Let’s step back for a moment from the debate about high frequency trading (“HFT”) and consider some basic economics and trading strategies.
Every economics class I have ever taken has always used a supply/demand chart to reflect a quantity willing to be supplied and demanded at every possible price, with the crossover point representing the current market equilibrium.
What is this “market equilibrium?”
This equilibrium is a state in which supply and demand are balanced, or in equal supply, assuming the absence of outside influences changing and all else being equal (or, “ceteris paribus,” as economists like to say in order to sound smart). Equilibrium reflects a competitive price or market clearing price which will not change until supply, demand or the outside influences change.
OK, so we have market equilibrium. But then suppose something happens. Let’s say the demand for the item changes, in the form of a motivated buyer showing up with the intent to acquire a significant quantity. Equilibrium has officially changed. We now have more quantity demanded at that price than the market is willing to supply. The price must rise until it reaches the market clearing price.
What some of our friends on the buyside would like is to buy their significant quantity without moving the price. They would seem to want to increase demand, without affecting the equilibrium. We can say both in theory (Econ 101) and in practice (decades of trading experience) that it does not work that way.
Let’s look at it another way. Trading is often compared to war, as evidenced by the wide use of game theory and strategy by traders, as well as the famed book “The Art of War” by Sun Tzu, which has inspired hordes of traders over the years.
Using this war analogy, let’s look at a strategy at the front lines of a conflict – the posting of sentries or “pickets” along the front line. This serves a couple of purposes. First, the enemy does not know how strong the front line is. Secondly, the pickets are placed to warn of the enemy’s advance.
When the enemy starts advancing, the pickets get run over. If they are lucky, the can retreat, but they always message back to headquarters about what is happening up front. Either way, “picket” was not a preferred assignment.
In the markets, we have participants who are willing to bid or offer stocks just one cent apart, now that we have penny pricing. In the old days we traded in eighths, or 12.5 cents. These tight prices are the pickets. They expect to get run over. But the message they send back when they do is for everyone to retreat to higher (or lower) ground.
The liquidity of the marketplace is not in how much I see on the bid or offer, because I know that these are just pickets ready to retreat as soon as they seen superior numbers.
It works that way in war, it works that way in the markets.
All of this strategy in the market is part of the price discovery process. We want to move into and out of the markets without any negative flat price impact. However, there is not always a natural seller present at the same exact moment in the same exact size when you wish to buy, and vice versa.
Thus, we trade with intermediaries. We trade with pickets who don’t want to get picked off or run over in large quantities. The secret is finding where the front lines (prices) really are where your demand meets the equal supply. That is called price discovery and trading.