CHAPTER 3

The Basics of Double Auction Markets in the Real World

While many textbooks would define liquidity as the readiness of an asset to be converted into cash, what exactly does this definition really mean to a trader who is looking to buy or sell (or short sell) a stock or commodity?

The practical use of this basic attribute of a market is often learned by newcomers to proprietary trading firms within their first week of training before beginning to trade live with the firm's capital, yet it's rarely taught to individual traders and investors whose own money is in the markets. Above all, the concept of a spread (a term generally used in finance to refer to the difference between the highest bid and the lowest offer on a market at any given time, though it depends on context) is distorted beyond recognition for those who began participating in the financial markets through retail foreign exchange dealers.

In foreign exchange (currency trading), the same mechanisms exist in a decentralized system, but the typical discussion of the spread is actually a reference to the artificially widened spread that a brokerage uses to charge a fee for its service in lieu of a commission charge. There is nothing inherently wrong with the practice (a similar practice is common in the bond markets), but the use of the term as a criterion for choosing a retail foreign exchange broker/dealer often distorts many beginners' concept of the actual spread in a natural market—especially in a centralized market like stocks and futures.

The spread is a natural function of the amount of liquidity on the market. The more buyers and sellers present and posting limit orders (orders to buy or sell at a specific price or better), the tighter the spread.

To gain a clearer understanding of this effect, compare it to other types of auctions.

Most people are familiar with the concept of an auction in the form of an English Auction, where bidders use open outcry to raise the bid until no further bidders are willing to exceed the latest bid, and thus the item is sold to the highest bidder. Here in the twenty-first century, many people will probably have participated in this type of auction electronically on eBay.

In an English Auction, the price of the item will rise as more and more buyers come in and bid. For example, if a DVD movie for sale on eBay currently shows a best bid of $4.50 and another buyer bids $4.55, the new buyer has effectively placed a limit buy order for $4.55 (meaning he or she is willing to buy the DVD for $4.55 or lower—although in an actual English auction, no one will sell it to you for a better price than your limit since it's inherently a one-sided auction). The important comparison is that the more aggressive buyers there are, the higher the bid will go, because every buyer will only have a chance to win the auction (get filled on the order) if he or she is the highest bidder at the end of the auction.

On a typical financial market such as a stock market, which is a double auction process during the regular trading day, there is no time limit that causes the highest bidder to get his or her order filled. Instead, there are two sides to a double auction market:

1. Bids: All the potential buyers who would like to buy, at a specific price or better (lower), will post their bids in the form of Limit Buy orders. Naturally, the more buyers there are who are willing to buy at a price higher than the current best bid, the higher the national best bid price will go.
2. Offers: All the potential sellers (whether they are unloading shares that they own or are opening a short-sell position) who would like to sell, at a specific price or better (higher), will post their offer (or ask) prices in the form of limit sell orders. And, of course, the more sellers there are who are willing to sell at a lower price than the current lowest offer, the lower the national best offer price will go (the term ask is interchangeable with offer in this context and is sometimes used on trading platforms with the same meaning).

The highest bid and lowest offer at any given time on a stock is known as the national best bid and offer (NBBO).

All the individuals and entities above are part of a single category of market participants: the liquidity providers (also known as those who “add liquidity” or simply “makers,” as in market makers). Why? Because they have placed orders at prices that do not overlap with the best price on the opposite side of the market. No trade will take place until a best offer overlaps (or crosses with) the best bid. This can either be in the form of a limit order that crosses the other side of the market or simply a market order, which automatically does so indiscriminately.

In other words, the only ways that the market price of a stock (or any financial asset traded on an exchange or over-the-counter in an electronic network) will ever actually change is if:

In the first two scenarios, the individuals or entities who moved the market are part of the other major category of market participants: liquidity removers (or takers). They have entered the market at a given moment and, by buying from the best offer or selling to the best bid, they have removed shares from the national best offer or bid respectively.

While this may seem like a common-sense aspect of the market, it's a facet of the market that is often misunderstood in many publications and editorials on finance. Markets may not necessarily go up with more buyers or go down with more sellers. If all those buyers and sellers are passively adding liquidity (i.e., buyers joining the best bid or sellers joining the best offer) there will be no movement of any kind in terms of price. In the last two scenarios, unless those who posted bids and offers voluntarily pulled out in unison (which is entirely possible in relatively illiquid markets such as thinly traded small-cap stocks), the price will only move if liquidity removers (takers) cross with the prices of liquidity providers (makers), or if liquidity providers (makers) leave the market by themselves. So it's inaccurate to say that a stock dropped because more sellers came in. And there are times when the difference between lack of demand and sudden abundance of supply should make a difference in your perception of the market situation.

While stocks will often trade back and forth in between the spread at fractional prices, especially on highly liquid stocks with tight one-penny spreads, regulations have rendered it illegal for any exchange or ECN to post a visible best bid and best offer at less than 0.01 (one penny) apart as long as the stock is priced above one dollar. (These are the types of constantly changing regulations that traders quickly become accustomed to, but the basic premise of the double auction market will always remain the same. Also note that, in this particular case, trades between the national best bid and ask are simply not shown, they are still legal if they are hidden and when transactions occur at those prices, and they must still be reported on the consolidated tape which is shown on the Time & Sales window on most direct access platforms.)

To clarify another common misconception, it is inaccurate to say, “Limit orders are always adding (making or providing) liquidity.” If one places a limit buy order at a price that matches the best ask or higher, the limit order will instantly be filled and the buyer will still effectively be a remover because he or she did in fact remove liquidity: It was the order that came in and was matched against a sell limit order, and therefore took away the liquidity that was present before. Likewise, if a limit sell order is entered with a limit price that matches the national best bid or lower, the limit sell will also be instantaneously matched and therefore will have removed liquidity from the market. It's true, however, that all market orders will immediately remove liquidity, and cannot possibly add, because the sole purpose of a market order is to get it filled right away at the best price currently available (and the best price currently available to a seller is the best bid; the best price currently available to the buyer is the best offer).

The only real difference between a limit order and a market order is that the market order will still fill if the market suddenly moves away. For example: If you see that the best offer is 1.50 and you enter a market buy order one millisecond after all the sellers with limit orders at 1.50 cancelled their orders, and the next level of offers is at 1.51, then you will get your order filled at 1.51. However, if in the same scenario, you entered a limit buy order with a limit price at 1.50, it would only have removed liquidity and gotten filled if the offers at 1.50 remained active. If they had all been cancelled before your order reached the market centers, your order would not inadvertently be filled at 1.51.

Market centers (exchanges, floor specialists, ECNs, dark pools, Automated Trading Systems) exist for the purpose of matching orders, regardless of whether they are limit or market orders. The main difference is that market orders are indiscriminate of the price that the order will be filled at, whereas limit orders will only be filled at the limit price or better. Both can remove liquidity if they cross with the best price on the opposite side of the market.

Also, orders do not typically match in size so a single entity (whether an individual or an institution) trading a larger size will overpower a large number of people on the opposite side of the market. So, assuming none of the parties adding liquidity will cancel their orders, if there are 8 million shares on the best bid and 200,000 shares on the best offer, it will take less shares to “break” the offer (and effectively cause the market to go up to the next level) than it would take to break the bid (and cause it to drop a level). In reality, the concept of breaking a level should be fairly obvious as soon as a trader sits in front of a Level 2 quote and Time & Sales window, and watches a stock move up and down for a few minutes. This is a more effective exercise using a highly liquid stock (symbols that trade more than 1 million shares per day on average) for beginners to learn the feel of this process as it unfolds in real time.

All the displayed orders (the bids and asks that are voluntarily made visible) are the displayed liquidity on the market. This is what is shown on a Level 2 quote. (A Level 1 quote, which is typically found on websites, displays only the best bid price and the best ask price. A Level 2 quote shows all the visible bids and asks on the market at any given time including those that are outside of the market: bids that are lower than the best bid and offers that are higher than the best offer.)

An often debated issue today is that it is not currently required to display all liquidity provider (maker) orders visibly as displayed liquidity. There is absolutely nothing that prevents a large institutional buyer or seller from hiding its entire actual order size as a hidden order on an ECN, as an iceberg order, or as an order routed to a dark pool (alternative trading systems that exist for the sole purpose of matching non displayed orders—I elaborate on this in coming chapters).

However, there still are a variety of reasons why one might voluntarily choose to display bids and offers on the market. (Some are perfectly legitimate and others fall into a gray area.) The most important reason is that most ECNs are time-price priority (meaning the earlier you enter your order, the farther in front of the line you will be when a remover comes in and hits your price at that ECN). However, the ECNs are also required to give priority to displayed orders (bids or offers) before the hidden orders. Depending on the sizes on the currently displayed quote on the Level 2 relative to the size you hope to transact, and of course the nature of your strategy, this may or may not matter much to you at any given time.

For example, there are 200,000 shares on the bid posted on the ECN called EDGX (one of Direct Edge's dual exchange systems), and you enter 10,000 shares hidden on the bid side (you set display to zero on your limit buy order to EDGX) and then, after you entered your order, another 50,000 displayed shares are posted on the bid on EDGX by another buyer. Because you chose to hide your order, those 50,000 shares that came after you will cut in line in front of your 10,000 shares; otherwise, if you had chosen to display your order, you would be in front of them due to price-time priority.

Why does this matter? Well, if a liquidity remover decided to sell 250,000 shares at market on EDGX (or they entered a limit sell order with a price at or below the bid price that you joined), you would still not get filled on your hidden orders. If you had displayed them, however, you would have gotten filled. This is because, rather than having 200,000 shares in line in front of you (which would be the case if you had chosen to display since that was the number displayed at the time before you entered your order), you now have 250,000 shares in front of you (the 200,000 entered before you and the 50,000 that entered after you because that 50,000 chose to display).

On a real Level 2 quote, there is rarely only one ECN on either side (bid and offer) of the market. The exceptions are very illiquid stocks (stocks that are rarely traded and have a relatively low average daily volume). On highly liquid stocks, you will often see most of the major exchanges on both sides, whether the stock is an NYSE-listed name or a NASDAQ over-the-counter name, in today's hybrid national market system. However, only NYSE listed stocks will show the “NYSE” destination among them (this is the floor; as of this writing, the NYSE is one of the only major exchanges that still operate a physical floor with human specialists).

Assuming no orders are cancelled, the price level will not break down (bids eliminated by sellers who are removers) until all the bids at all the exchanges and ECN systems have been matched with removers' sell orders. Likewise, the price level will not break up (offers eliminated by buyers who are removers) until all the offers at all the exchanges and ECNs have been matched with removers' buy orders. The trade-through rule in Regulation NMS (National Market System) requires that no ECN, exchange, or other destination can fill an order outside of the current national best bid and offer. All the displayed liquidity on the NBBO, if not cancelled, must be matched by removers' orders before the price level will actually break up or down. In other words, assuming liquidity providers don't voluntarily cancel their orders at once, a new price (or a new balance between supply and demand) cannot be discovered in a centralized market without the participation of liquidity removers within the NBBO.

The combination of the Level 2 quote (which shows all the displayed liquidity) and the Time & Sales (the tape, which legally must report every trade that takes place on the stock in real time, regardless of whether the original orders were displayed or not) allows a trader to participate in today's mostly electronic poker-like game of showing and hiding one's hand, and strategically choosing a destination to route an order to buy or sell for better cost efficiency and odds of succeeding in getting his or her order filled.