Last post I talked about speculation, market making, and the similarities between them and running a retail store like a grocery.  Now I want to get away from that metaphor and talk about the details of how orders are entered and executed in a market – the ways in which a financial market is nothing at all like your grocery store.  This is a bit technical, so put on your nerd glasses and let’s get down to it.

The first concept to understand is that of an auction market.  An auction market has several properties:

• The product being traded must be fungible – that is, they must all be equivalent.  One share of MSFT is just as good as another – when you want to buy one you don’t actually care which share you get.
• Prices are negotiated solely through participants stating bids to buy and offers to sell, with each bid/offer consisting of a price and a quantity.  Note: traders use the terms “offer” and “ask” interchangeably.  I’ll try to use “offer” consistently, but I’ll probably slip up some times.
• These bids/offers are public knowledge, although which ones belong to which participants may not be (see below).
• When there are bids/offers that overlap (ie. buyers who are willing to pay more than sellers are willing to sell for) then the orders are matched up, and transactions occur.  When bids and offers match up there is a matching policy that decides who does business with who and at exactly what price.
• A couple of additional order types are usually supported – market orders and stop orders – which I’ll describe in a follow on post.

These days, most major auction markets are implemented using computers to track orders, do the matching, and track the completed transactions.  Computerized auction markets typically hide the identities of the participants, just showing the direction, price, and size of their orders.

The opposite of an auction market is a negotiated market where the parties talk directly and agree on a price.  Negotiated markets are typically used for over the counter financial products where interest in the product is sporadic or the terms of the product themselves are negotiable.  I plan on talking almost entirely about exchange-traded products on this blog, so you don’t need to worry too much about negotiated markets.

Central to an auction market is the idea of the order book and the limit order type.  The order book simply tracks who is willing to trade and at what price.  At one time it was a physical entry book, now it’s managed by the exchange computer.  The order book contains all orders which have not yet been matched up.  An example:

The market in question is the market for XYZ company stock.  Initially the order book is empty.  Bob puts in a limit order to buy 100 lots (a lot is 100 shares) of XYZ stock @ $65.40.  Since there is currently no one to match the order with, it is added to the book which now reads

Bob: buy 100 @ $65.40

Now, let’s break the example for a second and talk about limit orders.  A limit order, which is what Bob used,  indicates the worst price at which you’re willing to do business.  If you get a better price, obviously you’d take it.  But that’s the worst you’ll take.  So when Bob enters his order, the exchange matcher looks in the book to see if there’s anyone who will sell at a price of $65.40 or lower.  It turns out there’s no one else in the book, so Bob’s order is added to the book.

Now Juan decides that he wants to sell 200 lots of XYZ, and the lowest price he will accept is $66.02 (he enters the order SELL LIMIT 100 XYZ @ $66.02).  This order does not match with Bob’s (they can’t agree on price) so Juan’s order is likewise added to the book.  Now the book is

Juan: sell 200 @ $66.02

Bob: buy 100 @ $65.40

Now Maria enters the order BUY LIMIT 50 @ $66.50.  This order matches with Juan’s – the price Maria is willing to pay is higher than the price Juan charges.  So the exchange matcher pairs up the orders and sells 50 of Juan’s lots to Maria.  The price given is always the price that shows in the order book, not Maria’s higher offer.  So the transaction would be to sell 50 of Juan’s lots to Maria at $66.02.  This doesn’t fill Juan’s order completely, so the leftover would remain and the book would look as follows:

Juan: sell 150 @ $66.02

Bob: buy 100 @ $65.40

This is a very simple example, but it illustrates an important point: there are two basic kinds of orders – those that can be paired up with what’s already in the book (often called marketable) and those that do not match anything in the book and which thus go into the book.  The interplay between these two kinds of orders is incredibly important – it determines the dynamics of how a market behaves at a very low level.  People entering non-marketable orders are market makers – in market jargon, they “provide liquidity”.  They know what price they want to do business at, but have no proof that anyone else wants to do business at that price – they simply hang their order out there and see if anyone fills it.  This is analogous to the grocer selling beans in the previous post – he offers beans for sale at a fixed price with no certainty that anyone will buy them.  In this example Bob and Juan are market makers, albeit one sided ones (most market makers make both the bid and offer side of the market simultaneously).  After they entered their orders there was more in the order book than before.  Maria, in contrast, entered a marketable order, and is thus a liquidity remover/consumer – after her order there is less in the book.

Now, one might ask how Maria could know that her order was marketable.  The answer is that the exchange matcher makes part of the order book information visible to all market participants.  At a minimum, the highest priced bid and lowest offer and their associated sizes are public.  What is not shown is who that order belongs to – names are omitted, and if there are multiple orders at the same price their sizes are combined.  This is sometimes referred to as “level 1” information – a piece of old NASDAQ terminology that sometimes is used elsewhere.  Most markets also make the rest of the order book entries available, again stripped of names.  This is called “level 2” or depth of market (DOM) information.  Exchanges frequently charge an additional fee to see this information because it takes quite a bit of bandwidth to broadcast full DOM information in fast moving markets.  They may also only show the top several orders, not everything in the DOM.

There’s a lot more to be said about auction markets – we still need to cover the market and stop order types, what a real order book looks like, more about matching policy, and opening auctions/crosses. But I’m getting hand cramps from typing all this, so it will have to wait for another day.