Interpreting the bid/ask spread requires different skill
sets than reading changing prices on the ticker tape. This poorly understood supply/demand
engine compresses and expands constantly, responding to shifting market conditions. But
most spread movement reveals nothing more than pure noise and has little directional
value. While scalpers can use these frequent choppy periods to grab quick profits,
technical traders should stand aside and wait. Directional signals will erupt from the
spread regularly and allow them more rewarding entries.
Bid/ask is a highly efficient market distribution
mechanism that presents a constant moving target for traders. There are 6 components to
predicting price from the spread: strong ask, neutral ask, weak ask, strong bid, neutral
bid and weak bid. Follow the tape with a focus on these forces and youll access
excellent short-term momentum data.
When conditions create volatility or imbalance, the spread
widens and price tends to surge farther on fewer shares. While this movement can be
nerve-wracking, it also provides most of the profit potential the day trader is likely to
The electronic markets operate differently than the listed
exchanges. NASDAQ Level I shows only the best bid/ask underlying their competitive market
maker system while Level II lists all the players chasing the inside price. A single
specialist and several third party exchanges direct all the action on the NYSE. The size
of available shares shown on the tape tends to be accurate on the listed exchanges. But
NASDAQ size remains highly deceiving. While the drab 10x10 mystery lots of prior years are
gone, both execution and bid/ask displays are marred by exchange rules designed to profit
insiders and hurt both investors and traders.
Although the marketplace ultimately decides price
direction, specialists and market makers constantly use their inside knowledge to trigger
volume and profit their own accounts. Specialists have the "little black book"
that shows the location and size of all stop orders. Market makers have a similar
advantage with Level III. In the absence of more pressing market conditions, insiders will
always push price in the direction they expect the most volume or one that will set up
their own accounts for the most gain.
A quiet neutral, neutral-negative bid/ask or high volume,
high negative bid/ask can both provide favorable trading environments for the short-term
trader ready to go long. In neutral markets, cash waits for opportunity and price can jump
quickly when it appears. And wide, highly negative bid/ask spreads in very active markets
often signal a short-term bottom and offer quick bounce profits.
Serious traders also watch tick, breadth and index to
predict the impact of the ticker tape. Use these measures to locate convergence-divergence
with individual price action. For example, index movement provides highly accurate
prediction on short-term direction for many individual stocks. Use them to filter entries
during corrections and to locate key reversal zones. Avoid long positions when an
underlying index violates key support, even when the tape is improving.