Here, I want to share some very basic knowledge about how auctions work. I’ll explain it using an example, taking the ES (E-mini S&P 500) future. The tick size (smallest possible price change) is $0.25.
I’ll assume that the current bid price is $4000, and the current ask price is $4000.25.
Bid Price
The bid price indicates that there are buyers who have placed buy limit orders with a limit price of $4000 or lower on the stock exchange. These buyers are only willing to buy at $4000 or below. So, if anyone wants to sell their contract using a market order, it will be sold at $4000.
Ask Price
The ask price indicates that there are sellers who have placed sell limit orders with a limit price of $4000.25 or higher on the stock exchange. These sellers want to receive at least $4000.25 or more for their contracts. In this case, if anyone wants to buy a contract using a market order, it will be bought at $4000.25.
In other words, some buyers have a maximum price they are willing to pay, and some sellers have a minimum price they want to receive for their contracts. Market participants who simply want to buy or sell a contract use market orders, which means they are willing to accept the prevailing market conditions, either the bid or ask price. This is unless there is a simultaneous buy market and sell market order at the same time.
Spread
The difference between the ask and bid prices is called the spread. The spread tends to be narrower in markets with higher liquidity.
Slippage
Slippage occurs when there is a significant imbalance between buyers and sellers at a particular moment. To illustrate with our example, if a majority of market participants believe the ES will rise, there will be many market buy orders and fewer limit sell and market sell orders. Let’s use hypothetical numbers:
Suppose there are market buy orders for 1000 ES contracts at $4000.25, and on the other side, there are sell limit orders for only 200 ES contracts at $4000.25. Then, at $4000.50, there are 200 contracts, and so on.
For the market order buyers: The first 200 buy at $4000.25, the next 200 buy at $4000.50, and so forth. So there will be some market order buyers who pay more than the original $4000.25 ask price.