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What are Bid/Ask Spread & Market Impact?

TL;DR: Prices on Google/Yahoo Finance are not tradable prices.

One of the most common bug reports we receive is that trades didn’t get executed at the same price as Google/Yahoo Finance. Ironically, the discrepancy results from several of our most distinguishing features. This post details the reasons behind the differences and demystifies our trade pricing methodologies.

Bid/Ask Spread

Traders coming from other virtual trading simulators have been trained to believe that the “last quote” – the price on Yahoo or Google Finance – represents the most up-to-date, tradable price. This is unfortunately not true in real life.

Financial transactions involve a bid/ask spread:

  • The bid price is the highest price that a dealer is willing to pay for a security (equivalently, it is the most an investor can sell a security at);
  • The ask or offer price is the lowest price that a dealer is willing to sell the security at (equivalently, this is the least that an investor can buy a security at).

The ask price is always higher than the bid. This way, a dealer can buy the security at bid, then sell it to another investor at the higher ask price, and make a profit by facilitating these trades.

The picture below shows the real time quotes for BOX. As you can see, the last price that it traded at is 17.5. This is the price that is quoted on Yahoo/Google Finance, and this is the price that many traders expect to be able to get when they trade BOX. However, if you look at the bid/ask, you can see that the price at which you can buy BOX (ask) is 17.99, while the price at which you can sell BOX (bid) is only 17.3. The lesson here is that the last price plays no role in the next transaction.

Bid/ask spread of BOX

The bid/ask spread (i.e., difference between bid and ask) is usually very tight (just 1 cent), but can be very large for some securities and in certain market environments. If we had ignored bid/ask, we would’ve enabled some very profitable and yet completely unrealistic strategies to occur on Stockfuse. Take a look at the stock chart for AMD below. In the last 45 minutes of trading, the “last price” of AMD appeared to be jumping between 2.66 and 2.67. In reality, however, the price didn’t change at all – buyers were buying at 2.67 and sellers were selling at 2.66. When a buy order is executed, Google/Yahoo shows 2.67; and when a sell order is executed, Google/Yahoo displays 2.66. Ignoring this bid/ask spread, investors could buy at 2.66 and sell at 2.67 on a virtual simulator, doing it numerous times to capture a potentially sizable profit. Stockfuse does not allow such unrealistic arbitrage opportunities to take place.

Bid/ask bounce of AMD

Market Impact

Going back to the BOX example, we now know that investors must purchase the stock at the ask price of 17.99, but the ask size at the time was only 100 shares. If you purchase more than 100 shares, the execution price can potentially rise even more. This is known as market impact.

When you execute a large buy order, you incur market impact cost for several reasons:

  • The price must be raised in order to attract sellers to the market to sell to you;
  • You are signaling to the market that you believe the fair value of the stock is higher than its current price, and other market participants will account for this in their pricing and increase the equilibrium price.

Other virtual trading platforms ignore market impact, which allows investors to trade in and out of millions of shares of a penny stock at a time, capturing unrealistic profits. These orders, in real life, could 1) take days to execute if not longer, and 2) raise the market price substantially along the way.

Stockfuse uses a proprietary transaction cost model to compute the market impact for each trade. In some cases, this can move the final execution price further away from the last quoted price.

So how large is the overall transaction cost? It depends on the order size (quantity), liquidity (e.g., volume), trading environment (e.g., volatility), etc. We studied every trade executed on Stockfuse over the last week and here’s the breakdown:

  • 57% of the trades incurred cost between 0 and 0.5 cents per share.
  • 26% of the trades incurred cost of 0.5–1 cent.

So over 83% of the trades incurred less than 1 cent of transaction cost. The remaining orders were generally large trades in illiquid penny stocks.

We hope this post demystifies the pricing methodology on Stockfuse. At Stockfuse, we take the integrity of trading performance very seriously. Our goal is to provide realistic simulated trading performance that’s actually obtainable in the real market. At times, this creates the perception that we’re providing unfavorable pricing, but this is what trading is like in real life and we want our users to be mindful of these “hidden costs” when they begin trading in the real world.