Many exam candidates struggle to understand the terms involved with trading securities. This is only possible if the candidate has never entered his or her own orders online. I, on the other hand, knew exactly how to explain bid-ask, stop, limit, etc. for the first Series 7 class that I ever taught for the big company in this industry. That's because I had entered all types of market, limit, and stop orders for both stocks and bonds through my TD Ameritrade accounts. But, if you haven't done that, you'll probably need some extra help. So, here goes.
There are broker-dealers out there who act as "market makers" and step in between buyers and sellers of stock. You and I don't want to find buyers and sellers, so we go through a dealer/market maker. Let's say Goldman makes a market in MSFT. They publish:
BID: $25 ASK: $25.10
Just like at Sotheby's sellers always sell to a bidder--so we can get that $25 bid right now if we want to sell our MSFT. Buyers always have to pay the ASKing price--so we can buy MSFT for $25.10. That little 10cent per share is Goldman's "spread," and they make money by running as many transactions as possible in which they pay somebody a lower price and immediately sell to someone else at a slightly higher price.
It's a two-sided "coin," in which the test can haze you. Do market-makers buy at the BID, or do customers sell at the BID price? Yes--that's what happens. Customers can sell to the market maker, who will buy at the BID price.
Do market-makers sell at the ASK price, or do customers buy at the ASK price?
Exactly right.
A limit order is used if you don't like the BID-ASK prices. You don't want to pay $25.10? Put in a buy-limit order at $24. If the ask price drops to $24 or lower, you buy the stock. If it doesn't drop, you don't. You want to sell but get more than that $25 bid? Place a sell-limit order at $26. If the bid rises to $26 or higher, you'll sell. If it doesn't rise, you won't.
