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Say I wanted to short ABC Company because I believe the stock price will go down 7% or more. The ask price is $6 and the bid price is $5. Volume is 4-5 Million shares. I decide to short $2000 dollars worth of shares.

This is where I get confused. Would I be paying ask or bid price? And if I was paying ask price, would the ask price have to go below $5 dollars before I would make any profit?

I'm just confused if my whole trading strategy is viable if the bid/ask spread is large. Thanks!

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Terminology

Bid

A bid is an offer to buy something on an order book, so for example you may post an offer to buy one share, at $5.

Ask

An ask is an offer to sell something on an order book, at a set price. For example you may post an offer to sell shares at $6.

Trade

A trade happens when there are bids/asks that overlap each other, or are at the same price, so there is always a spread of at least one of the smallest currency unit the exchange allows.

Shorting

Betting that the price of an asset will go down, traditionally by borrowing some of that asset and then selling it, hoping to buy it back at a lower price and pocket the difference (minus interest).

The process

So, let's say as per your example you borrow 100 shares of company 'X', expecting the price of them to go down. You take your shares to the market and sell them - you make a market sell order (a market 'ask'). This matches against a bid and you receive a price of $5 per share. Now, let's pretend that you change your mind and you think the price is going to go up, you instantly regret your decision. In order to pay back the shares, you now need to buy back your shares as $6 - which is the price off the ask offers on the order book.

Because of this spread, you have lost money. You sold at a low price and bought at a high price, meaning it costs you more money to repay your borrowed shares. So, when you are shorting you need the spread to be as tight as possible.

  • You would also want as tight a spread as possible if you were going long. It is the same just in opposite directions. – Victor Jan 27 '16 at 9:28
  • Yes, generally when trading you always want as tight of a spread as possible, regardless of strategy. – William Dunne Jan 27 '16 at 9:29
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It this a real situation or is it a made up example? Because for a stock that has a last traded priced of $5 or $6 and volume traded over $4M (i.e. it seems to be quite liquid), it is hardly likely that the difference from bid to ask would be as large as $1 (maybe for a stock that has volume of 4 to 5 thousand, but not for one having volume of 4 to 5 million).

In regards to your question, if you were short selling the order would go in exactly the same as if you were selling a stock you owned. So your order would be on the ask side and would need to be matched up with a price on the bid side for there to be a trade.

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