The Mechanics of a Trade - Part 2 of 3

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This subject is quite complicated so if you have not read the first Part then it is probably best to look at that first - you can find it here:

http://wheeliedealer.weebly.com/educational-blogs/the-mechanics-of-a-trade-part-1-of-3

Example 2 - You want to buy 3 Shares in Company XYZ but this time you use a ‘Limit Order’
The basic Assumptions are as I listed at the start of Example 1. This time you still want your 3 Shares in XYZ but because it got kicked back at you in Example 1, you have decided to use a Limit Order through your Broker, where you indicate a maximum Price you are prepared to pay for the Shares. For this one, here are the steps as your Order flows through the various Processes:

• You follow the Online procedure with your Broker to place a Limit Order for 3 Shares and this time you say on the Limit Order that you are prepared to pay “up to 55p” for the Shares (as per the ‘Starting Prices’ bit in the bottom Left Hand corner of the diagram, the Buy Price is 52p at NMS but you know that you cannot get the 3 Shares you want at that Price so you accept that you have to pay a bit more and you say you will go up to 55p). Of course you could do this over the Phone with your Broker. It is also possible that you enter a different, possibly lower, Price into you Limit Order but the risk is that the Order will not get filled and you will not get the Shares you want. With the Brokers I use an Order usually has a ‘Good ‘til Cancelled’ option (GTC) and I think you can choose various time periods like until the end of the day etc. As a personal thing, I often find that if I really want to buy some Shares as a Long-term Investor, it is better to pay perhaps a bit more than you would ideally like because you need to be ‘on the Train when it leaves the Station’.

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• Your Broker enters your Limit Order into the Order Book - this is what you can see using Level 2 and if you have Direct Market Access (DMA), then you can enter Orders onto the Order Book yourself. It is possible that your Broker B1 actually puts an Order at a Lower Price into the Order Book - for example, you are prepared to pay “up to 55p” but your Broker in this example entered that Buy Order as 54p because in their experience they thought a better Price was achievable or perhaps the Price had dropped a bit in the Market when the Order was placed (this would be very rare I suspect and only on tiny Stocks where Humans are involved). I think that Brokers can use the Market Quotation System in a similar way to what I described in Example 1 to get a Quote direct from a Market Maker and to accept that Price if they think it is acceptable, as long as it falls at or under your Limit Price of course.

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• All the Market Makers for Stock XYZ can see the Order Book and they will see your Buy Order for 54p or whatever Price your Broker put it in at (up to the 55p Limit that you instructed). Note also that other Traders who have Direct Access to the Order Book can also act on the other side of Orders that sit in the Order Book and in fact I understand that the majority of Participants who are on ‘the other side’ of an Order are actually Traders rather than Market Makers.

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• Market Maker 1 (MM1) raises the Price they are prepared to Buy from Shareholders at - in other words, they raise the Sell Price which encourages other Shareholders to Sell all or part of their Stock in XYZ and this raising of the Price creates ‘supply’ so that Market Maker 1 can obtain Shares which he/she can then sell on to you. I am not entirely sure how the mechanism on the Price rising occurs but I think the Market Makers have an obligation to always offer a Buy and Sell Price and when raising their Sell Price (the Price other Shareholders can sell their Shares for) they also put up the Buy Price and the Mid Price is just the midway point between these two Prices (in other words the mid point of the Spread). After all, the Market Makers by definition have an obligation to ‘Make a Market’ (perhaps they are more interested in marking a Market for themselves !!) and it is this role which helps to provide Liquidity which is particularly important for small Market Capitalisation Shares. I now understand that this is how it is supposed to work but in practice, especially on the tiny Shares, there are instances where the Market Makers do not in fact honour the NMS Prices.

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• When Shareholder ‘A.N.Other’ puts in his or her Order to Sell a Share in this example, their Broker (B2 in the diagram but of course in reality it might be the same Broker) places their Sell Order into the Order Book and in this case we would expect Market Maker 1 to Buy that Share through the Order Book. Of course that could happen under the Quotation System like I discussed in Example 1 and other Market Participants who have access to the Order Book can trade on it as well.

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• Market Maker 1 now has 3 Shares (remember in the previous example they had 2 Shares which they were offering at NMS) and therefore they can fulfil your Limit Order for 3 Shares at 54p in this example (see the ‘New Prices‘ at the bottom in the middle).

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• Market Maker 1 could have bought the extra Share from another Market Maker and these kinds of deals are quite common I think. In this case I have shown this with Market Maker 4 in the diagram.

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So in this example the important point to realise (‘take on board’ in the Business Jargon BS speak) is that Market Makers can obtain Stock from Shareholders by raising the Buy/Sell Price in order to encourage Holders to sell. So this is an extremely important concept - the ‘Free Float’ for a Stock at a given time and price is not static and it can vary to a large extent and this depends on the Conviction of the Shareholders (Institutions like Fund Managers will be very firm Holders) and the Price, because a very High Price will encourage Sellers (even among Fund Managers) and very low Prices can encourage Buyers (again this can be Fund Manager buying - it is often the case that Fund Managers do not buy or sell huge chunks of Shares but they trim their Holdings or add to their Holdings at various times, depending on how ‘tactical‘ their approach is). Of course that level of ‘Conviction’ by Holders also depends on the News around the Company that is current at that time.

The other important thing to think about in this Example is what I started this Blog off with about how Buyers and Sellers are always matched - there might be periods where a Market Maker has Shares sat on their Books, but with a finite and limited number of Shares there always has to be a Buyer and a Seller (or one Buyer and many Sellers or many Buyers and one Seller etc.). 

Market Makers tend to be specialists in their Stock and this is particularly the case on AIM Shares and Smallcap Shares. I understand that these Market Makers might hold Stock on their Books for a few Days but they tend to ‘go flat’ over a Weekend although this all depends. In general the Market Makers in a given Stock will always have some amount of Stock on their Books so they can do their role in making a Market and ensuring some liquidity for Traders/Investors. Obviously they don’t want to hold too much Stock because in effect that would be dead money if it is a Stock that doesn’t get traded much.

Because they know their Stocks really well, they have a good understanding of Results Announcements coming up and any Broker Reports that are due to come out and any News that is likely to move the Market like perhaps a new Product Launch or a Share Placing or something (having said that I understand they are not supposed to know about Placings due to ‘Chinese Walls‘ but I suspect this is rather debatable !!). They are always ahead of you !!

On a Share where very few Trades go through on the average Day, the Spread between the Buy and Sell Price will be very wide because the Market Maker turns a Profit by making a wider percentage on a low turnover. On a Stock that is traded lots, for example on a MegaCap like Vodafone VOD, the Profit Margins are tiny with a tight Spread but the volumes are huge so the Market Makers can do very well thank you very much !! In such cases there is a lot of competition with many, many Market Makers and they are all competing to get the Trade volumes so that they can make more Money - this squeezes the Spread closer together than on a rarely traded, low volume, Stock.

Order Book
This Link gives more information on the Order Book and how it works etc:

https://www.investopedia.com/terms/o/order-book.asp

And this bit on Limit Order Book is worth reading:

https://www.investopedia.com/terms/l/limitorderbook.asp

One point worth stressing from this is that it must be appreciated that there is a difference between Unfilled Orders sat on the Order Book which can perhaps gives clues to the kind of Buying or Selling interest for a given Stock, and the ‘Trades’ data which you can find on various Websites which is historic and shows Trades that were executed (this stuff is pretty useless as I have explained in other places).

Hopefully this example of why a Price would move up on a Stock because of a particular Trade gives Readers an appreciation of the kinds of granular events that take place when you Buy or Sell a chunk of Shares. Clearly if you were to add lots of these kinds of Trades together then you can see how a Price would move up substantially especially if there was a limited Free Float and existing Holders were very committed to holding on to their Shares and needed a lot of encouragement to make them Sell any.

In Part 3 we will look at more examples of Trade Types with a ‘Tree-Shake and what happens when a Big Buyer wants a load of Stock.

Cheers, WD.


Related Blogs
This one is exactly my earlier point about it being better to be on the Train when it leaves the Station than to miss it because you wanted a slightly better Price:

http://wheeliedealer.weebly.com/educational-blogs/i-cant-buy-that-ive-missed-the-boat