A MARKETPLACE WALK-THROUGH

Suppose that the market is in a steep up-trend, and I decide that I want to be a part of that trend, so enter the market with a buy order. In order for a transaction to take place, there must be someone who is willing to sell to me. But why on earth would anyone want to sell to me when the market is in such a steep up-trend?

There are various reasons for this:

• Someone else may have bought into the trend much earlier. They now want to exit their position and take their profits. Because they bought to enter the position, they must sell to exit it.
• Someone else has a different assessment of future price direction to mine and therefore they want to do the opposite to me, so they enter the market with a sell order. We cannot both be correct, obviously, and for only one of us will the trade prove profitable.
• Someone else wishes to establish a position because they have a different agenda within the market to me. While I expect price to rise over the next few hours, they may be entering the market with a sell order because they expect price to fall over the next few weeks, months, or even years. Or they may have no expectations of the market whatsoever, and may just be looking to hedge other activities, whichever way price moves. More of this in a moment.

Many different people, organisations, banks, and funds all speculate within the marketplace for very different reasons. Let’s try and build up a picture of how this works with different types of traders, and how their different expectations interact.

AMAZING AIRLINES are worried that the price of jet fuel (which is derived from crude oil) is set to rise. This will make their operating costs more expensive, and they will either have to operate at a lower profit, or maintain their profit margin and pass on these costs to their customers. If they do the latter, they may lose customers, and so their profits may decrease anyhow. Neither of these options is attractive, so they decide instead to hedge their position by buying contracts in crude oil. This protects them whatever the outcome – if fuel prices do rise, then their operating costs will increase, but the value of their investment in crude oil will increase by an equal amount. If fuel costs drop then the value of their investment in oil will decrease, but this will be offset by the increased profits because their operating costs will be less.

AMAZING AIRLINES contact their broker FANTASTIC FINANCE, who has lots of staff on the floor of the Chicago Mercantile Exchange where contracts in crude oil can be bought and sold. One of the phone clerks sitting at a desk at the edge of the floor takes down the order, and passes it to a runner, who takes it to their broker in the pits. If it is busy, the phone clerk may communicate directly with the broker through elaborate hand signals or shouting.

FANTASTIC FINANCE’S broker executes the trade by buying the contracts from SCALPER SAM. SCALPER SAM is a Market Maker. Having bought the contracts at a lower OFFER price, he now aims to sell them where the BID price is higher, thereby making his profits from the spread. He will hope to scalp these small profits hundreds of times throughout the day.

SCALPER SAM bought these contracts just a few moments before at a lower OFFER price from SPECULATOR SMITH. A technical trader, SPECULATOR SMITH has been studying his price charts and watching the news, and is convinced that prices in Crude Oil cannot get much higher and are set to plummet sometime soon. So he decides to sell contracts in an attempt benefit from his predicted price decline. Ultimately, SPECULATOR SMITH has assumed the original price risk of AMAZING AIRLINES.

From this example we can begin to identify some of the common market players:

• The Hedger – Is usually a company whose business is exposed to the real world risks of price changes in a particular commodity, and who aims to limit this risk by ‘betting both ways’ on future price movement.

• The Broker – Is responsible for carrying out the actual buying and selling on behalf of a client, aiming to get the best price available at that time. Because they act on a fixed commission, brokers are completely immune to price changes. Because they operate on behalf of many clients they improve the efficiency of the marketplace.

• The Market Maker – trades risk liquidity and aims to profit from the SPREAD. A side effect of his activity is to ease the process of buying and selling and maintain liquidity in the market, acting as a shortcut for those who want to jump straight to the front of the BID/ASK queue and pay his prices. Scalpers operate on a price differential between buyers and sellers within the same market place at different times; those who operate on a price differential between different market places at the same time (eg the value of the pound in London versus the value of the pound in Hong Kong) are known as arbitrageurs.

• The Speculator – Is someone who aims to profit from future price movements in the markets. Speculators range from seasoned professional traders and fund managers through to members of the public, who normally buy and hold onto stock for longer periods in the belief that its value will increase.

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