Bids and Offers

The building blocks of financial markets are two types of order:

1. Bid: a rate at which a price maker is willing to buy
2. Offer (also called Ask): a rate at which a price maker is willing to sell

Bids and offers need to have a size associated with them. Saying, “I will buy apples for 10p each,” is interesting to another market participant but not enough information; will you buy ten apples or a million apples?

There is an important distinction between price makers (also called market makers) and price takers within financial markets. Price makers leave orders in the market. Price takers come into the market and trade on existing orders. If a price taker wants to buy, the contract must be bought at a price maker's offer, and if a price taker wants to sell, the contract must be sold at a price maker's bid. Put another way, the price maker buys at their bid and sells at their offer, while the price taker sells at a price maker's bid and buys at a price maker's offer.

Within the market for a particular financial contract, if a trader wants to buy, there are essentially two ways of doing it:

1. Pay an offer (i.e., buy from someone who is showing an offer).
2. Leave a bid and hope that someone sells to you.

To sell, again, there are two possible methods:

1. Give a bid (i.e., sell to someone who is showing a bid).
2. Leave an offer and hope that someone buys from you.

There are two major differences between these approaches. The first is that trading on existing bids and offers can be executed instantly while leaving orders can take longer and may not happen at all since it requires someone else in the market to trade on your order. Generally, this requires the market to move toward the order level. The second difference is that leaving orders usually results in transacting at a better rate.

A reduced view of the current market is often given, showing only the single best bid and single best offer in a given contract. The best bid is the highest of all current bids (i.e., the most that anyone in the market is willing to pay to buy the contract). The best offer is the lowest of all current offers (i.e., the least that anyone in the market is willing to receive to sell the contract). The best bid and best offer combine to form the tightest two-way price in the market (i.e., the price with the tightest bid–offer spread, or put another way, the smallest difference between bid and offer).

Exhibit 3.1 shows a snapshot of an imaginary international apple market, showing bids on the left and offers on the right with shaded backgrounds. This is called the order book, which shows the depth in the market (i.e., all current bids and offers in the market) and a size associated with each order. Prior to transacting, this market is anonymous (i.e., it isn't known which market participant has left any particular order) and it often also isn't clear whether an order at a particular level is one order or a collection of multiple orders aggregated together.

In this example, the best bid is 9p and the best offer is 11p. Most of the time, the best bid is simply referred to as “the bid” and the best offer is “the offer.” Lower bids and higher offers are referred to as being “behind.”

For a given contract, offers are (almost) always above bids. However, in some situations, a market will be choice, meaning the bid and offer are at the same level. Even rarer, the offer can be below the bid—an inverted market. Markets rarely stay genuinely inverted for long, since the market participants showing the inverted bid and offer should be happy to trade with each other and hence restore the normal bid–offer direction. An inverted market often occurs when the relevant market participants can't trade with each other for some reason.

Trader X wants to buy 100 apples at 8p and trader Y wants to sell 100 apples at 8p. If trader X and trader Y each know what the other wants to do, they should be happy to trade with each other at 8p. It is therefore vital that both traders know of each other's intentions. For a market to function efficiently, transparency and the flow of information are key considerations.

Back to our apple order book: As mentioned, selling 10 apples in this market can essentially be done in two ways:

1. Give the bids. Five apples can be sold at 9p and five apples can be sold at 8p (so five of the 8p bid would remain). This averages at a rate of 8.5p to sell the apples but the transaction will certainly be completed.
2. Leave an offer. The rate of 11p already has an offer there. By “joining” (i.e., showing the same offer) the 11p offer in 10 apples, the size of that offer will go up to 40 apples.

   Note that if the 11p offer starts being paid, the original 11p offers will be transacted first. The offer could also be left at a higher level, at 12p or 13p, which would lead to potentially transacting at a better rate (selling higher), but the higher the offer, the lower the chance of transacting and the longer it will take.

In practice, particularly in faster markets, traders work buy or sell orders using a combination of trading on orders and placing orders. If the order was in larger size, the trader might dynamically leave (place) and remove (pull) orders, depending on how the market is reacting in order to get the best possible transaction level (fill).

In the apples example, if the 11p offer were to further increase in size, it is possible that bids would be pulled, or would be moved lower, since traders will see the large size on the offer and conclude that there are a large number of sellers in the market who will push the price lower. For this reason it is sometimes appropriate to transact an order in smaller chunks over time to reduce market impact.

Exchanges offer different order types that give additional control around how a bid or offer is processed. For example, limit orders allow buyers to define their maximum purchase price and sellers to define their minimum sale price while fill-or-kill orders are either executed immediately in their entirety, or else the order is canceled.

Decisions on how to transact within a certain market are based on an understanding of the relationships between transaction size, probability of transacting, transaction speed, and transaction rate. These factors are often combined into one word: liquidity.

Market Making

What follows is a simplified example of some market-making activity in our imaginary international apple market. Within this market, traders request prices directly from each other and 1,000 apples have just traded in the market at 10p. Trader B comes to trader A requesting a price in 200 apples. Trader B does not disclose a buying or selling preference so trader A makes the two-way price shown in Exhibit 3.2.

The bid is 9p and the offer is 11p. Therefore, trader A has shown a bid–offer spread of 2p. Trader A is assuming that the midmarket price of apples is still 10p. Hence if trader B transacts on either side of the price, the trade will contain some spread from the midmarket price.

Trader B now has three options:

1. Buy 200 apples (or fewer) at 11p (i.e., pay trader A's offer). If trader B buys, trader A sells; hence trader A would have “sold at their offer.”
2. Sell 200 apples (or fewer) at 9p (i.e., give trader A's bid). If trader B sells, trader A buys; hence trader A would have “bought at their bid.”
3. Pass. Trader B can decide not to buy at 11p or sell at 9p and therefore can walk away from the transaction. This could happen for many reasons; perhaps better prices are being shown by other traders in the market (lower offers or higher bids depending on whether trader B is a buyer or a seller) or perhaps trader B has had a change of mind and no longer wants to transact. Trader B does not have to explain to trader A why the price is being passed but it can be useful to know why (called feedback): If another trader is, for example, showing better bids, trader A can use that information in their future price making.

Trader B buys 200 apples at 11p. Therefore, Trader A has sold 200 apples and Trader A's apples position has gone shorter by 200. Although the actual exchange of apples for money may not occur until later, trader A's exposure to the price of apples changes as soon as the trade is agreed.

Trader A broadly now has two options:

1. Warehouse the risk and “run the position” (i.e., keep the changed exposure to the price of apples).
2. Close out the risk by going back into the market and trading to offset the exposure.

Trader A decides to warehouse the risk. Trader C now enters the market and requests a new two-way price in 200 apples from trader A. Here are three different possible scenarios for what happens next:

Scenario 1

Trader A quotes the same two-way price shown in Exhibit 3.3.

This time, trader C sells 200 apples at 9p. Hence trader A buys 200 apples, exactly offsetting the first transaction. By showing two-way prices to counterparties with opposite “interests” (buy/sell directions), trader A has managed to buy low (at the bid) and sell high (at the offer). Overall, trader A's position is back where it started, having earned 200 (contract size) × 2p (spread) = 400p for these two transactions. By market making, the trader has balanced their position (hence reducing risk) while locking in a profit. This scenario illustrates the advantages of being a market maker when counterparties have offsetting interests, called two-way flow.

Scenario 2

Due to the initial transaction occurring, trader A believes that the price of apples is rising in the market. Plus trader A is short from the initial transaction and doesn't want to get any shorter. Therefore, trader A makes the price shown in Exhibit 3.4, with a relatively better (higher) bid to make it more likely that trader C will sell, and a relatively worse (higher) offer to make it less likely that trader C will buy.

Again, trader C has three options:

1. Buy 200 apples at 12p.
2. Sell 200 apples at 10p.
3. Pass.

If trader C is a seller, trader A is hoping that trader C decides 10p is a good price at which to sell. Raising the bid has increased the probability of trader C selling but it has reduced the amount of spread trader A will capture if trader C does sell.

Trader C was a buyer, but another trader in the market showed a lower offer, so trader C passes trader A's price. Trader A can use this information in future price making. This scenario illustrates how market makers use their trading position to influence their price making.

Note how important the flow of information within the market is. Depending on the market structure, the previous trade at 11p may be known by everyone or it may only be known by the traders involved in the transaction. The longer the time between transaction and reporting, the more power market makers have because they are personally involved in more trades and hence have access to better information.

Scenario 3

Once again, trader A does not want an increased short apple exposure so quotes a higher bid and a higher offer as shown in Exhibit 3.5.

Trader C pays the offer: Trader A showed a higher price but again the offer was paid. Trader A goes to the market to get a price in 400 apples to hedge (“get out of” or “offset”) the position acquired from the previous two transactions. The rate received back from the market is shown in Exhibit 3.6.

The price of apples is rising and trader A is stuck with a short position. Trader A certainly does not want to sell even more apples at 12p, and if the position is bought back at 14p, an average loss of 2.5p will be locked in. A substantial part of the market has the same position. As traders go into the market to hedge their positions, the market moves higher, which causes the trader to lose money from the short apple position. This scenario illustrates the risks of being a market maker arising from not being in complete control of the trading position.

Price Making and Risk Management Overview

Success in price making depends on assimilating information from the market. The more information a trader has about market activity, the more likely it is that they know the current midmarket levels, which in turn increases the chances of successfully servicing clients and capturing spread. When many banks quote on the same contract in competition, to win the trade, the trader needs to show the best price of all traders quoting on the contract, but at the same time they attempt to maximize the spread earned from the midmarket level.

The key to successful risk management is to take positions (long or short) in financial contracts that make money as time passes and the market moves. Traders talk about the market “moving against” them (when losing money) or “moving for” them (when making money). For buy-side market participants (e.g., hedge funds) the risk management process is straightforward: They go into the market and transact only deals that they think will make money based on their analysis. As seen earlier, however, for market makers it is often not their decision to take a position. Rather, positions are generated as a consequence of market-making activities when the trading desk takes on the opposite position to the client when the client transacts.

Key risk management decisions for traders therefore involve inventory management, or in other words, deciding when to warehouse risk and when to close it out. Traders make these decisions based on their current reading of the market: direction, liquidity, sentiment, and so on plus trading decisions are also made with reference to risk limits. P&L targets and risk limits should be in line: Greater risk gives the opportunity for greater reward but it does not guarantee greater reward, only greater P&L volatility. Risk limits therefore keep P&L volatility to acceptable levels.