Investing: back to basics

In this blog Nilan Morar, head of trading at Purple Group, explains in very basic terms how shares are traded in terms of supply and demand, liquidity and spreads.

“It’s worth what someone is prepared to pay for it.” Have you ever heard this statement before? It applies to just about everything we’re exposed to in life when trying to ascribe value to something, and it’s probably true most of the time.

Perhaps the most obvious examples would be of a seller of a motor vehicle or a property. The seller will generally always think it’s worth more than the buyer, hence the asking price is typically higher than the buyer’s price. The process that follows thereafter – to the point where the buyer “meets” the seller (in price terms) and concludes the transaction – is largely indifferent to the electronic meeting of a buyer and seller of shares online.

Participation in the market can broadly by divided into two parts, active or passive participation or otherwise referred to as price makers or price takers. The characteristics of each type of participation differ slightly, with each presenting slight advantage or disadvantage. Let’s explore these a bit deeper.

With reference to the quote window below, the highest price a buyer is prepared to buy at (bid price) is 2250c, while the lowest price that a seller is prepared to sell at (offer or ask price) is 2800c.These two prices represent price makers as they have published their respective prices on screen and they are willing to accept the uncertainty of whether or not they will trade in lieu for the benefit of achieving their stipulated price. The difference between the bid and offer price is referred to as the bid/offer spread (or spread or double) and the importance of paying attention to the spread becomes apparent especially when looking at relatively illiquid shares of mainly medium and small companies.

Liquidity is best described as the ease with which one can buy or sell an asset given the number of willing buyers and sellers at any given time. Given this definition it would be fair to assume that the more liquid an asset is, the more trades there are and hence more volume traded.

For the purposes of this example let’s assume that there are no other market participants (i.e. price takers) and only those on screen.

Example:

Buyer: Paul – looking to buy 500 shares at 2250.

Seller: Donald Trump – looking to sell 10 000 shares at 2800.

The buyer, Paul, has only two options, i.e. stay on the bid at 2250 until the seller (Donald Trump) has to sell and gives Paul shares at his price or Paul pays Donald Trump his price of 2800. Conversely Donald Trump could wait until Paul buys from him at 2800 or, if he cannot wait any longer, he can sell to Paul at 2250. This is known as crossing the spread.

If Paul has to conclude the trade for whatever reason he has to pay 2800, doing this would mean that he is paying a price 24.5% above the price he initially wanted to pay. Volume in this instance would not be a concern as there are more shares for sale than what is required by Paul. He wants to buy 500 shares while Donald Trump is selling 10 000. However, consider the seller, and assume that he had to conclude his sale, he would effectively have to sell to all the buyers loaded down to a price of 2155. This stack of buyers and sellers is known as the market depth, and indicates buyers and sellers at their different prices. 2250 and 2800 would be the best bid and offer respectively. So back to Donald Trump, he would sell 500 at 2250, 5000 at 2200 and the balance of 4500 at 2155, resulting in a weighted average price of 2182.25. This translates into a price that is about 22% lower than he initially wanted to sell at. There are not many reasons that I have come across that would warrant one to cross a spread north of 5%, let alone 20% and this must be a consideration when executing a transaction.

In this particular instance there was only one trade in this share for the day, at 2500, reflected as the last trade. If you were trading on a platform that referenced the underlying market for prices (but not necessarily for volumes or immediate execution) then you would see 2250 – 2800 as the spread, which is 100% accurate as these prices reflect the best bid and offer in the underlying market. Further if your trading was non DMA (Direct Market Access) which implies that you would not be trading on exchange, you would be a price taker, i.e. you would be buying at the best offer (the lowest seller available) or selling at the best bid (the highest buyer available) at the time of your execution.

Some platforms, notably those that aim to provide an extremely cost effective offering, such as EasyEquities, drive attention towards investing rather than trading. To overcome the minimum trading costs that are not passed on to clients, trades would be accumulated until such point that it makes economic sense to execute. Clients, however, are not prejudiced in any way whatsoever as they are filled at the prevailing best bid or best offer at the time of execution, and the risk of movement in price is assumed by EasyEquities. It challenges traditional execution as participants chose the value of their trade rather than the price they wish to trade at. It is therefore possible that one could pay 2800 while there is no corresponding trade in the underlying market as EasyEquities would affect their corresponding transaction at a different time during the day or maybe even on a different day, at a different price.

You should always consider the width of the bid offer spread when concluding transactions as this spread would immediately determine how much the market needs to move by for your trade to break even.

This article was originally published on the EasyEquities blog.