The Basics

How Markets Can Fall Without Actually Trading

One of the things many market participants fail to realize is that prices do not require transactions taking place to move. In fact, they tend to move most rapidly in the absence of trades. Why? Because when transactions are taking place it means buyers and sellers have come to at least a temporary agreement on value. Prices move most aggressively when there is no agreement, when one side has to give in to the other and alter its perception of value.

The confusion about all this comes from the fact that the most commonly known exchange price feeds show only transacted prices, not the bid/offer indicative prices which actually underlie everything. Forex traders don’t suffer this problem, of course, as they are used to see an indicative market. Most options traders are also well aware of this issue as thinly traded options can show last trades that are vastly different than the current price at which a trade could be done.

So here’s the deal. When all the buyers disappear from the market – meaning they pull their bids – the market falls until it finds a level at which the buyers are willing to come back in. That means market orders can get filled WAY below where they were expected to be filled. That seems to be at least part of what happened during the market plunge last week.

Here are a couple of good examples (hat tip to Wall St. Cheat Sheet)

“Of all the mysteries of the stock exchange there is none so impenetrable as why there should be a buyer for everyone who seeks to sell. October 24, 1929 showed that what is mysterious is not inevitable. Often there were no buyers, and only after wide vertical declines could anyone be induced to bid… Repeatedly and in many issues there was a plethora of selling orders and no buyers at all. The stock of White Sewing Machine Company, which had reached a high of 48 in the months preceding, had closed at 11 on the night before. During the day someone had the happy idea of entering a bid for a block of stock at a dollar a share. In the absence of any other bid he got it.”
John Kenneth Galbraith, 1955, The Great Crash

“I started accumulating stocks in December of ’74 and January of ’75. One stock that I wanted to buy was General Cinema, which was selling at a low of 10. On a whim I told my broker to put in an order for 500 GCN at 5. My broker said, ‘Look, Dick, the price is 10, you’re putting in a crazy bid.’ I said ‘Try it.’ Evidently, some frightened investor put in an order to ‘sell GCN at the market’ and my bid was the only bid. I got the stock at 5.”
Richard Russell, 1999, Dow Theory Letters

This leaves one with the very legitimate question as to whether it is a good idea to use market orders or standard stops, which become market orders when their trigger price is met or passed.

Trading News

The Dominant Players in Forex

I see the question all the time about where prices come from in the forex market and who drives them. The answer is that it comes from the market makers in the inter-bank market. Want to know who the big players are there? Here’s the current ranking as per Euromoney (hat tip to Clint at BabyPips).

Source: Euromoney FX survey FX Poll 2009
Source: Euromoney FX survey FX Poll 2009

According to that same survey, the daily volume of forex trading breaks down like this:

  • Western Europe 50.19%
  • North America 26.98%
  • Asia 14.54%
  • All others 8.39%

Here’s something most folks probably don’t realize, however. According to a Financial Times article posted today, about two thirds of the $3.2 trillion in daily forex market transaction volume done each day is derivatives (see Most Active Forex Currency Pairs). That’s heavily in swaps. The focal point of that FT article is on the potential impact of new legislation requiring derivatives to be cleared through central clearinghouses.

It’s worth noting that the only bank in the ranking list above that does retail forex trading business is Deutsche Bank, which has the dbFX platform. The way I understand it, DB is a major liquidity provider to retail forex brokers. So the answer to the question of who is making prices in the forex market is Deutsche Bank.

Reader Questions Answered

Is My Broker Stealing from Me?

The following was actually left as a comment on the site, but since I’m sure it’s something which is a question many people have, I want to take the time to provide a public answer. Here it is:

I have a serious question about broker stealing. This relates to how brokers, specifically options brokers, mark to market. I’m with xxxxxx and these people are thieves. Every day I buy dozens of contracts and they always mark them to the bid. I’m losing hundreds of dollars every day simply by virtue of the way they mark to market. For instance, I have some calls on FWLT. The last trade was at 7.2. I bought at 7.0. Yet they marked my trade at 6.4, the bid. Which means that, at 10 contracts, they’re telling me I lost $800 versus actually MAKING $200 based on the actual contract price. Xxxxxx is stealing from me, aren’t they? Your response is greatly appreciated.

If you’re a forex trader I’m sure you already know what I’m going to say here. 🙂

In any market the last trade is just that – the last trade. It doesn’t necessarily represent the current market price. Sure, in actively traded markets the last trade and the current price (as per the bid/offer) are going to be essentially the same. In thinner markets, like options, however, there can often be some time between trades actually getting made – even days.

Even though no actual trades have taken place during a period of time, that doesn’t mean the market hasn’t moved. If you’re in a call position and the underlying stock falls in price, by definition the value of the options are going to decrease. If no one does a trade in those options, then you won’t see it in transacted price, but it will absolutely show up in the price you actually pay or receive if you go into the market to do a trade. Market makers are always adjusting their bids and offers to reflect changes in the market.

So, when your broker marks your position to market each day, they are doing so based on where you would be able to exit your open positions, not based on a last transacted price which might totally unreflective of the market reality. That means if you are long they will mark your positions based on the bid, since that’s the price you would sell at to close out.

As you can hopefully see now, your broker is not stealing from you. If you bought 10 calls at 7.0 and the current bid is 6.4, then were you to close your trade out by selling you would take a 0.60 loss per contract, or $600 total. That is what your broker is reflecting in their mark-to-market.