The Invisible Hand just picked my pocket
August 23, 2007 11:58 AM Subscribe
Stock Market Filter: How do stock exchanges like Nasdaq/NYSE figure out (based on supply and demand) what price to assign to a given stock? Its not 'pure' supply and demand. Given a steady volume, prices still oscillate within ranges. How do market makers make their decisions on the oscillation as they search for the most efficient price for a given market?
In other words, as I understand it, all market makers have some procedures and (secret?) formulas by which they take supply/demand information for a given stock, and turn that into prices. For instance, given a steady volume and steady supply and demand, you'll still see the the price chart of a stock oscillate within a range. Its that oscillation -and its rules - that i'm wondering about. How do they determine that behaviour? Is it a computer formula? Based on what? I figure they are seaching for most efficient price (a price that maximizes transaction volume, cuz they make their money on transaction volume). This is similar to the way retailers oscillate prices of merchandise by having 'sales' and price reductions followed by price increases, as they search for the maximum volume the market will bear.
I know nasdaq is an electronic market so its probably a computer formula there. How about at NYSE and older stock markets? How do market makers make their decisions on that oscillation as they search for the most efficient price? Based on what criteria? Is it just a random 'probing' of the market?
In other words, as I understand it, all market makers have some procedures and (secret?) formulas by which they take supply/demand information for a given stock, and turn that into prices. For instance, given a steady volume and steady supply and demand, you'll still see the the price chart of a stock oscillate within a range. Its that oscillation -and its rules - that i'm wondering about. How do they determine that behaviour? Is it a computer formula? Based on what? I figure they are seaching for most efficient price (a price that maximizes transaction volume, cuz they make their money on transaction volume). This is similar to the way retailers oscillate prices of merchandise by having 'sales' and price reductions followed by price increases, as they search for the maximum volume the market will bear.
I know nasdaq is an electronic market so its probably a computer formula there. How about at NYSE and older stock markets? How do market makers make their decisions on that oscillation as they search for the most efficient price? Based on what criteria? Is it just a random 'probing' of the market?
Price charts of a stock oscillate because they record actual completed trades. These aren't records of any output of some kind of formula. These are just records of real trades that took place between two parties.
Sellers who wish to sell a stock submit an 'ask' price. If they can find a buyer who has submit a 'bid' price that is identical, a trade can occur, stock for money, at that price.
At any given time the exchange maintains an 'order book' of bids and asks. Computers and brokers match up any that are matchable and put buyers together with sellers. Some companies have dedicated brokers that work face to face, bargaining with other company's brokers to move large volumes of stock.
Did this answer your question or is there some other aspect that isn't clear?
posted by ikkyu2 at 12:12 PM on August 23, 2007
Sellers who wish to sell a stock submit an 'ask' price. If they can find a buyer who has submit a 'bid' price that is identical, a trade can occur, stock for money, at that price.
At any given time the exchange maintains an 'order book' of bids and asks. Computers and brokers match up any that are matchable and put buyers together with sellers. Some companies have dedicated brokers that work face to face, bargaining with other company's brokers to move large volumes of stock.
Did this answer your question or is there some other aspect that isn't clear?
posted by ikkyu2 at 12:12 PM on August 23, 2007
Response by poster: sanko - its not entirely determined by buyers and sellers. Market makers (traders, brokers) often talk about activities they do, such as "shaking the tree" -- a procedure where a price is lowered by the market maker or broker in an effort to 'shake out' the stop orders (and thus make the commissions from those sales) in certain stocks. So the broker has some control over this.
posted by jak68 at 12:13 PM on August 23, 2007
posted by jak68 at 12:13 PM on August 23, 2007
Response by poster: ikkyu2 -- thanks, that does clarify things a bit. I guess I meant to talk about ask/bid prices and how they're set. You're saying that ask/bid prices are entirely brought to the brokerage firm by buyers and sellers. But how does that explain activities like 'shaking the tree'? Doesnt the broker -- even in his role as the person who matches up buyers with sellers - have some 'pull' on the direction of the price? Maybe that is more true in a face to face situation rather than a computerized situation?
posted by jak68 at 12:16 PM on August 23, 2007
posted by jak68 at 12:16 PM on August 23, 2007
Response by poster: for instance --- sanko - in the link you posted, even there it says that the broker is the one who controls the ask/bid spread (and takes the spread as his commission). So the broker does have control over the spread (and thus over ask/bid prices)
posted by jak68 at 12:19 PM on August 23, 2007
posted by jak68 at 12:19 PM on August 23, 2007
Bid/Ask prices are for the most part set by the sellers and buyers but there is also a specialist for any given stock that is required to provide a certain amount of liquidity by being on the other side of the trade when there are imbalances.
posted by zeoslap at 12:22 PM on August 23, 2007
posted by zeoslap at 12:22 PM on August 23, 2007
Response by poster: zeoslap - thats for example what i mean -- if there is a specialist providing liquidity -- how do they decide when to intervene? What defines an 'imbalance'? Are there set criteria for that? Or is it up to the whim of the particular broker?
posted by jak68 at 12:24 PM on August 23, 2007
posted by jak68 at 12:24 PM on August 23, 2007
They have to intervene if there are no buyers/sellers available and get some perks for the additional risk that entails, the rest of the time they are acting as normal market maker making their profit on the spread.
posted by zeoslap at 12:30 PM on August 23, 2007
posted by zeoslap at 12:30 PM on August 23, 2007
jak, suppose you're an ABC shareholder. You're interested in buying 1,000,000 shares of ABC at a good price - say, 9. It happens you already own 1,000,000 shares and the last trade price is 10.
If ABC is relatively low volume, you take a look at the order book. You see that you can take 50,000 of your shares, fulfill every open order, and drive the trade price down from 10 to 8.50.
Now it may be that when the 8.50 trade crosses the wire, someone's trailing stop-loss order executes and they sell 5,000,000 shares at market or at a limit of 8.75 or whatever. Now you swoop down, pick up 1,000,000 for 8.75, and you're done.
Gaming stop-loss orders, however, is not where the technology is today - maybe that's where it was in 1962, although I doubt it.
Right now we are about 4 steps ahead of that - you have huge computer systems manned by teams of Ph.Ds in statistics and quantitative analysis, trying to outthink and outgame each other on these price moves. God knows how much volume is just attributed to these computers shuffling shares back and forth, trying to shake out some profit; I don't know, but I know that fraction is way more than the volume contributed by good faith trades by retail investors like you and me.
posted by ikkyu2 at 12:44 PM on August 23, 2007 [2 favorites]
If ABC is relatively low volume, you take a look at the order book. You see that you can take 50,000 of your shares, fulfill every open order, and drive the trade price down from 10 to 8.50.
Now it may be that when the 8.50 trade crosses the wire, someone's trailing stop-loss order executes and they sell 5,000,000 shares at market or at a limit of 8.75 or whatever. Now you swoop down, pick up 1,000,000 for 8.75, and you're done.
Gaming stop-loss orders, however, is not where the technology is today - maybe that's where it was in 1962, although I doubt it.
Right now we are about 4 steps ahead of that - you have huge computer systems manned by teams of Ph.Ds in statistics and quantitative analysis, trying to outthink and outgame each other on these price moves. God knows how much volume is just attributed to these computers shuffling shares back and forth, trying to shake out some profit; I don't know, but I know that fraction is way more than the volume contributed by good faith trades by retail investors like you and me.
posted by ikkyu2 at 12:44 PM on August 23, 2007 [2 favorites]
Studying the pricing that results from exchange rules and practices (either with theory or empirical work) is generally referred to as "market microstructure" and it is an entire specialty unto itself in economics/finance.
posted by milkrate at 12:50 PM on August 23, 2007
posted by milkrate at 12:50 PM on August 23, 2007
Ikkyu2 is right. For more insight, I'd recommend reading anything by Richard Wyckoff or the book Master the Markets, by Tom Williams. You'll look at the markets with new eyes. Prices are manipulated by the market makers using supply and demand
Basically, their premise is the market makers already know information ahead of the herd (the public), they know who has large buy and sell orders on their books and have a good idea where the stops are. They then manipulate the market to their advantage.
For example, look at the daily chart for HD on around June 20th or 21st. You'll see a huge surge in volume and a large gap up in price. According to Williams, this is a classic move by market makers to suck in the herd to continue to buy, while the market makers know there's a problem with the stock and they're selling all their holdings to the herd and preparing to short. Anyone who follows Wyckoff or Williams who saw that move would have known that they should be rushing to the emergency exits.
You'll see a similar move end of May/beginning of June with WMT.
I'd also recommend reading Floyd Norris' blog in the New York Times for some good insight.
posted by TorontoSandy at 1:33 PM on August 23, 2007
Basically, their premise is the market makers already know information ahead of the herd (the public), they know who has large buy and sell orders on their books and have a good idea where the stops are. They then manipulate the market to their advantage.
For example, look at the daily chart for HD on around June 20th or 21st. You'll see a huge surge in volume and a large gap up in price. According to Williams, this is a classic move by market makers to suck in the herd to continue to buy, while the market makers know there's a problem with the stock and they're selling all their holdings to the herd and preparing to short. Anyone who follows Wyckoff or Williams who saw that move would have known that they should be rushing to the emergency exits.
You'll see a similar move end of May/beginning of June with WMT.
I'd also recommend reading Floyd Norris' blog in the New York Times for some good insight.
posted by TorontoSandy at 1:33 PM on August 23, 2007
Richard Wyckoff died in the 1930s His description of the markets is, to be charitable, a bit obsolete.
Tom Williams is a huckster who makes ridiculous claims about how the markets move. It's all bullshit. There are zillions of arbitrage firms that specialize in detecting any exploitable pattern, and then using it for profit.
A particularly easy to understand example of why this is all nonsense is the January Effect. It used to be that people did a lot of trading at the end of the year for various (often tax-related) reasons, and caused the first few days of January to have larger than normal gains.
However, once this pattern was recognized, traders started buying in December to take advantage of that... and then traders started saying "people are going to buy in December... so I'm going to buy in November", until the effect got washed out almost entirely.
Please don't waste your time on any of that.
posted by Tacos Are Pretty Great at 2:05 PM on August 23, 2007
Tom Williams is a huckster who makes ridiculous claims about how the markets move. It's all bullshit. There are zillions of arbitrage firms that specialize in detecting any exploitable pattern, and then using it for profit.
A particularly easy to understand example of why this is all nonsense is the January Effect. It used to be that people did a lot of trading at the end of the year for various (often tax-related) reasons, and caused the first few days of January to have larger than normal gains.
However, once this pattern was recognized, traders started buying in December to take advantage of that... and then traders started saying "people are going to buy in December... so I'm going to buy in November", until the effect got washed out almost entirely.
Please don't waste your time on any of that.
posted by Tacos Are Pretty Great at 2:05 PM on August 23, 2007
The ability of a market maker to manipulate the bid/ask spread is almost nil. If a market maker tries this, another market maker will simply complete the trade and leave the other with a loss. So it won't happen. Prices are set by the buyers and sellers. It truly is a market.
There are some stock exchange requirements that market makers provide liquidity by personally buying or selling if there are no other buyers or sellers. But if buyers and sellers are present, they set the price.
posted by JackFlash at 3:56 PM on August 23, 2007
There are some stock exchange requirements that market makers provide liquidity by personally buying or selling if there are no other buyers or sellers. But if buyers and sellers are present, they set the price.
posted by JackFlash at 3:56 PM on August 23, 2007
Another thing to realize is that every single transaction -- its price, quantity and time -- are public knowledge. Buyers and sellers would know if some people were getting different pricing than expected from published trade information.
Contrast this to the airline industry where each person on the plane may have paid a different price for their ticket and there is no easy way to find out.
posted by JackFlash at 4:12 PM on August 23, 2007
Contrast this to the airline industry where each person on the plane may have paid a different price for their ticket and there is no easy way to find out.
posted by JackFlash at 4:12 PM on August 23, 2007
Response by poster: thanks, all. Different opinions are represented here but each is informative.
posted by jak68 at 6:52 PM on August 23, 2007
posted by jak68 at 6:52 PM on August 23, 2007
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posted by sanko at 12:10 PM on August 23, 2007