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Quick-School on Market Microstructure

In this article, we will try and explain how all major financial markets in the world function and why it is important to understand how they function for you to exploit them and make money from them. Before we start I would like to clarify that this article is written for novices and the concepts explained are simplified for the reader to understand and so the logic is not airtight.

Let’s start with a very simple and intuitive example. Suppose, you enjoy watermelons and visit your local market to buy some for the long weekend ahead. Let’s put in a few assumptions before we start to make it very easy. Let’s assume there are multiple watermelon sellers and you’re the only buyer who wants to buy a single watermelon. Furthermore, you have no bias towards any individual seller and the quality of watermelon available at any shop is the same.

So you visit the market and visit all sellers and ask them for the price. Now as the quality is similar at all shops, the only thing you are concerned with is price. Whoever gives you the lowest price, will be able to sell his watermelon to you. This is a classic buyer’s market. You hold the proverbial leash here and you decide which shop to buy from. Now, let’s reverse the situation. There are multiple buyers or customers and you’re the only shop that sells watermelons. Assuming everyone wants to buy one watermelon from you, you hold the leash in this scenario. This is an example of a classic seller’s market. But realize this, in both scenarios the buyer and the seller have to agree on a price for the transaction to take place. Although it is tilted in favor of the buyer in the first case and the seller in the second case, the transaction only happens when a mutual understanding is reached.

Now, let’s complicate the scenario a bit. Let’s assume that there are many different sellers and multiple buyers but the number is static and that in every transaction only one watermelon is exchanged. Although the situation does become somewhat complex, we can still figure out that the majority of sellers, as well as buyers, will be happy leaving the marketplace, because most likely they will find someone willing to sell/buy from them at a reasonable price that happens to be within their budget. Now, let’s further complicate this, suppose the sellers and buyers entering and exiting the market is random. So the number of given sellers and buyers at any given point in time is dynamic. Now we are facing a bit of a problem. But we still think that the majority will leave satisfied. This is what finance guys call a dynamic dual auction process. The numbers of sellers/buyers in the markets are always changing and the last price at which a trade occurred is always displayed on a screen that is visible to every market participant.

To make it more complex, discard the assumption that in every transaction only one watermelon is sold. Suppose a buyer wants to buy a dozen, then lots of sellers will flock to him. Likewise, to a seller offering a steep discount, lots of buyers will flock to his shop to buy from him. If you realize how much of chaos this is and have started to appreciate the complexity of the situation and realize how supply and demand run the market, then congratulations. You are on your way to understanding why markets are so complex and dynamic.

Let’s draw equivalence to the stock market from the above example. In place of a watermelon, the underlying asset becomes a share in a company. But multiple companies imply multiple stocks and multiple buyers and sellers in the market. (Skipping the IPO part, which we will cover in our upcoming articles) so how do you know if the stock you want to buy is correctly priced?

Whether it is undervalued or overvalued? You could use a lot of tools. Few examples are Technical Analysis, Fundamental Analysis, Order Book et cetera. In this article, we would like to give you all a basic primer into market dynamics concerning the order book.

Explaining the following using what we call DOM (Depth of Market)

What you see is a DOM window. If you carefully see we have 4 columns. The second one from the left is the most important, it's the price. In this case, we have a tick value of 0.25. (For the students from another background out there, tick means the Least Count of that asset on that market) This means that market can only move in multiples of 0.25. It cannot move 0.35 or 0.20. Now that we have understood that, let's examine the first and the third columns. The first column is called Bid and the third column is called Ask. But what do you mean by bid price? And what do you mean by ask price?

Bid means that people are waiting at that price to buy security as they find it undervalued at that price. And likewise, ask means that people are waiting to sell that security at that price because they find it overvalued at that price. So what do you do if you want to buy security?

The first question is how badly do you want to buy security? In the given example you could buy it instantly by placing a buy order at 2040.75 as we have sellers sitting there. This is what is called buying with a market order. So basically you would be matched with a best seller and the security gets transferred to your account and the cash gets transferred to the seller's account. But what if you want to buy, but not instantly and are willing to wait. You place a bid at lower than what the lowest seller is offering and then you wait. This is called buying with a limit order. If someone feels like the price at which you are buying is overvalued they will come down to your level and sell and you would get the security. The same process takes place when you sell instead of buying only in reverse.

Bid shows the demand for the asset while ask shows the supply of the asset.

One rule of trading is – To buy low and sell high. So when buying you want the lowest price at which it is feasible to buy and when selling you want the highest price at which it is most profitable to sell.

The fourth column denotes volume. What do you mean by volume? Volume is relatively easy to understand. It tells you the number of transactions that took place at that price.

This is another example that will hopefully make the concept of Bid & Ask, crystal clear to you all. Here, don’t confuse the name volume as a trading volume. It is showing the number of bids and asks. Also, this is a more compact way of showing bid-ask spread which requires only 2 columns instead of the three used in the above example.

To conclude, it is these simple concepts that make the markets run and that too on very large scales. The number of players in the markets and the ever-increasing complexities of manufactured financial products has made the whole system seem way out of a common understanding of people, but it is important to know that the underlying concepts of all of these are very intuitive to humans and not merely technical jargon. And a willingness to understand them at a deeper level is a sure way to either help you make sense of the markets or successfully trade them.

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