805. It means 1,895-1,905. Similarly, 1,890-00 means 1,890-1,900.
Now you can face any bid-offer price confidently.
If you are the curious and questioning type, you are probably asking yourself “what is in it for the guy who quotes these bid-offer prices?”
The answer is just one word – spread.
The person who quotes makes money on the spread. Here is how.
Consider a guy who quotes ACC all day long. He is a market-maker (MM). Others come to him to buy or sell because he always has a firm price for them to transact. Every item has a standard ‘market lot’, say, 100 shares of ACC.
Take a day when the market opens. ACC has been trading at fairly steady prices and had closed at 1,850 the previous evening.
MM will start with an opening quote of 1,845-55, meaning he buys ACC at 1,845 and sells at 1,855, 100 shares per transaction.
The first customer comes along, asks the price, and sells 100 shares to MM at 1,845. Now MM is plus 100 ACC shares, or ‘long 100’, at 1,845.
MM changes his quote to 1,843-53. Please note that he shifts his quote a little bit, to the side where he has been ‘hit’.
If the next customer buys ACC at 1,853, MM squares off with Rs800 profit. But if this customer also sells ACC, this time at 1,843, MM becomes 200 ‘long’, and his next quote is 1,841-51.
The other MMs dealing in ACC may still be quoting 1,845-55, or something close to that.
Hence, compared to the market price for you to buy ACC shares, viz., 1,855, our MM friend is quoting 1,851, whereas the market will buy ACC at 1,845 while our MM will pay only 1,841.
Thus, our MM’s quote is the best for anyone buying ACC, and the worst for anyone selling.
If the next customer in the market is a seller of ACC, he will not come to MM, but if he is a buyer, he will. MM’s quote has become one-sided, intentionally, because MM wants someone to buy ACC from him.
Sure enough, the next customer for our MM is a buyer of ACC, who buys 100 shares at the best rate going – 1,851.
Now our MM is only 100 ‘long’.
Look at his ‘position’ after these three transactions.
- Bought 100 shares at 1,845
- Bought 100 shares at 1,843
- Sold 100 shares at 1,851.
Net position – he owns 100 shares at a price of 1,837 (1,845 + 1,843 – 1,851). Already he is in profit, because if other MMs are quoting 1,845-55, he can sell his 100 shares at 1,845 and earn Rs800.
Better still, he can continue to offer an attractive price to anyone buying ACC, say 1,842-52, which is still better for a buyer of ACC than the other market quotes (1,852 versus 1,855).
If a customer now buys 100 shares from our MM at 1,852, he ‘squares’ his position, i.e., brings his holding of shares to zero, and makes a profit of Rs1,500.
The MMs buy and sell all day long, making a small profit every time. Multiply this by hundreds of transactions, involving lakhs of shares, and yes, MMs do make money.
Today, a lot of this is done by machines through what are called algorithms.
In a steady market the spread is tighter, maybe Rs5 for ACC. If the market is volatile, the spread will widen, perhaps to Rs20.
Mind you, our MM does not have any particular ‘view’ about ACC shares.
In fact, he does not care whether ACC goes up or down, as long as people buy and sell through him.
If the price is volatile, so much the better, because more people will buy or sell, his spread is bigger, and he earns even more.
If our MM does have a ‘view’ or an overnight ‘position’, he will slant his starting quote accordingly.
If he is ‘long’, or expects ACC to fall, he will make his quote attractive to buyers, e.g., 1,840-50 when the other MMs are at 1,845-55.
Of course, MMs can be hit by a sudden catastrophe.
When Ronald Reagan was shot, the US dollar dropped sharply within a minute. But such calamities can happen in any business at any time.
Now that you know all about the B&O stuff, do not let the numbers faze you.
(Deserting engineering after a year in a factory, Amitabha Banerjee did an MBA in the US and returned to India. Choosing work-to-live over live-to-work, he joined banking and worked for various banks in India and the Middle East. Post retirement, he returned to his hometown Kolkata and is now spending his golden years travelling the world (until Covid, that is), playing bridge, befriending Netflix & Prime Video and writing in his wife’s travel blog.)