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THE MECHANICS OF COMPETITIVE MARKETS

The ability of customers to place orders at restricted prices as well as at cur �rent market prices is an essential feature of market making on the New York Stock Exchange, and on many similar markets. Approximately 60% of all executed orders on the NYSE are market orders. The most prevalent type of restricted order is labeled a limit order. Buy limits constrain the broker to execute the order at a specified price or lower, and conversely for sell limited orders. These orders arc recorded on the book of the specialist, who receives commissions for handling them. In addition to these commissions, which con �stitute riskless income, the specialist enjoys profits (and sometimes losses) by trading on his own account.

A customer's order to buy or sell at the market is transmitted to the ap �propriate broker on the floor of the Exchange. It is this floor broker's duty to obtain the best possible price available at the time. To do this, he goes to the post where the stock is traded and asks the specialist for a quote. Let us assume that the specialist is not trading for his own account. The specialist quotes his book by announcing the highest buy limit and lowest sell limit entered on it. As an illustration, a simulated page from an imaginary specialist's book ap �pears in Table IV. Tho quote for the stock will bo 33 4/8 bid, 33 5/8 asked. A market buy order would bo oxecutcd at 33 5/8; a market sell at 33 4/8. The bid price differs from the asking price, and both exist concurrently in time.

There is no such thing as a single price at which stocks may actually be traded for time intervals as short as between consecutive transactions. The double-valued nature of potential executed prices (the quote) has important consequences for the sequence of actual executed prices.

Consider now what happens when a sequence of random buy and sell orders (without a preponderance of either), arrives at the post of the specialist whose book looks like Table IV. In the short run, the limit orders on the book will act as a barrier to continued price movement in either direction. Until all limit orders at tho highest bid (33 4/8) and the lowest offer (33 5/8) are executed, transaction prices will fluctuate up and down between tho bid and the offer in accordance with the random arrival of the market orders. Moreover, the period of oscillation may tend to last longer than a glance at the specialist's book would suggest; additional orders to buy at 33 4/8 and to sell at 33 5/8 are to be expected. Therefore, the pattern of numerous reversals displayed by the data exhibited in the previous sections is just what one might expect from the current system of trading on the Exchange.

Holbrook Working has reported a similar tendency to reversal in the intra-day price movements of Chicago Wheat futures [19]. His sampling study in �cluded 143 scries of 100 successive price changes covering the years 1927-1940. He reported that in 70 of the 143 series, the price changes of 1/8 of a cent in either direction were followed by opposite changes 75 or more times out oi 100. Furthermore 140 of the price series considered contained 65 or more reversals per 100 changes.4

This tendency to reversal is to be expected in any market in which a broker controlling the supply of the commodity makes available a firm quote for a limited amount of time. Thus, suppose a coin dealer in uncirculated 1909-svdb pennies puts out a weekly quote sheet. A typical quotation might be $265 bid, S300 offered. For one week the price for all transactions (his and all others who read his quote sheet) will oscillate between those levels or at a slightly narrower spread if ho has casual competitors. One can verify this by checking the transactions reported on the various teletypewriter systems, e.g., Interna �tional Teletype Network.

If a sequence of market orders will generate reversals when buy orders and sell orders arc equally numerous, it will generate continuations and runs when one type of order predominates. Suppose, for example, that the specialist of Table IV receives a sequence of market buy orders. The price of execution will be 33 5/8 when the first order comes in, but it will quickly advance to 33 6/8 as the limit orders at 33 5/8 are exhausted. With continued buy market orders, the price will soon reach 33 7/8. At this point, the statistical record will show a continuation—a rise from 33 5/8 to 33 6/8 followed by another rise from 33 6/8 to 33 7/8. And if more buy orders come in, the price will rise to 34, and the rocord will then show three successive rises—that is, one continuation fol �lowed by another.

Our analysis shows how the tape reader can infer the composition of market orders by observing the pattern of reversals and continuations in ticker prices. Frequent reversals suggest buy and sell orders in roughly equal proportions; more reversals are then to be expected. Absence of reversals suggests orders all on one side— to buy if price changes are up, to sell if price changes are down; a continuation of trend is then to be expected. A long sequence of transactions at one price suggests that market orders are all on one side but have not yet exhausted the limit orders at that one price. Were it not for the possibility of matching market orders, a long sequence of transactions at one price would seem to suggest that the next change in price would agree in direction with the last preceding change. But this conclusion has to be modified, since there is an unequal clustering of limit orders at different eighth positions.