Order books, market makers, high-frequency trading
Market microstructure describes how a price arises from individual orders. It explains why the displayed price and the price you finally pay can differ.
Learning objective: After this lesson you can explain why the displayed price and your actual execution price can differ.
Nobody sets a price. It arises when a new order meets one that's already waiting. Whoever waits brings liquidity to the market. Whoever trades immediately takes it away.
Market Makers
Market makers specialise in waiting. They quote a buying and a selling price at the same time and earn from the spread. Whether the price rises or falls hardly matters to them. They earn from lots of trading.
High-Frequency Traders
High frequency traders often do the same, just very fast and on a huge scale. Their edge is millionths of a second, not smarter judgment. If you invest for the long term, it barely affects you. If you trade short term, they're your counterparty.
Displayed Price and Execution
Remember: the displayed price is the last trade that happened. What you pay depends on what's currently waiting in the order book. With large orders or thinly traded assets, the two can differ noticeably.
The order book holds the waiting orders, sorted by price and time. An order that's to be filled immediately works its way through the other side one price level at a time. The bigger it is, the worse the average price. This price impact grows roughly with the square root of the ratio between your order and what's normally traded in a day. An order for a hundredth of daily volume therefore moves the price noticeably less than one for a tenth, but not ten times less.
What the Spread Covers
A market maker's spread covers three things: their costs, the risk of holding a position that moves against them, and the danger of trading with someone who knows more than they do. The third point explains why spreads widen before and after news. That's when the danger is greatest that someone on the other side is better informed.
High-Frequency Strategies
High frequency trading covers various strategies: electronic market making, arbitrage between trading venues and exploiting tiny time advantages. Studies mostly find that spreads get tighter and there's more liquidity in normal operation. In stress phases, though, these traders often withdraw. In the so called flash crash of May 2010, the American stock market fell almost ten percent within minutes, partly because suddenly hardly anyone wanted to buy.
Summary
- The displayed price is the last trade, not your execution price.
- The spread also pays for the risk of trading with better informed people.
- High frequency traders normally tighten spreads and withdraw in stress phases.
Did you get it?
Why does the execution price get worse with large orders?
Because the order works its way through the order book one price level at a time.
What three things does a market maker's spread cover?
Their costs, the risk of a position moving against them and the danger of trading with better informed people.
How do high frequency traders behave in stress phases?
They often withdraw, and that can amplify short crashes.
Check your understanding
Your task
An order of one hundredth of the daily volume moves the price less than one of a tenth. Use the square root rule from the lesson to calculate roughly by what factor the price impact grows, and compare it with the factor of ten you would naively expect. Write one sentence on what that means for your orders in thinly traded stocks.
Sources and further reading
- In an official statement on the flash crash of 6 May 2010, the US Securities and Exchange Commission (SEC) confirms that many market participants withdrew from trading because prices moved too fast, which dried up liquidity further during the stress. View source ↗
Related
- Spread, slippage, and liquidityStage 2
- Who really moves the marketsStage 1
- Order typesStage 2
- Matching questions for this stageQuestions