What a Market Solves
A market exists to solve one problem — a buyer and a seller who cannot find each other — and every mechanism in the rest of this course is a consequence of how it solves it. Solving it is not free: on the two instruments quoted later in this lesson, the identical round trip costs 0.002 per cent of the position on one and 4.5 per cent on the other, and neither figure has anything to do with being right.
Prerequisites: none. This is where the course begins, and it assumes you have never placed a trade.
You own a hundred shares of something and you want to sell them. There is no exchange, no broker, no screen. Just you and the problem.
The problem is not what they are worth. The problem is finding one person who wants exactly what you have, in the amount you have it, at the moment you want to be rid of it. What the shares are worth is a different question, and a market is not built to answer it.
You post a notice
Selling 100 at $50.
You have just done two things worth naming. You have made a price — before your notice there was no $50. And you have committed: anyone may take you up on it, and you must honour it if they do. That is a limit order. A price you are willing to trade at, and a size, standing there whether or not anybody comes.
Nobody comes. So you change the notice to $49, then to $48. The price has moved, and nothing about the shares has changed. It moved because nobody would take the old one.
Someone else posts a notice too
Buying 100 at $46.
Now two offers stand. Yours to sell at $48, theirs to buy at $46. Every market names these: the highest price anyone will pay is the bid, the lowest anyone will sell for is the ask, and the gap between them is the spread. Here it is $2.
And nothing happens. Both of you have named a price and neither will cross to the other’s price. This is the ordinary condition of a market: two lists of people willing to trade on their own terms, and no trade taking place.
Those two notices are the object the rest of this module is built from, and it is worth knowing that in advance. Lesson 2 multiplies them into the full list of everyone currently willing to trade. Lesson 3 takes one of them and follows it through to a fill. Lesson 4 prices the gap between them. By lesson 6 a whole day of them has been compressed into a single candle, and by lesson 7 you are reading the trail they leave behind one print at a time. Lesson 9 is where the whole book comes back at once and asks who was standing in it, and why.
Then someone arrives who has to sell
They do not have a week. They can see the buyer standing at $46, and they take it.
They could have posted their own notice at $48 and waited. They chose $46 instead, and the $2 difference is not a fee that anybody charged them. It is what they paid to be finished now rather than maybe. That is a market order: not a price but an instruction — trade me against whatever is standing there, at whatever it costs.
Almost every trade is those two people meeting. One posted a price and waited; one accepted a price and did not. The exception is an auction, where everybody is matched at a single price at a single moment and nobody has to cross to anybody — that is how each trading day opens and closes, and lesson 42 takes it apart.
Who was the buyer at $46?
This is the question the rest of the course is built on, so it is worth sitting with. Somebody was willing to buy when nobody else was. Why?
One possibility is that they wanted to own it. They think it is worth more than $46, they bought it, and they are finished.
The other possibility is not a view. It is a job. They bought at $46 intending to sell at $48 to the next person who has to buy in a hurry. They are not predicting anything. They are being paid $2 to be the one standing there when somebody needs to trade and nobody else is available. That is a market maker, and the spread is their revenue.
It is not free money, and the reason is most of this module. Between buying at $46 and selling at $48, they own something they never wanted to own. If the price falls to $40 inside that window, the $2 is irrelevant. That exposure is the whole reason a spread exists, and lesson 5 is where it gets a name and a number.
Which gives you the first thing in this course you can actually use. The spread is a price, and it is the price of somebody else’s risk. When that risk rises — an earnings release due, a thin afternoon, an instrument nobody trades — the spread widens, because the person quoting it demands more to carry the position. A spread is not a cost the market imposes on you arbitrarily. It is a reading of how dangerous the market currently is to stand in.
What it costs to be the impatient one
Take a liquid ETF quoted 512.30 bid, 512.31 ask. You buy at market, paying the ask: 512.31. You change your mind and sell at market a second later, receiving the bid: 512.30. Price never moved. You are down $0.01 a share, or 0.002 per cent of the position.
Now the same round trip in a $1.50 micro-cap quoted 1.48 bid, 1.55 ask. You buy at 1.55 and sell at 1.48. You are down $0.07 a share — 4.5 per cent of the position — having been neither right nor wrong about anything.
| Instrument | Bid | Ask | Round trip per share | Share of the position |
|---|---|---|---|---|
| Liquid ETF | 512.30 | 512.31 | $0.01 | 0.002% |
| $1.50 micro-cap | 1.48 | 1.55 | $0.07 | 4.5% |
Same trade, same conviction, and one costs more than two thousand times the other as a share of what you put up. Before either position can make a penny it has to earn back that gap. Nothing in this arithmetic depends on your being a good trader or a bad one, which is why it comes before any of the material about being right — and most people choose what they trade without ever running it, though it is two quoted numbers and one division.
What this does not settle
This describes a market with one venue and a visible list of orders. Real equity markets run across many venues at once, carry orders you cannot see, and contain participants working on timescales this description ignores entirely. None of that changes the mechanism — it changes who gets to use it, and how quickly. Lesson 2 puts the real list in front of you; lesson 26 explains why part of that list is an advertisement rather than a fact.
The impatient seller could have posted at $48 and waited, and that sentence quietly skips something. They would have stood behind you at $48, and a resting order second in a queue at a price the market never returns to is not a slow fill; it is no fill at all. Everything on this page counts prices. Nothing on it counts position in the queue, and position is often what decides whether a patient order trades.
Both notices were for exactly 100, which is the convenience that made the arithmetic clean. A real book rarely holds the size you want at the price you want, and an order larger than what is standing at the top gets filled at an average across several prices instead of at the one you were quoted. Lesson 3 follows a single order through that.
The $2 was called the market maker’s revenue, and it should have been called gross revenue. Nothing here nets off the occasions when they buy at $46 from somebody who is selling because they know something, and the price is $44 before anybody arrives to buy at $48. The spread has to cover that as well as the risk of holding what they never wanted, and lesson 5 is where both halves get priced.
And nothing here tells you who was right. The buyer at $46 and the seller at $48 both believe they got the better of it, and this lesson has no opinion. What the mechanism reveals is who was willing to wait, which is not the same as who was correct. That leaves you with one thing you still cannot do: nothing on this page tells you how to look at a completed trade on a screen and say which of the two sides was the one that had to be there.
Every trade has two sides, and one of them chose to be there while the other needed to be. Reading a market is telling them apart.
Problems
- The round trip. A stock is quoted 24.10 bid, 24.14 ask, with 500 shares available on each side. You buy 200 at market and sell 200 at market one second later; the quote has not moved. What did that cost in dollars, and what percentage of the position is it?
- The other way. Same stock. Instead you post a limit to buy at 24.10, it fills, and later you post a limit to sell at 24.14, and that fills too. What did the round trip cost this time? Name the thing you gave up in exchange, and describe one situation in which giving it up would have been expensive.
- Your own base rate. Pick one instrument you can watch for a session. Record its bid and ask ten times across the day, including the first ten minutes and the last ten. Compute the round-trip cost each time as a percentage of the position. Report the highest, the lowest, and the ratio between them. That ratio answers something this lesson only asserts: how far the price of being impatient moves inside one ordinary day, on an instrument nothing in particular happened to.
Sources. Larry Harris, Trading and Exchanges: Market Microstructure for Practitioners (Oxford, 2003), chapters 2–6, for the mechanism described here. Lawrence R. Glosten and Paul R. Milgrom, “Bid, Ask and Transaction Prices in a Specialist Market” (Journal of Financial Economics, 1985), for the derivation of why a spread must exist even where no one has any costs to recover.
You can now say what a price is and where one comes from. The next lesson replaces the two notices with the real list, every resting order at every price, and the first thing that list settles is that the price you were quoted was only its top line.
The Order Book
The two notices in this lesson, multiplied into the real list of everyone currently willing to trade.
Read Lesson →The Spread Is the Price of Immediacy
What the $2 gap is actually charging for, and what makes it widen.
Read Lesson →Why Anyone Quotes At All
Inventory risk and adverse selection: the two problems that explain nearly everything a market maker does.
Read Lesson →What Should You Actually Trade?
The round-trip arithmetic of this lesson, turned into a ranking across instruments.
Read Lesson →Educational only. Trading involves substantial risk of loss. Not financial advice. Past performance does not guarantee future results.
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