Markdown: What it is, How it Works, Special Considerations

What Is a Markdown?

A markdown in finance is the difference between the highest current bid price among dealers in the market for a security and the lower price that a dealer charges a customer. Dealers sometimes offer lower prices to stimulate trading; the idea is to make up for the losses with extra commissions.

Key Takeaways

• A markdown in finance is the difference between the highest current bid price among dealers in the market for a security and the lower price that a dealer charges a customer.
• Subtracting the price on the inside market from the price a dealer charges retail customers gives a spread. This spread is known as a markdown if it is negative; it is called a markup if it is positive.
• Markups are more common than markdowns because market makers can usually obtain more favorable prices than retail customers.

Understanding Markdowns: Bids and Spreads

In finance, bid prices are how much buyers offer to pay. Ask prices are the amounts that sellers are willing to accept. The difference between the highest bid price and the lowest ask price is called the bid-ask spread.

The inside market represents the best bid and ask price. These prices give the most accurate idea of the stock’s current market value. These bid and ask prices are often available between market makers and other institutional investors rather than retail investors.

Markdowns and Markups in Finance

Subtracting the price on the inside market from the price a dealer charges retail customers gives a spread. This spread is known as a markdown if it is negative. The spread is called a markup if it is positive.

Markups are more common because they allow brokers to make a profit when selling shares from their inventory to retail investors. That said, markups are usually small, and the SEC has rules against excessive markups. Market makers can usually obtain more favorable prices than retail customers. Market makers can buy securities in bulk and have access to inside market prices. When they buy and sell securities, they make markets more liquid.

However, there are situations where markdowns occur. For example, a municipal bond issue might not have as much demand as a dealer thought it would. In this case, they might be forced to reduce the price to clear their inventory. Dealers might believe that by marking prices down, they can generate enough trading activity to make up for their losses through commissions.

Financial firms do not have to disclose markups and markdowns in principal transactions. However, they do have to in some situations.

Markdowns and Disclosure

It is important to note that financial firms do not have to disclose markups and markdowns in principal transactions. So an investor can easily be unaware of the price difference. However, there is an exception: markups and markdowns on sales of fixed income securities to retail customers must be disclosed if the firm offsets the trade on the same day with other principal trades in the same security. A principal transaction occurs when a dealer sells a security out of its own account and at its own risk. An agency transaction occurs when a broker facilitates a transaction between a customer and another entity.

In the U.S., many companies combine the roles of broker and dealer. These firms are broker-dealers. When you purchase a security from a broker-dealer, the financial transaction might be either a principal transaction or an agency transaction.

Broker-dealers are required to disclose how a trade is completed in the trade confirmation, along with any commissions. However, they are not required to disclose markups or markdowns, except under certain circumstances.

Special Considerations: Excessive Spreads

Regulators generally consider markups and markdowns of more than 5% to be unreasonable, but this is only a guideline. Markdowns of more than 5% can be justified in light of prevailing market conditions. Relevant market conditions include the type of security, the dealer’s broader pattern of markups and markdowns, and the price of the security.

As a general rule, the best brokers keep spreads far below excessive levels because of intense competition in financial markets. High spreads are also more likely to be an issue with thinly traded securities.

As a general rule, the best brokers keep spreads far below excessive levels because of intense competition in financial markets. High spreads are also more likely to be an issue with thinly traded securities.