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06 Price with Time

Price, Offers and Bids

Given a market in a particular class of thing typically there will be bodies offering to sell at or above certain prices and bodies bidding to buy at or bellow certain prices.

There will also be those who are selling or buying at the market price. In other words they are selling by accepting a given bid to buy or buying by accepting a given offer to sell.

In a modern street market it is usual for the stall holders to offer things for sale at a given price and for you to buy at the price on offer. Where as the stock exchange and other financial exchanges have both offers to sell and bids to buy at a variety of prices.

So a market generally consists of offers to sell, bids to buy. Some choose to buy at the lowest market price or sell at the highest market price and thus fulfil the bids to buy and offers to sell waiting on the market. So the market selling price is set by the lowest offer, while the market buying price is set by the highest bidder. The difference is the spread and this is usually small.

Once the lowest offer for sale has fulfilled then the next lowest offer becomes the new market selling price. The selling price has risen.

Once the highest bid to buy has been fulfilled then the next highest bid becomes the new buying price. The buying price has dropped.

So the market selling and buying price changes as a result of the buying and selling its self. Also of course new offers to sell and bids to buy are put on the market, often trying to undercut the market selling price or better the market buying price.

Supply and Demand

  • The the amount offered for sale at each price forms a distribution I will call the supply characteristic of the market.
  • The amount bid to buy at each price forms a distribution I will call the demand characteristic of the market.
The actual distributions show that demand and supply curves look nothing like those in economic text books which suggest that at twice the market price you find twice the sellers and half the buyers! This is false, particularly with basic commodities like food we buy within reason what we need.

To see the traditional view of supply and demand just search for it on the web or look at wikipedia's article. See Wikipedia.

To see real supply and demand curves live on the web take a look at Oanda the foreign currency traders and on the left you can see a graph with price plotted vertically and the amount or volume of sell and buy orders at any given price. See Oanda. Note the orange plot, the other plot is explained below.

Of course some will argue that financial market trading doesn't represent reality. Wrong - It is part of reality. Of course the supply and demand graph for bread would look different maybe but it sure ain't those nice theoretical curves.

Normal and Reverse Trading

Normal Trading

Recall that given a market in a particular class of thing there will be bodies offering to sell at or above certain prices and bodies bidding to buy at or bellow certain prices.

Long

Traders who believe the price will rise will try to buy at a low price and later sell at a higher price so as to make a profit. This is normal trading. Plotted in Orange on Oanda. (In the financial markets this is called taking a long position.)

For example a trader decides to buy rice at or below a certain price.

(When they buy they are opening the position and when they sell they are closing it.)

Short

Traders who believe the price will fall will try to sell at a high price and later buy at a lower price so as to make a profit. This is still normal trading. Plotted in Orange on Oanda. (In the financial markets this is called taking a short position.)

For example a trader decides to sell rice at or above a certain price. (If the trader doesn't have any rice they can borrow it and then later buy some rice so as to return it.)

(When they sell they are opening the position and when they buy they are closing it.)

Summary

So normal traders offer to sell at or above a price and buy at or below a price.

Reverse Trading

Long

If a trader buys at a price but then the price falls that trader has made a loss and if he expects the price might fall further he will sell at the market price even as it is dropping. In effect traders have a price, below the price at which they bought, which if reached or passed they will sell at the market price.

For example a trader buys rice expecting the price to rise, but just to be safe they decide that to stop the loss they will sell quickly if the price drops to 90% of their buying price. In effect they will sell at 90% or below.

The result of this is that given a market in a particular class of thing there will be bodies offering to sell at or below certain prices. In normal trading bodies sell at or above a certain price. So this is reverse trading. Plotted in Turquoise on Oanda.

Short

If a trader sells at a price but then the price rises that trader has made a loss and if he expects the price might rise further he will buy at the market price even as it is rising. In effect traders have a price, above the price at which they sold, which if reached or passed they will buy at the market price.

For example a trader sells rice expecting the price to drop, but just to be safe they decide that to stop the loss they will buy quickly if the price rises to 110% of their selling price. In effect they will buy at 110% or above.

The result of this is that given a market in a particular class of thing, there will be bodies offering to buy at or above certain prices. In normal trading bodies buy at or below a certain price. So this is reverse trading. Plotted in Turquoise on Oanda.

Summary

So reverse traders offer to sell at or below a price and buy at or above a price.

Virtual Trading

In the financial markets the majority of traded volume is not to buy or sell a given valuable. The majority of trades are simply intended to give a trader a stake in a valuable for a period of time. i.e. they buy with the intention of selling later or sell with the intention of buying back later. As has been said this is called taking a long or short position, respectively. In the end the long traders never take delivery of the asset they trade in, and the short sellers never deliver the asset they trade in. Indeed although short sellers are supposed to borrow the asset they are short selling for the period their position is open many exchanges allow them to sell an asset a few days before they actually borrow it. This means of they close their positions before these days are up they need never borrow the asset. This is called naked short selling.

Clearly if the exchange has traders holding long positions on 273Kg of gold and also traders holding short positions on 273Kg of gold then what ever happens to the gold price, one side will gain what the other looses when the positions are closed. The exchange does not need to worry about actually having the gold!

The majority of trades on the financial markets are virtual trades, nothing is delivered and the amount of valuable being traded is far greater than the amount of real valuable in existence. This is how the markets can end up not reflecting real supply and demand but simply reflecting the beliefs of traders and their manipulation of the market.

In truth in order to ensure that the free market works properly trading should be limited to real valuables. If Traders want to gamble on the price then a second virtual market should be set up where prices follow the prices in the real market but cannot influence it. That's my opinion.

Crashes and Booms

The normal traders actions have a negative feedback effect on the market in that as prices rise they sell, contributing pressure for prices to fall, while as prices fall they buy, contributing pressure for prices to rise. The result is price stability.

The reverse traders actions have a positive feedback effect on the market, in that as prices rise they buy, contributing pressure for prices to rise further, while as prices fall they sell contributing pressure for prices to fall further. The result is price instability, boom or crash.

Price Crashes

Recall that the market selling price is set by the lowest offer, while the market buying price is set by the highest bidder. The difference is the spread and this is usually small.

When a seller comes and sells an amount at the market price it will be bought by the highest bidder. If they have more to sell it will be bought by the next highest bidder and so on down the bids. Thus the buying price will drop as lower and lower bids to buy are fulfilled.

When the buying price drops it may cause reverse traders to meet their trigger prices, causing them to sell. Thus the buying price will drop further as lower and lower bids to buy are fulfilled.

This will continue down to a price, where the total amount of all the offers to sell (below the original price) is less than the total amount of all the bids to buy (below the original price).

Thus one sale can be the cause of a cascading price drop in the market buying price.

The lowest offer to sell which determines the market selling price is not immediately effected by the drop in the buying price resulting in a large spread between the two.

What happens next in the spread vacuum? The buying price is now well below any offers to sell and the question is will the selling price follow or will the buying price come back up. This is determined by where new offers to sell and bids to buy come on the market and also if anyone will buy or sell at the post crash market prices.

If the crash was driven by sellers who sold simply because the price was down then it is very likely to come back up again once the reverse trader sells have been fulfilled, giving a serious advantage to those who bought during the selling frenzy.
(This happened on 6th May 2010 See Financial Times Online That sinking feeling)

However if the crash was driven by sellers who sold based on some sustainable opinion then it is very likely to stay down once the reverse trader sells have been fulfilled giving the advantage to those who sold during the selling frenzy.

If the crash had a good reason it is likely that new offers to sell will be pitched lower taking the selling price down towards the buying price. If there was no good reason for the drop then bids to buy will be pitched higher again tending to restore the buying price. However the price will remain quite volatile until the vacuum has filled.

For any price below the current price the support is the amount that must be sold at market price to bring the price down to it.

For any price above the current price the resistance is the amount that must be bought at market price to bring the price up to it.

Price Booms

Recall that the market selling price is set by the lowest offer, while the market buying price is set by the highest bidder. The difference is the spread and this is usually small.

When a buyer comes and buys an amount at the market price it will be sold by the lowest seller. If they have more to buy it will be sold by the next lowest seller and so on up the offers. Thus the selling price will rise as higher and higher offers to sell are fulfilled.

When the selling price rises it may cause reverse traders to meet their trigger prices, causing them to buy. Thus the selling price will rise further as higher and higher offers to sell are fulfilled.

This will continue up to a price where the total amount of all the  bids to buy (above the original price) is less than the total amount of all the offers to sell (above the original price).

Thus one buy can be the cause of a cascading price rise in the market selling price.

The highest offer to buy, which determines the market buying price, is not immediately effected by the rise in the selling price resulting in a large spread between the two.

What happens next in the spread vacuum? The selling price is now well above any bids to buy and the question is will the buying price follow or will the selling price come back down. This is determined by where new bids to buy and offers to sell come on the market and also if anyone will sell or buy at the post boom market prices.

If the boom was driven by buyers who bought simply because the price was up then it is very likely to come back down again once the reverse trader buys have been fulfilled, giving a serious advantage to those who sold during the buying frenzy.

However if the boom was driven by buyers who bought based on some sustainable opinion then it is very likely to stay up once the reverse trader buys have been fulfilled giving the advantage to those who bought during the buying frenzy.

Prices driven up by a rise in prices are never firm, but prices driven up by opinion are as firm as the opinions.

Conclusions

Market instabilities are caused by reverse trading in particular when it is based on price alone as can be the case in many automated trading systems which allow advance placing of orders to sell at market price in a falling market or to buy at market price in a rising market. These are known as "stop loss orders"  and are intended to protect investors that place them, however placing them risks them causing price movements that will fulfil them before returning to close to the previous price. (Flash crash 6th May 2010 Financial Times Online That sinking feeling)

Price is a matter of opinion and so prices driven down by a fall in prices or driven up by a rise in prices are never firm, but prices driven down or up by opinion are as firm as the opinion on which they are based.

So in a way stop loss orders intended to protect the investor do more to destroy him. If you are not sufficiently confident in the investment, not to need a stop loss, then you are not sufficiently confident in the investment. Clearly leverage requires stop losses which says a lot about leverage! (Not talked about leverage yet TODO.)

Stop Loss Hunting

A wise player knows that stop loss orders are there and provided opinion is stable, can sell to start a price cascade down, buying lower down before the return to normality, thus reaping the stop loss orders which fall like corn under the scythe as the price drops. (Hence it should be called stop loss reaping)

Similarly a buy can be used to start a cascade up, a trader selling at the higher price before the return to normality.

This kind of action is common in the financial markets.

Reverse trading is the result of a loss of confidence in a market and leads to instability where it exceeds normal trading.

If the orders on the exchange are known then it is possible to calculate the change in price that will result from a buy or sell of a given size at the market price. Where the amount to sell below a price exceeds the amount to buy, selling a large amount followed by buying back that amount will lead to a profit at the expense of the stop loss orders which are wiped out.

Other Boom Busts

Investopedia offers more boom bust stories;

In March 2009, Blackstone Group CEO Stephen Schwarzman said that up to 45% of global wealth had been destroyed by the global financial crisis. Reuters. March 10, 2009. An incredible destruction of wealth but it was not physical wealth that was destroyed, only what people were prepared to give in cash for what was essentially the same wealth.

Investors that invest for capital price appreciation of a commodity are doing little for the physical economy, and even endanger it by taking money away from the real wealth generating investments such as firms.

Inflation and Deflation

Prices are raised due to competition amongst buyers and lowered due to competition amongst sellers. It is the things on offer for sale and the money in bids to buy that will directly determine price. These are connected but not necessarily determined by the amount of money and the amount of tradable things in the economy as a whole.
  • In an economy if the sum of prices for total amount offered for sale is more then the total amount of money bid. Then unless some prices drop some things will remain unsold creating a market surplus.
  • Similarly if the sum of prices for total amount offered for sale is less then the total amount of money bid. Then unless some prices rise some bids to buy will remain unfulfilled creating a market shortage.
Clearly;
  • if the amount of money bid increases or the amount of things offered decreases there will be market shortages or price inflation,
  • if the amount of money bid decreases or the amount of things offered increases there will be market surpluses or price deflation.

Market shortages or market surpluses can be created when prices resist market conditions otherwise they are corrected by inflation or deflation. If nobody wants apples because too many were grown then prices become negative. i.e. you would have to pay bodies to take them.

Markets and Reality

There is a very important distinction between market shortages and surpluses, and real physical shortages and surpluses.
  • Need in a community, is an objective thing and leads to deterioration of health when not satisfied.
  • Want in a community, on the other hand is something that does not lead to deterioration of health and so is subjective.
If there is a market surplus or a shortage of a class of thing in a community price may adjust to match market demand and supply so eliminating the market shortage or surplus. However this does not imply that real physical needs or wants have been met, it does not imply that there are not real physical shortages or surpluses.
  • People without money may go hungry.
  • People with money may buy things they don't need or want simply to satisfy a desire to shop (retail therapy). 
Market shortages and surpluses do not always correspond to real physical shortages and surpluses. Such is, excessive poverty and excessive wealth.

What should be done? Should the wealthy give to the poor? Or does the imbalance simply represent the poor's lack of capability to generate physical wealth to sell, while the wealthy have generated physical wealth?

Are we looking at the point where the market becomes dysfunctional and should be controlled, or is the market functional, and should remain free?

Monkeys Using Tokens

Although this film isn't directly relevant it is interesting to see that monkeys can be taught to use token money and that humans and monkeys have a similar approach to risk.

Why do we make irrational decisions so predictably? Laurie Santos looks for the roots of human irrationality by watching the way our primate relatives make decisions. A clever series of experiments in "monkeynomics" shows that some of the silly choices we make, monkeys make too.

Given $1000 and then a choice to;
  • get $500 more, or
  • toss a coin, and get $0 or $1000 more,
most choose to get £500 more.

However given $2000 and then a choice to;
  • lose $500, or
  • toss a coin, and lose $0 or $1000,
most choose to toss the coin.

Thus with gains people are risk averse, but with losses they take risks. Experiments with the monkeys tokens and grapes show they do the same.

I would say that Laurie Santos' advice on trading show her inexperience of it. When to pull out and take your gains or losses is quite a subtle decision. The markets call a traders bluff many times and it is recognising the bluffs that becomes an art form.

Laurie Santos: How monkeys mirror human irrationality

YouTube Video




(C)2010 Tom de Havas. The information under this section is my own work it may be reproduced without modification but must include this notice.





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