Markdown

A markdown 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 will sometimes offer lower prices in order to stimulate trading; the idea is to make the money back in extra commissions.

In the market for a security, bid prices are the prices that would-be buyers are offering, while ask prices are the prices that would-be sellers are offering. The difference between the highest bid price and the lowest ask price is called the bid-ask spread. The inside market, or the trading in a particular security that occurs between market makers (dealers that meet certain criteria), is usually characterized by lower prices and smaller spreads than the market for retail investors.

The difference, or spread, between the price that a dealer charges a retail customer for a security and the price on the inside market is known as a markdown, if the spread is negative, or a markup, if it is positive. Markups are more common: since market makers buy securities in bulk, and since inside markets are more liquid, they can usually obtain more favorable prices than retail customers.

This is not always the case, however. 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 mark down the price in order to clear their inventory. Or they might believe that by marking a security's price down, they can generate enough trading activity to make up their loss through commissions.

It is important to note that markups and markdowns in principal transactions do not need to be disclosed, so an investor can easily be unaware of the price difference. 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, so they are referred to as broker-dealers.

When you purchase a security from a broker-dealer, the transaction might be either a principal transaction – possibly including a markup or markdown – or an agency transaction, in which the broker-dealer only benefits by charging a commission. Broker-dealers are required to disclose how a trade is completed in the trade confirmation, along with any commissions; they are not, however, required to disclose markups or markdowns, except under certain circumstances.

Regulators generally consider markups and markdowns of over 5% to be excessive, but this is a guideline, rather than a rule. Markdowns of 5%–10% can be justified in light of prevailing market conditions, the type of security, the dealer's broader pattern of markups and markdowns and the price of the security. Undisclosed spreads of over 10% are considered fraudulent.