The Auction Market
Within each trading pit, offers to buy and sell are shouted out in an auction style known as "open outcry." The vocalization of prices is key to the whole exchange as it allows every trader an equal opportunity to participate (in theory), allowing for a smoother flow of prices and opportunity.
The bid is the highest price the floor is quoting for the purchase of a commodity contract. The offer is the lowest price the floor is quoting for the sale of a commodity contract; also known as the ask. The difference between the bid and offer (or ask) is the bid/ask spread. This is known as the market. Typically when people think of a market, they think of a single price. However, markets are made up of bids and offers. The combination of a bid and offer is a market.
Traders wishing to buy a futures contract shout out bids, while traders wishing to sell a futures contract verbalize their offers. This is what is referred to as the market price, the highest bid and lowest offer. The spread between the bid and ask is how most of these guys and gals make a living, buying the bid and promptly selling the offer, hopefully pocketing the difference before prices can change against them.
The bid represents the highest price the floor is willing to pay. This is the price that the public sells at and the floor buys at. The bid is always lower than the offer or asking price. Being able to buy at the bid and sell at the offer is one of the privileges of exchange membership.
The ask, or offering price, is the price the floor is willing to sell contracts at. This is represented as the lowest price, which they are willing to sell at. If one were to buy a futures contract, more than likely this would be the price they would pay.
Most of the shouting one hears on the exchange floor is the posting of bids and offers. For example trader A may yell "215 for 10!" while trader B would respond "ten at 216." Trader A has indicated that he is willing to buy 10 contracts at 215 ($2.15 per bushel), wile trader B responded that she is willing to sell 10 contracts at 216 ($2.16 per bushel). This jockeying for position is carried out thousands of times a day, with trader C maybe bidding 2151/2 on 30 contracts and trader D responding with an offer of 50 contracts at 2153/4. If trader X hears that trader D is willing to sell at 2153/4, trader X may yell "Sold" indicating that he is willing to pay (buy) 50 contracts at 2153/4, and a trade is consummated.
The tendering of bids and offers makes up much of the noise and mayhem on the trading floor. Bids and offers are yelled out as loud as possible, so everyone can hear. Traders in the pit have to pay attention to others bids and offers as the highest bid and the lowest offer must be fulfilled before another bid or offer can be placed.
Using our example, trader X buys 50 contracts from trader D at 2153/4. Trader X then may bid to buy more at 2151/2the highest bid in the pitor higher. If he bids 216, then trader B, who was offering to sell at 216 would sell his/her contracts to him. Or, given that trader X bought 50 at 2153/4, trader B may change his offer to 2161/4 and the shouting continues.
If you ever find yourself in Chicago, be sure to visit the Chicago Board of Trade and Mercantile Exchanges. Both exchanges have a visitor's gallery that overlooks the trading floor. If you place your hand up to the glass of the visitor's gallery you can feel the noise. Seeing the action in the trading pits gives you a new understanding of how a market operates, and the job of floor brokers, traders, and such.
This system, which seems clumsy and chaotic at first, is highly effective once it is understood. Because all transactions are done in "open outcry" everyone has an equal shot at the orders, ensuring fair pricing in the commodities markets. Although this system is extremely effective, in recent years a move has been underway to end the open outcry trading pits, replacing them with electronic screen-based trading. The shouting of bids and offers would be replaced by bids and offers posted on screens. Though much less glamorous, screen-based trading is effectively the same system, with microchips and processors replacing the loud voices of exchange members.