In the age of coronavirus, many individual stocks have experienced significant volatility with their stock price and some investors have encountered meaningful discrepancies between the buy and ask price of a particular stock.
Most stocks that are discussed on this site are highly liquid blue-ship stocks. This means that the price of the stock tends to trade in penny-by-penny increments. For instance, if Coca-Cola stock is trading at $48.32 per share, there is probably someone offering to buy the stock around that range and also someone trying to sell the stock around that range.
However, with thinly issued stocks such as micro-cap banks, the gap between the bid and ask price can be quite significant. In particular, the ask price of the stock may sometimes appear to you to be triple or even quadruple the most recent sale price of the stock. When you see this, you might wonder whether a seller is actually expecting that a buyer will pay such an absurd price for a particular stock.
The answer is usually no. The reason investors place an order with their brokerage to sell their stock at a price that dramatically exceeds the most recent sale price is because they do not want their stock to become available to short sellers.
Most people do not know this, but one of the ways that a brokerage house makes money is by taking their customers’ stock holdings and lending them to a short seller (for a fee) who is betting on the price of the stock to decline.
Due to SEC rules, brokerage houses are not allowed to allow short sellers to borrow “pledged” stock from their customers. A stock becomes pledged once there is some type of outstanding limit price sale pertaining to it. For instance, if you own 100 shares of Coca-Cola, and just let it sit in your brokerage account, Charles Schwab or Interactive Brokers or whatever entity serves as your brokerage is allowed to take that stock and lend it to borrowers for a period of time without providing you with notice. They keep track of this information on the back end through the clearinghouse.
This can create a downward pressure on the price of the stock that could cause it to decline in value. However, once someone places a limit order to sell a particular stock, the brokerage house is no longer legally allowed to let short sellers borrowed the stock. As soon as you place a limit order to sell your Coca-Cola stock at a price of $4,000 per share, the brokerage house can no longer allow short sellers or anyone else to borrow your stock even though it is effectively not for sale since the proposed sale price is over 80x greater than the most recent sale price.
Another reason why you might see some investors place a very high limit-sell order is because they want to take advantage of a “fat finger” or other market discrepancy that can sometimes exist in the market for thinly traded stocks. For instance, if you own 100 shares of a regional bank that is trading at $15 per share, you can enter limit sell order at $60 per share with the hope that someone on the buy side accidentally places a market order for the stock when no one else is trying to sell the particular stock at that moment in time. This type of scheme is usually difficult with most major brokers since they typically adopt a policy of informing market participants when the ask price is significantly higher than the most recent sale price, but sometimes a novice buyer does not fully appreciate the consequences and buys the stock any way.
Normally, this is not an issue for investors because there is usually a seller willing to sell the stock at a close price point to the most recent sale price. However, as a result of the present unusual circumstances, many stocks are now experiencing gaps in trading where the only ask price is sometime not seriously trying to sell the stock. Instead, they are motivated by a desire to counteract their brokerage’s ability to offer the stock to short sellers, or they might be the exploitative investors who have been their all along hoping that someone inadvertently pays too much, but the present market conditions are providing an opportunity for this opaque corner of market-making to reach the ordinary investor.
