Order books, market makers, high-frequency trading
Market microstructure describes how individual orders turn into a price. It explains why the displayed price and your execution price can differ.
A price isn't a value someone sets. It forms because an incoming order meets a waiting one. Whoever waits supplies liquidity. Whoever trades immediately takes it away.
Market makers specialize in waiting. They quote buy and sell prices simultaneously and earn the spread. They have no opinion on direction, they earn on turnover.
High-frequency traders do the same, just very fast and at large scale. Their edge isn't cleverness, it's milliseconds. For you as a long-term investor, that's largely irrelevant; for short-term trading, it's your counterparty.
The practical takeaway: the displayed price is the last completed trade. What you pay depends on what's currently in the book. For large orders or thin markets, that can diverge noticeably.
The order book sorts limit orders by price and time. A market order works through the other side along the price levels, which makes the average execution price worse as order size grows. This market impact empirically grows roughly with the square root of the ratio between order size and typical daily volume.
A market maker's spread covers three components: processing costs, inventory risk on the position taken on, and the cost of adverse selection against informed participants. The third component explains why spreads widen before and after news: the risk of trading against better-informed counterparties rises.
High-frequency trading spans various strategies, including electronic market making, cross-venue arbitrage, and latency arbitrage. Empirical studies mostly find tighter spreads and higher liquidity under normal market conditions, alongside a tendency to withdraw during stress, which can contribute to amplifying short-term price drops.
Summary
- The displayed price is the last trade, not your execution price.
- The spread also pays for the risk of trading against informed participants.
- High-frequency traders usually tighten spreads and pull back during stress.
Did you get it?
Why does execution price worsen with order size?
Because the order gets worked through the order book's price levels.
What three components does a spread cover?
Processing costs, inventory risk, and the cost of adverse selection.
How does high-frequency trading behave during stress?
Liquidity often gets withdrawn, which can amplify short-term drops.
Related
- Spread, slippage, and liquidityStage 1
- Order typesStage 1
- Copy tradingHype Check