Market Structure and Why Other People Matter – Part 3

Sep 18 2013

Part 2: The Bizarre Bazaar

Part 3: Empty Baskets, Empty Wallets

Now that they have a mental grasp on what’s going on, the newcomers can get involved in this market. If they’re looking to buy, they now have the ability to easily choose the seller who will offer them the best (lowest) price. Anyone looking to sell can now see who is willing the bid the highest. Let’s follow each side through the process.

image

_______________________________________________________________

 

image

 

This process starts to happen over and over as the newcomers continue to trade like this because it’s just common sense. There’s no point paying a higher price when you have the ability to pay a lower price. There’s no point selling at a lower price when you have the ability to sell for a higher price.

image

As this process repeated, the day passed, and newcomers from all over continued to visit this town square to partake in the market they heard about, some of the original townspeople had a stroke of genius (that, or they were really tired of having to explain what was going on with these lines over and over again). They decided that they should hang a large sign above these rows of buyers and sellers and simply display the current best offer and best bid, since anyone participating in the market would inevitably choose them anyway. This would, in effect, be the overall current price of apples for anyone who wanted to come to market and do business.

They felt that by doing this, they would avoid some of the confusion a newcomer would experience that was associated with seeing all of these different prices being displayed by each individual person and just move directly to what mattered: the best offer and the best bid.

Little did they know, it was only going to make things even more difficult for them.

As it turns out, in the height of all the excitement mixed with confusion, they forgot to take into account the amount of apples each person was willing to buy or sell. If someone who’s selling apples runs out of apples (or even simply has other obligations they need to tend to), they’ll just pack up and be done with selling for the time being. On the same token, if a person who’s buying stops wanting to buy (perhaps because they’ve run out of money), they’ll move on to something else. In either case, the price that they were putting up is no longer valid since they won’t be there anymore.

The townspeople learned this lesson the hard way when the market continued to boom. Newcomers continued to join in and buy and sell at the best market price that was conveniently posted on a large sign for them. They became comfortable with the system and actually preferred the advantage it gave them compared to having to ask each seller or buyer individually what price they were willing to do business at.

This awareness and confidence drove apple trading like crazy! On top of that, it was an especially sunny, humid day and many of these newcomers had traveled from a great distance away. The long trip helped deter some apple sellers from coming, but encouraged plenty of apple buying since these visitors were hungry and hot. This resulted in an overall larger amount of buyers than sellers. Sure enough, the seller offering the best price ran out of apples to sell.

image

But that’s not all. The mad rush of apple buying not only wiped out the seller, but it left plenty of people looking to buy at the price they saw posted, 1.96 florps; the same price that their friend just paid for an apple, or their mother just paid for an apple. They had their mind set on that price, and since now nobody was willing to sell to them at that price, they made their own sign declaring they were willing to buy apples at the price of 1.96 florps per apple.

image

Technically speaking, price can be at whatever a buyer and seller agree it should be at, but that only truly applies when those two are practically the only participants. In the Aaron Applegrower example at the start of all this (before this market was put into action), he was participating in a
‘market’ that just consisted of him and a select few others.

Once the market expands and there is a general consensus on price based on the best bid vs. the best offer, price is now dictated by what happens with incoming orders. When enough buyers come to the market and buy at the current price (which for buyers means the best offer price), they can potentially wipe out all of the selling interest at that price (in this scenario, that would likely mean actually running out of apples – an empty basket).

Understand that this can happen in the exact same manner in the opposite direction, too. If enough sellers came to the market and sold at the current price (just remember that for a seller, the ‘current’ price is the best bid price), they can potentially wipe out the buying interest at that price (in this scenario, that would be like the buyer running out of money – and empty wallet).

And that, despite being explained in a long and wacky manner, is why prices of things exist and why they change. This is the foundation of truly understanding all price movement. Let that sink in. Truly absorb that information. But don’t think it stops there: there’s still plenty more if you’re up for the challenge.

Up next: Part 4 – Big Bad Buyers and Supersize Sellers

Just a simple prop trader tryin' ta make a buck.