Reader Questions Answered

Market Makers and Opening Gaps

I received the following email from a trader named Ben.

I do have a question regarding the money maker and rapid price swings in equity prices. I understand /why /it happens but not /how./ It is the money maker who actually ticks the quote number up or down correct? It would make complete sense to me if there were only limit orders, where buyers indicate the max price they will pay and sellers indicate the min price they will accept. The money maker would simply have to match buyers to sellers. But with the market orders, it seems to me that the money maker is given a lot of freedom to change the price very quickly based on the volume of buyers and sellers at any given time. And I think that, in part, is what can drive prices up or down very quickly. The money maker makes his money on volume of transactions, not the price of transactions.

Then there are the instances of violent price swings immediately upon the market opening, based on good or bad news from the day before, after the market closed. My thoughts above apply, but the situation is a little different because the change in price tends to be almost instantaneous whereas the earlier case tends to happen over a few minutes or hours. I believe what happens is a large volume of automatically executed trades by people who had previously set up stop-limit or stop-loss orders. That triggers the immediate fall or rise in price and then rest of the market kicks in to react. The media is quick to report the violent price swings and the public then gets bullish or bearish real quickly. There are some more experienced traders who explicitly buy/sell on ups/downs. But something would still have to make the price rise or fall by say 10% to set the trigger. The initial rise or fall is probably from market order trades and then the fall/rise is sustained by a large volume of automated orders.

What do you think? After writing my piece above I have it worked out that the price swings are initially driven by freedom given to the money maker by those who execute market order trades.

First, I’m pretty sure that by “money maker” Ben means market maker. I can’t help but chuckle about the truism behind the error, though. ­čÖé

On the subject of the cause of initial price gaps at the open of trading, let me first say that there is overnight or pre/after-hours trading in so many stocks these days that what we may see on gaps on the daily chart of exchange-fed prices isn’t really a gap. It’s more like the reflection of a time break. Think of how an intraday chart would look if you didn’t show the trading that took place between 11:00 and 1:00. Chances are there would be a gap.

Now in the case where exchange trading is the only trading, it’s a question of price matching. The market maker (or specialist) looks to all the orders which have collected overnight and in the pre-market to come up with an initial price which best clears the market. That means the point at which the volume on the buy and sell side will most effectively match up. Of course from there the opening price will then impact standing order, causing knock-on reactions off that starting point.

As Ben noted, market makers make their money mainly from buying at the bid and selling at the offer. The more they do that the more money they make, so it behooves them to set their price at the point where most volume is going to transact. You can think of price movement as the continuous process of market makers adjusting the bid/offer to try to maximize volume. After all, it doesn’t make much sense to keep price at a point where no trades will get done.

Reader Questions Answered The Basics

System Back-Testing and Indicative Forex Data

Frequent emailer and commenter Rod sent me another good question yesterday, on the subject of trading system back-testing.

I want to backtest a strategy on some forex pairs. The timeframe would be 1 day, so I would be using EOD data. In this situation, how bad of a mistake, if at all, is it to rely on indicative data? If my forex broker cannot provide a historical database, what options do I have for a reliable test?

The difference between forex data and that provided by exchanges is an important one which a lot of folks don’t really appreciate. Exchange data is most traded price, meaning where actual transactions took place. Spot forex data is indicative price, which is the bid and/or offer where transactions could have taken place (but also may not have done).

Contrary to what Rod fears, using indicative prices is actually more realistic than using traded price. Why? Because you can be more accurate with where your fills would be. You don’t have to leave room for slippage they way you do testing something like stocks or futures where you don’t necessarily know what the bid/ask is. You know the price you could sell at (bid) and the price you could buy at (offer) – or at least one side of that with the ability to fairly easily determine the other in most cases.

The issue, however, is what data source you use. Ideally you want to be testing using the prices from the broker through whom you’ll be trading. This may not be as big a deal for EOD type trading, but for intraday├é┬átrading the little variances between the prices of different sources could make a big difference.