The Mechanics of a Trade - Part 3 of 3

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This Blog Series covers some pretty complicated stuff and I recommend that you read Parts 1 and 2 before you attack this one - you can find them here:

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

http://wheeliedealer.weebly.com/educational-blogs/the-mechanics-of-a-trade-part-2-of-3

Example 3 - You want to buy 3 Shares in Company XYZ - a ‘Tree-Shake’
This next situation only tends to happen on Small Stocks which are illiquid and where the actions of one Market Maker can affect the Price - on a large and liquid Stock, this kind of thing simply cannot happen as in effect it can throw up an arbitrage opportunity where another Market Maker can take advantage of the artificial Price move and in addition such big Stocks are watched by Traders in general for every tiny move and any mis-pricings would be quickly bought or sold away.

The basic Assumptions are as I listed at the start of Example 1 and your actions as a Buyer are similar to Example 2. This time you still want your 3 Shares in XYZ but because it got kicked back at you on Example 1, you have decided to use a Limit Order through your Broker. For this one, here are the steps as your Order flows through the various Processes; and this time rather than raising the Price to get more Stock to fulfil your Limit Order, the Market Maker ‘Shakes the Tree’ to scare weak Holders into panicking and dumping their Shares at a low Price:
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• You follow the Online procedure with your Broker to place a Limit Order for 3 Shares, this is the same as on Example 2, 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, 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.

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• Your Broker enters your Limit Order into the Order Book, this is also the same as in Example 2 - the Order Book 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.

 

• All the Market Makers for Stock XYZ can see the Order Book, as per Example 2, 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). This time I have only shown 2 Market Makers for simplicity reasons but for most Stocks there will be lots of Market Makers unless they are really tiny (and you are probably best avoiding those sorts of Stocks anyway, unless you are a ‘Trader’ or want to throw your money away.)

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• Market Maker 1 (MM1) lowers the Price they are prepared to Buy from Shareholders at - in other words, they lower the Sell Price which encourages other Shareholders (scares them is another way of putting it) to Sell all or part of their Stock in XYZ and this lowering of the Price creates ‘supply’ so that Market Maker 1 can obtain Shares which he/she can then sell on to you. This time it is not a higher Price and the dreams of locking in a juicy Profit that encourage Holders to sell but the fear that something bad is happening and this panics Holders into getting out as fast as they can (just before the Share Price inevitably recovers again !!). In such cases many Holders will be selling at a Loss just because they are so terrified that the Stock is suddenly going to tank big time. Another technical mechanism that assists this process is when Holders use Stoplosses and these get triggered by the sudden drop in the Price. That is the essence of a Tree-Shake and you can often see these after the event as Hammer Candlesticks on the Chart.

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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 although in such circumstances I would assume there is a way the Broker can just fulfil the Trades within their own Systems) 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 or as I mention on the Diagram, MM1 could get the Shares he/she needs from another MM. As in Example 1 this might be a case of using the Market Quotation system. Remember Market Makers are only part of this process and other Traders could be on the other side of the Trades that get executed. If you have Level2 and DMA, then you too could take advantage of such opportunities - but don’t assume it is ‘easy money’ (I am sure most of us now realise that there is no such thing after the Markets of recent times).

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• Market Maker 1 now has 3 Shares (remember in Example 1 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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• As per the Prices at the bottom of the Diagram, following the Tree-Shake and you getting your 3 Shares you wanted, the Price recovers to where it was at the start of the whole process.

Understanding this Example and how a Tree-Shake works in practice can be very helpful when trying to figure out what is going on when a Small Stock you hold does some ‘funny moves’. Such an appreciation can avoid you selling out in panic when the Price plunges unexpectedly and if you do not hold the Stock, or if you want to buy more, then a Tree-Shake can be an opportunity for you to Buy well although often the Price drop soon disappears so it is hard to take advantage of it (it may also be only in small size so hard to buy a meaningful amount).

When I see such a move on a Stock I hold I tend to instantly assume it is a Tree-Shake and I never let myself panic about it. I go to the News for that Stock on my ADVFN App and I look at the Free Bulletin Board as well - usually if there is something real and of note then it shows up on the Board. You can also put out a Tweet along the lines of “What the heck is going on a XYZ?” and usually someone will know what has caused the move if it is something proper rather than Market Maker fun and games.

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Example 4 - Big Buyer (Institution) wants to buy 10 Shares in Company XYZ
Again we are talking about the same Company XYZ and it has 100 Shares and the Free-Float is quite small. In this Example the Big Buyer (you can tell he/she is big because he/she has a hat !!) tells his or her Broker that they want to Buy 10 Shares and they will indicate a Maximum Price that they are prepared to pay - for example they might cap the Price at 56p as per the diagram, even though the Market Price is 52p to Buy when they initiate the Order. Note, the Big Buyer is prepared to pay more than the 52p because they are keen to get hold of the Stock and they realise that Sellers will only part with what they hold if the Price is high enough to motivate them to Sell.

They could of course be more aggressive and tell the Broker to Buy at a Price below the Market Price, for example up to 49p, but this will be troublesome for the Broker and need a lot of effort to manage the Order and take a lot longer. There is of course no guarantee the Broker will be able to get the Stock required either and most Big Buyers who are Fund Managers or Pensions or some other sort of Institutional Buyer are very much Long Term Investors and they will be more focussed on obtaining the Company Shares they want after spending a lot of time doing analysis, than whether or not they get a ‘perfect’ Buy Price for a point in time.

The Broker will have told the Big Buyer that it will take some time to get the Stock and it might be a Week or something. The Broker will then ‘work’ the Order which means that they break the Order for 10 Shares up into smaller Parcels which are more likely to get Shares from Holders because none of the Holders wants to sell 10 Shares even if they had them. The Broker will perhaps buy some Shares using a Market Order as per Example 1 in some instances or they may place Limit Orders in the Order Book which the Market Maker will then try to fill by doing Tree-Shakes or Raising the Price like in Examples 2 and 3. The Market Makers could also buy Shares from another Market Maker. 

It is in the Broker’s interest to try to get the best Prices they can (‘the Best Execution’) even though the Big Buyer said they would pay up to 56p. This is because the Big Buyer can easily switch to another Broker who would get them better Prices if they are unhappy. That is how markets work !!!

Brokers have relationships with Market Makers and can speak to them on the phone and stuff and the ability of a Broker to work with a Market Maker to get hold of Stock is an important skill (and of course to be able to dump it if necessary). I am sure there are many Rules governing these relationships but I suspect there are quite a lot of practices that happen that may not be truly to the benefit of End-Customers - it is a murky game I am sure.

So the Broker splits the Order for 10 Shares into several smaller Chunks and this will be reflected in the ‘Trades’ information which you can see on Websites like MoneyAM or ADVFN etc. after the Trades have been executed. The important thing to realise though is that an Order for 10 Shares would probably appear at the end of a Day and would show as 10 Shares Bought but in reality it was several smaller Buys of Shares which occurred at various times during the Day. So that is a bit misleading and yet another example of how this ‘Trades’ information is not all that useful.

In the Example on the diagram, because of the limited number of Shares and the actions by the Market Makers and the Broker to get hold of Shares to fulfil the needs of the Big Buyer, the Price will have moved about lots as Tree-Shakes were done or the Price was pushed up to encourage Holders to Sell.

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Conclusion
There are perhaps other scenarios which could be used but what I have included here should cover the main ones and give Readers a pretty good feel of how things work in practice. As I mentioned it is all very complicated and I am sure that I have not got every bit of detail 100% spot on here but I am mostly right - at lease conceptually even if some of my definitions are wrong. That in itself should be enough to give Readers a better appreciation of what is involved and in specific practical terms it should make you more aware of what is happening during a Tree-Shake and also make you more wary of the ‘Trades’ information.

Just below I have included a link to Michael Taylor’s (@vilage_idoit) FREE eBook and I recommend you read that and in particular the chunk on Level 2.

My head hurts now………….Well done for getting through all this.

Cheers, WD. 


Related Blogs
Here is the one I wrote years ago about this sort of thing. Much of this will be repetitive on what I have written in this new Blog (and I won’t be surprised if there are a few contradictions !!) but it is probably worth taking the time to read it again. Especially if you are at work and let’s face it you have nothing better to do and the Boss is out on the Golf Course !!

http://wheeliedealer.weebly.com/educational-blogs/why-do-share-prices-rise-and-fall

This Blog is about Candlestick Charting - it is short and sweet but should demonstrate why I am such a big fan:

http://wheeliedealer.weebly.com/educational-blogs/a-cheap-alternative-to-level2

And you can find Michael’s Book via a Link on my ‘Weekly Performance’ page but here is a Link anyway (if it doesn‘t appear as a pop-up, then there is an Orange Button at the top right hand corner of Michael‘s Homepage):

https://www.shiftingshares.com/