Investing in the stock market may seem intimidating at first, but understanding how stock transactions work can help you make smarter decisions. Whether you’re a long-term investor or an occasional trader, knowing the mechanics of buying and selling stocks ensures that you get the best prices and avoid unnecessary costs. This article will explain the fundamentals of bid and ask prices, market makers, order types, and trade settlement, all in simple terms.
How Stock Transactions Work
When you buy or sell a stock, there isn’t always another person on the exact other side of the trade. Instead, transactions are facilitated by market makers and wholesalers who ensure that trades happen smoothly. Here’s a breakdown of the key players:
1. The Bid and Ask Prices
- The Bid price is the highest price someone is willing to pay for a stock.
- The Ask price is the lowest price someone is willing to sell the stock for.
- The difference between these two prices is called the Bid-Ask Spread.
- Market makers profit from this spread by buying at the bid price and selling at the ask price.
For example, if you want to buy a stock, you will have to pay the ask price, while if you sell a stock, you receive the bid price.
However, the ask price can vary across different brokers due to differences in how they route orders. Some brokers offer better pricing through smart order routing and direct exchange access.
Which Brokers Offer Better Ask Pricing?
- Fidelity – Consistently ranked among the best for price execution and doesn’t accept Payment for Order Flow (PFOF).
- Interactive Brokers (IBKR) – Offers direct exchange access, lower spreads, and price improvement.
- Charles Schwab – Has good execution quality, but some order flow is routed through wholesalers.
- TD Ameritrade – Decent execution, but like Schwab, it routes through wholesalers.
- Robinhood / E*TRADE / Webull – Uses PFOF, meaning execution may not always be the best, but offers commission-free trading.
How to Get the Best Ask Price When Buying a Stock
- Use Limit Orders – Prevents you from overpaying by setting a fixed purchase price.
- Trade During Regular Hours (9:30 AM – 4 PM ET) – Avoid pre-market/after-hours, where spreads are wider.
- Choose a Broker with Better Execution – If you trade frequently or make large purchases, consider Fidelity or IBKR for better pricing.
2. Market Makers and Wholesalers
Since buyers and sellers don’t always match up perfectly, market makers step in to ensure liquidity (the ability to buy or sell quickly without big price changes). These firms, such as Citadel Securities and Virtu Financial, profit by managing the difference between bid and ask prices.
Similarly, wholesalers handle retail broker orders behind the scenes, often offering small price improvements but also making profits from trade execution. Some brokers, such as Robinhood or TD Ameritrade, sell orders to wholesalers in a process called Payment for Order Flow (PFOF). While this allows commission-free trading, it may not always guarantee the best price.
3. Clearing and Settlement
After a trade is executed, it must go through a clearinghouse, such as the Depository Trust & Clearing Corporation (DTCC). This process ensures that the buyer receives the shares and the seller receives the money. Currently, trades settle in T+2 (two business days after the trade), but the system is transitioning to T+1 in 2024, making transactions faster.
How This Affects You as an Investor
Now that we understand how trades are processed, let’s look at how this affects different types of investors.
A. Long-Term Investors (Buy-and-Hold Strategy)
If you are investing for the long term (such as buying dividend stocks or ETFs), here’s what you should consider:
- Use Limit Orders for Large Investments: A limit order lets you buy a stock at a specific price, preventing you from overpaying in volatile markets.
- Avoid After-Hours Trading: Prices fluctuate more in pre-market and after-hours trading due to lower liquidity, leading to wider bid-ask spreads.
- Monitor Order Execution: Some brokers route your trades to wholesalers, meaning you may not always get the absolute best price. If this concerns you, consider brokers with direct exchange access (e.g., Fidelity, Interactive Brokers).
- Understand Trade Settlement Timing: Starting in 2024, trade settlements will complete in one business day (T+1), meaning you’ll get your funds or stocks quicker when selling or reinvesting dividends.
B. Active Traders (Short-Term Strategies)
If you occasionally trade around core positions or engage in short-term stock movements, here are some additional strategies:
- Use Limit Orders Instead of Market Orders: Market orders execute at the best available price, which can be unpredictable. A limit order guarantees your price but may take longer to fill.
- Be Cautious at Market Open and Close: The first and last 10 minutes of trading are often the most volatile. Prices fluctuate rapidly, and bid-ask spreads can widen.
- Watch for Hidden Costs in Order Flow: If you trade frequently, understand how your broker handles order routing. Some brokers offer price improvement features for active traders.
- Take Advantage of Faster Trade Settlements: With T+1 settlement, reinvesting profits or switching positions will become more efficient.
Key Takeaways
- Bid and Ask prices determine what buyers pay and sellers receive, with market makers profiting from the spread.
- Ask prices can vary across brokers, with some offering better execution through smart order routing and direct exchange access.
- Market makers and wholesalers ensure smooth trading, even if no direct buyer or seller is available.
- Trades go through a clearinghouse before settlement, ensuring the exchange of money and shares.
- Use limit orders to control your buying price, and avoid trading during volatile periods for better execution.
- The move to T+1 settlement in 2024 will speed up transactions, helping investors reinvest dividends and rebalance portfolios faster.
Understanding these mechanics helps you execute better trades, avoid unnecessary costs, and build wealth more efficiently. Whether you’re a beginner or a seasoned investor, applying these principles ensures you get the best value for your investments.
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