What is a “market”? The typical person off the street would probably say that a market is a place where trading occurs. While responding, that individual might have in the back of his/her mind visions of large, loud, and aggressive men in brightly colored jackets yelling and screaming at each other on traditional exchange floors. But does a market have to be a place? No. There are many types of markets: supermarkets (where you can purchase everything from food to flowers, detergent to DVDs), flea markets (where people buy and sell used items), black markets (in which illegal or illegally acquired commodities trade hands), stock markets, meat markets, money markets, and farmers markets. In short, there are many different institutions that we identify as a market. Nevertheless, when many of us think of a market, we tend to think of the organized financial markets and more explicitly, the trading floors of the securities exchanges.

What is a “price”? Adam Smith (the real Adam Smith) once said,

More precisely, what this indicates is that if I give up four USD, I will receive one hamburger. Though it may sound odd when articulated in this way, when we are buying hamburgers, we are selling Dollars, and the price identifies the rate of exchange. And though it may sound even stranger, McDonald’s buys Dollars with hamburgers, though almost everyone would identify McDonald’s typical daily activity as selling hamburgers.

Let’s ask another question. For the sake of argument (even if it is counterfactual), assume you own a car; heck, as long as it’s hypothetical, you may as well assume that you own an extremely nice car. Now my question is, “Would you like to buy another car just like yours?” Some of us may think that we do not “need” another car, but if I asked you whether you’d like to buy another car just like yours for USD 1, most people would immediately respond in the affirmative (if only because they would make such a purchase intending to resell that car in the near future at a higher price). If asked, “Would you be willing to sell your car?” some people might respond, “no” because they “need” their car, for example, to get to work, but, by the time I started offering USD 20,000,000, most people would tend to oblige. What is the point? Economists often talk about “the buyers” and “the sellers” as if they are well-defined groups of economic agents, but whether you are a buyer or a seller may very well depend on the price. Prices drive markets. This is no less true of the foreign exchange market than any other market, and, remember, it is best, especially in FX, to think of every price as a ratio of quantities.

Most people say that the market went up because there were more buyers than sellers, but that need not be strictly true. One seller with a great deal of product to sell or “to go” may interface with a huge number of buyers, but the numerical superiority of the quantity of buyers may not be sufficient to keep the market price from plummeting as the seller goes about his/her business. Price behavior depends on the quantity being offered for sale, the quantity for which buyers are bidding, the time frame involved, the urgency of the two sides of the market, and a myriad of other factors that a well-known economist named John Maynard Keynes once characterized by the expression “animal spirits.”

The good news for the marketmaker is that their counterparty has to sell low and buy high. Counterparties (sometimes called “market takers”) are said to have to “cross” the bid-ask spread.

To avoid the confusion associated with foreign exchange for now, let’s think about gold. Gold is not foreign exchange—even if it has served, in many different forms, as money over time and, to this day, is sometimes used for international trade settlements. Gold is a very simple commodity (heck, it’s more than just simple, it’s an element: AU), and, as a fairly elementary product, it will allow some basic points to be made.

Unlike the formal securities exchanges, which record and report prices in an extremely timely and highly reliable fashion, the market for gold, like foreign exchange, is predominantly OTC (and so there is no central repository of information into which all trade data flows, through which prices and quantities are organized, and from which these numbers are disseminated). Nevertheless, gold, like FX, is traded globally in a large, active, and relatively transparent market. It is usually easy to obtain a price for gold that one might be relatively confident reflects a very recent transaction. For the sake of argument, let’s say that gold last traded at a spot price of S = USD 400 per ounce.⁵ Are you ready to make a market? You might try the following: “375 bid, offered at 425” or more succinctly “375-425” (read “375 at 425”). This would indicate your willingness (as a marketmaker) to buy gold for USD 375 per ounce and your willingness to sell gold at USD 425 per ounce. If some counterparty were to “hit your bid” (which means to sell to you where you are willing to buy, i.e., 375) and another counterparty were, simultaneously, to “lift your offer” (which means to buy from you at the price at which you are willing to sell, i.e., 425), then you would “capture” the “bid-ask spread” of USD 50 with every matched pair of these transactions that you do.

There are two methods for gaining insight into where the market is going. The first goes by the name of fundamental analysis and the other is known by the blanket expression technical analysis. These are two very different approaches.

As a marketmaker, you control only one thing: your position. You can be “long” gold, or “short” gold, or have no position at all.⁶ Of course, in reality, marketmakers are constantly doing transactions, and therefore changing their inventory dynamically throughout the day. Now it is possible for you to influence your position as a marketmaker by the markets that you make (i.e., by the prices that you communicate to your clients). If you have purchased a great deal of gold as the day has evolved (i.e., you are very long), then, as a marketmaker, you are probably inclined to want to sell some of your inventory (since the larger your inventory, the greater the risk you have if the price of gold drops), and if you are short, you are probably inclined to want to buy back some of that gold (unless you are extremely confident the price will fall). A trader who is inclined to want to reduce a long position is said to be “better offered” (i.e., to be asking a lower selling price than the other traders), and someone is said to be “better bid” if they are conveying a higher proposed purchase price than the rest of the market.

Some news is predictable, at least in terms of the timing of its dissemination. For example, gold mining production figures, as mentioned earlier, are reported monthly by the U.S. Geological Survey. In general, a great many financial and economic numbers, from unemployment data and new job figures, to GDP, international trade imbalances, measures of inflation (such as the Consumer Price Index), corporate earnings, housing starts and new home sales, survey results on consumer confidence, are all reported relatively regularly (although admittedly with a varying degree of reliability depending, for example, on whether the data are compiled from surveys or obtained from the population, on who reports the information, on whether the numbers are subject to frequent and/or significant revision). In short, although the number itself might be in question, there is no uncertainty about the timing of its release.

Marketmakers, traders, broker/dealers, and many market participants refer to better informed agents as “smart paper” in reference to the paper tickets that once formed the foundation of market order flow. In some situations, a marketmaker is not allowed to inquire (of the broker executing a customer order) whether that customer is buying or selling; the responsibility of a marketmaker is to quote a two-sided market—as the knowledge of what a customer wishes to do (that is, buy or sell) presumably would allow an unscrupulous marketmaker to skew their price up or down and thus take advantage of that customer. Securities regulations are very strict in ensuring investors fair prices and orderly execution. Having said that, because the FX market is not encumbered by many of the rules and regulations of the securities laws (foreign exchange is not a security), in principle there is no reason why a marketmaker could not ask a client what they wanted to do (i.e., buy or sell). Practically, though, it is generally considered unprofessional to inquire on any reasonable size market order. Then again, on a particularly large order, one might hear an FX marketmaker ask, “Full amount?” By this they are asking if the entire order is being placed with them or if a basket of similar orders are simultaneously being launched to every other marketmaker. It might make a difference to a trader (in terms of taking on a large position, in terms of their anticipated ability to lay off some of that inventory with other market professionals, and in terms of managing their overall portfolio risk) who might otherwise be able to slowly “work their way out” of a large trade without the market knowing what trades they would like to or have to do. Finally, there are instances in which a client, wishing to place an order in a particularly illiquid currency pair or difficult-to-hedge exotic option (to be discussed later), might be asked, “Do you want to buy it or do you want to sell it (possibly with additional inquiries about the magnitude of the proposed transaction)?” because the legitimate width of the bid-ask spread might be (justifiably, but uncomfortably) rather wide in those instances.

Unlike the case in some of the other financial markets, there is no legislated maximum bid-ask spread in gold or FX, but the competitiveness of the gold and FX markets keeps the bid-offer range in these product areas as “tight” as anywhere (i.e., a very small bid-ask spread). Of course, this might also depend on the face or notional amount that one’s counterparty wishes to trade. To put some perspective on the issue of bid-ask spreads, U.S. equities, until recently, traded in 1/8ths and of a Dollar; since decimalization (which arrived in the United States in 2000), prices have been quoted in cents (resulting in a reduction in the size of the quoted bid-offer spreads), with a typical bid-ask being a few cents wide. In FX, most currencies are quoted out to the fourth decimal place and markets are usually only a few “pips” wide (to be defined in Chapter 5). Of course, we should really look at bid-ask in terms of percentages (for this to be a legitimate comparison), but the extremely tight bid-ask spreads in the major currency pairs in FX generally reflect a very competitive and highly commoditized market. For the record, a typical bid-ask spread in gold on a typical day with last trade at S = 400.00 might be USD .40, or 399.80-400.20.

Volatility, or the “jumpiness” of market prices, would matter to a marketmaker because if the price of gold tends to move up and down violently (which is what volatility is all about), then, to keep from being “run over” (that is, from being on the wrong side of an informed customer’s trade), a marketmaker would want to widen out their bid-ask spread. For example, with the last trade at S = 400, a bid-ask of 399-401 might be in order if gold fluctuates only minimally each day, but a marketmaker might feel more comfortable quoting 397-403 if it was the case that gold frequently experienced two to three Dollar average daily price swings.

All too often, I have heard people blame marketmakers for manipulating market prices, and, while this has no doubt happened on occasion, for the most part, traders are facilitating their customers’ orders and simply reacting and responding to the buying and selling that is going on in the market. An actual marketmaker once explained, “The prices you see are not set or determined by us. We reflect, like a thermometer, what the supply and demand are. That final price you see up on the board is representative of what the entire world feels that commodity is worth at that time and place.”⁸