6 ms·

The bid ask spread is a measure of how far behind you are the moment you buy a stock. If the ask is $10 but the bid is $9.75 you've lost 0.25 per share the seco

by ced 11y ago

The bid ask spread is a measure of how far behind you are the moment you buy a stock. If the ask is $10 but the bid is $9.75 you've lost 0.25 per share the second you make a trade. That makes some sense, but who have you lost it to? I was thinking about it the other day, and it seems that the "liquidity is good" argument can make some sense if people are not willing to make a transaction immediately. If I want to sell a bag of apple for 1$ _right now_, and someone else is willing to buy that bag for up to 1.50$ in a week, then I can appreciate that there's a middleman (providing liquidity) willing to hold the bag for me during that time and that he makes some profit from the spread. However, if the buyer and seller are both willing to make the trade at roughly the same time, then it's much better if they do it themselves (splitting the 50 cents of value amongst themselves) than if a middleman gets into the picture. More or less the argument made here: http://smbc-comics.com/index.php?id=3890 http://smbc-comics.com/index.php?id=3890

harryh 11y ago
You've lost it to a market making who is charing you for providing a service. Whenever you trade with a market maker you are buying liquidity (which used to be expensive but is now a lot cheaper). You're saying "I want to take the price you are offering right now and am not willing to take the risk that someone else will never come along to trade with me at a slightly better price." If you don't want to trade with a market maker you can avoid purchasing their liquidity by placing a limit order that doesn't cross the spread. You'll then wait until someone else comes along to trade with you. Of course, you're taking a risk that the stock price will move away from you and you'll never trade. Normally this is the risk the market maker takes for you (which is why you pay him) but you can always do it yourself if you want. In that comic the first caveman is getting a price that is right in front of him. He's not willing to wander around hoping to find a better price in another cave. That's a service that the 2nd caveman is performing for him. That's why the 2nd caveman gets paid. The key thing to realize is that market makers don't just "get into the picture" by muscling their way in when other people don't want them there. Think of them off to the side selling liquidity for anyone who wants to walk up to them and buy it.
- mrchicity 11y ago
  And you haven't really "lost" anything since you never had the ability to trade at the theoretical future fair price to begin with--nobody does. As you mention, your best alternative is to work non-marketable limit orders. This, too, has a real price: adverse selection, risk of missing your fill, connectivity costs, time spent monitoring multiple markets and updating your order. If you're a large investment bank or fund, your cost to do this may be lower than crossing the spread. For the average investor, no way.
  - harryh 11y ago
    Indeed, I agree that "lost" isn't the best word choice here. Instead "spent" would be better. You've spent money paying for a service provided by the market maker. And due to the wonders of automation, the cost of that service has been drastically reduced.
- ced 11y ago
  Thank you for the detailed explanation, I get the point about liquidity and traditional market makers, that makes sense. But isn't the point about HFT (at least, the part that is described in the comic) being "insider information" reasonable? Some people are willing to sell now for a low price, and some people are willing to wait longer for a better price, but I don't think anyone is unwilling to wait 1 millisecond for a significantly better price, no? Does liquidity on the millisecond scale make sense? > He's not willing to wander around hoping to find a better price in another cave. That's a service that the 2nd caveman is performing for him. I can see that, and in some contexts it's a very valuable service. But suppose I'm caveman 1. I know that CaveBob is a middleman. Everytime he comes to see me, it's because he knows something I don't, and I end up regretting my trade with him because a few hours later, I invariably realize that I could have made a much better trade. Then I'll stop trading with CaveBob, of course, and I'll naturally bump into those needing my meat a few hours later. In a stock exchange, I can't stop trading with CaveBob's, as far as I know. If a stock market without market makers and HFT rises by 5% every year, then by participating, I can hope to make as much if I'm average at trading. In a market with HFT, they will be taking part of the 5% with very low risk (through technological advantage), so it's not clear what's left, and the decision to participate is not so clear.

by ced 11y ago

harryh 11y ago

You've lost it to a market making who is charing you for providing a service. Whenever you trade with a market maker you are buying liquidity (which used to be expensive but is now a lot cheaper). You're saying "I want to take the price you are offering right now and am not willing to take the risk that someone else will never come along to trade with me at a slightly better price." If you don't want to trade with a market maker you can avoid purchasing their liquidity by placing a limit order that doesn't cross the spread. You'll then wait until someone else comes along to trade with you. Of course, you're taking a risk that the stock price will move away from you and you'll never trade. Normally this is the risk the market maker takes for you (which is why you pay him) but you can always do it yourself if you want. In that comic the first caveman is getting a price that is right in front of him. He's not willing to wander around hoping to find a better price in another cave. That's a service that the 2nd caveman is performing for him. That's why the 2nd caveman gets paid. The key thing to realize is that market makers don't just "get into the picture" by muscling their way in when other people don't want them there. Think of them off to the side selling liquidity for anyone who wants to walk up to them and buy it.

mrchicity 11y ago
And you haven't really "lost" anything since you never had the ability to trade at the theoretical future fair price to begin with--nobody does. As you mention, your best alternative is to work non-marketable limit orders. This, too, has a real price: adverse selection, risk of missing your fill, connectivity costs, time spent monitoring multiple markets and updating your order. If you're a large investment bank or fund, your cost to do this may be lower than crossing the spread. For the average investor, no way.
- harryh 11y ago
  Indeed, I agree that "lost" isn't the best word choice here. Instead "spent" would be better. You've spent money paying for a service provided by the market maker. And due to the wonders of automation, the cost of that service has been drastically reduced.
ced 11y ago
Thank you for the detailed explanation, I get the point about liquidity and traditional market makers, that makes sense. But isn't the point about HFT (at least, the part that is described in the comic) being "insider information" reasonable? Some people are willing to sell now for a low price, and some people are willing to wait longer for a better price, but I don't think anyone is unwilling to wait 1 millisecond for a significantly better price, no? Does liquidity on the millisecond scale make sense? > He's not willing to wander around hoping to find a better price in another cave. That's a service that the 2nd caveman is performing for him. I can see that, and in some contexts it's a very valuable service. But suppose I'm caveman 1. I know that CaveBob is a middleman. Everytime he comes to see me, it's because he knows something I don't, and I end up regretting my trade with him because a few hours later, I invariably realize that I could have made a much better trade. Then I'll stop trading with CaveBob, of course, and I'll naturally bump into those needing my meat a few hours later. In a stock exchange, I can't stop trading with CaveBob's, as far as I know. If a stock market without market makers and HFT rises by 5% every year, then by participating, I can hope to make as much if I'm average at trading. In a market with HFT, they will be taking part of the 5% with very low risk (through technological advantage), so it's not clear what's left, and the decision to participate is not so clear.