Small Brain: What Makes a Market?

Don’t worry, I’m not going to jump in to talking about market-making, volatility, arbitrage and volume flows in this article series just yet.

Actually, I lied. That’s exactly what I’m going to talk about. Like, starting right now. For all the new people. Article number two, let’s fucking go! But fret not, we’re gonna start with the absolute basics and I promise you’ll be able to follow along.

So the primary question here is quite literally, what makes a market… a market? How does a market come to exist?

We all know you gotta have a buyer and a seller, blah blah old news. But going back to the previous article, let’s tie in the concept of value. In the first part of that post, I talked about valuing my car at a price of one hundred live chickens. Let’s stick with that scenario, because it makes me giggle. If that’s what I decide my car is valued at, it’s an opinion. Just like your opinion that my car is worth more chickens, less chickens, or ought to be valued against something else entirely. Maybe bushels of honeycrisp apples. Like I said in the last article, the car can’t actually considered to be worth anything at all to anyone but me, unless there’s someone willing to agree with me and make the swap. But how is anyone to know that I wish to exchange my car for chickens?

Ah, right. I need to announce my offer to make the exchange. Preferably in a public place, where plenty of people will see it. Maybe someone will be interested in this sweet deal! I’m going to post my offer, my asking price, on Facebook. And craigslist. And eBay (does anybody even use eBay anymore? idk). You get the point, I’ve made my offer, now to wait until someone decides to accept it. Now here comes my buddy Rick, from Facebook. Not the smartest chap, he didn’t read the listing very closely. He messages with his bid: 25 live goats in exchange for my 1995 automatic v6 Ford Mustang (a real panty-dropper when I was 18, trust me.) Now, goats are not nearly as good as chickens in my opinion, because goats are assholes. But he wants my car! After leaving Rick on read and thinking for a moment, I have a solution. I’ll simply have Rick post an offer to exchange live 25 goats for 100 live chickens. He can make the exchange, then he and I can make our exchange for my car.

Rick, (again, not the sharpest lightbulb in the toolshed) agrees to find a buyer for his goats. But now you step in; you want Rick’s goats, but you don’t have any chickens, only 50 bushels of delicious honeycrisp apples! You make a bid to trade with Rick and he’d love to accept it, but you see he really needs a car more than he needs 50 bushels of apples.

Now after arguing a bit, we’re all getting a little irritated, Rick is very confused and you’re tired of the goats trying to eat your apples. (I told you, goats are assholes). If only there was a way we could standardize the exchange for all of our various commodities. Maybe we could have someone print pieces of paper, or make little gold circles or something, and then just agree to use those to trade with, instead of herding goats, lugging apples and getting 16 miles to the gallon in a Mustang with a missing catalytic converter.

If you’ve successfully followed along with my weird-ass metaphors and mildly nightmarish hypothetical scenarios (like owning a piece of shit mustang with the catalytic converter cut out, who in their right mind would do that at 18 hahahahaha), you may have realized that you, Rick and I have just invented the concept of money. Turns out, bartering is a pretty tedious way to exchange things and severely limits your options. But if all of us decide that these pieces of paper, or this chunk of rock, or that string of code is worth using in order to avoid the inconvenience of herding goats around to trade for chickens to trade for cars, then… well, it is! Remember, value isn’t a fact, it’s completely subjective! But now that we’re all measuring using the same thing, it’s a lot easier for me to figure out just how badly you want Rick’s goats. And how badly he wants my car. Maybe I can charge him more than 15k! It is a pretty sweet car, after all.

So now I change the terms of my offer, my asking price. I tell Rick that he can have this dope-ass ride (and the 1/8th a tank of gas in it) for $16k. I value those $16k pieces of paper at one beat-up piece-of-shit Mustang, because I know that I can exchange them later for 100 live chickens and even have some cash left over to buy food for them. Now Rick, a true paragon of intellect, determines that this is a hell of a deal. He accepts my asking price, the cash and keys change hands and we’re on our separate ways. Don’t ask me how he got all those goats in the Mustang.

All in a good day’s work. But this negotiation business has gotten me hungry and I’m starting to think those apples of yours look pretty good! How much do you want for one? Oh, you weren’t planning on selling them individually? I’ll give you 10 bucks for one if you do, I’m recently rich! 16k in my pocket baby!

Well, that’s not a bad deal… but you wouldn’t be able to sell your last bushel because the grocery store you deal with only buys in increments of complete bushels. But wait! Your neighbor sells apples individually! And he only charges a dollar each. You grin, pocket my ten dollars and I munch away. On your way back home, you stop at your neighbor’s fruit stand. Only one apple left! You buy it for a dollar, and laugh at how stupid I was to overpay by nine dollars. Easy money for you! Good thing you didn’t sell me two though, there wouldn’t have been enough apples for sale to make your profit, and you’d have lost out on a whole bushel sale. It all worked out in the end though, what a fantastic day!

…And they all lived happily ever after, except Rick. He’s still stuck with his goats, who are assholes.

Now, if you were paying attention in that story, we saw a relatively large number of market dynamics in play. We had bids and asks placed across various (highly exotic) markets, we had a mark price set for MUSTANG/USD with one unit of volume in the market, and two different prices on a volume of 1 at each price point on APPLE/USD, which you were smart enough to arbitrage out. Oh, and we invented money. Seems handy.

A lot of these little interactions seem obvious in a simple story like this one. Most people already know all this, or at least understand immediately what is going on. You might think a tiny, local market like apples or one specific car are completely different than the digitized, high-speed financial markets of today but I disagree. Every market on the planet requires a minimum of two things: a bid or ask to be placed in a location visible to at least one other participant, and a participant willing to accept that bid or ask. The moment someone accepts a “resting” bid or ask for the first time, a market is created. There is now a specific value assigned to that asset, measured in whatever it was exchanged for.

In any heavily-traded market, there will be thousands of bids and asks set at a wide array of price points, and large amounts of people and money accepting them on both sides of the orderbook (the ledger of active bids and asks). The number of units changing hands is recorded as volume. If the volume of market buyers willing to accept the resting asks reaches the number of units listed for sale at a given price point, the buyers can choose either to accept the next highest offer to sell (and get a worse price), or they can choose to stop buying. If they accept the next highest offer, a new price is printed for the asset in question. It is now worth slightly more, according to the market. The same is true of market sellers, except they rely on pre-existing offers to buy and if those run out, the price will go down.

This works exactly the same as the sale of my car to Rick, except… well, most markets are faster. Thousands of assets can change hands in milliseconds and just as many bids or asks can be placed, moved to new prices or removed from the market entirely.

Boiled down to the base level (one could say a… foundation for thought?), all markets function exactly the same way: two entities find a price they agree on and make a transaction. Once there are no more people willing to exchange at that price point, participants must choose between not participating, or taking a worse price than previously available. Once an order at the new level is accepted, that level becomes the new market (or mark) price. This is how price fluctuations occur.

Note that in this entire article, I never mentioned why I wanted chickens. Or why Rick wanted my Mustang, or why you wanted his goats. Lastly, I never mentioned why someone might accept enough resting bids to lower price, or enough resting asks to raise it. That was intentional; the end result is always the same, as is the process by which prices moves. Price goes up when people accept resting asks until there are none left at the original price, only more expensive prices. It doesn’t matter in the slightest why people accept those asks! I didn’t ask Rick why he accepted my offer, because it didn’t matter to me. I just wanted that amount of cash more than I wanted my car. I valued that quantity of cash more. In the same way, it doesn’t matter why other market participants are buying or selling, only whether they are. Their participation is a reflection of their sense of asset value. You may agree with their valuation or you may not, but remember that the mark price is the only standard we have, and it is subject to every participant’s whims to some degree. Remember that all value is subjective!

So often, traders (particularly amateurs) work very hard to find “reasons why” the market went up, down or sideways. And there are reasons! But not the ones you think. The reason the market moves is because there are enough participants accepting resting orders to exhaust them at a particular level and move the market. That is the reason, the only reason. If you truly want to know for certain the logic for a market move, you’ll have to ask every single participant who filled, moved or removed an order during it! A difficult task, I don’t recommend it.

You get two foundations for thought today, I’ll leave you with this one.

Market action trumps market explanation; people lie but prices do not.

I wrote this article, there’s no financial advice in it or anything, insert usual disclaimers and follow me on twitter. Please clap.