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Strategies & Market Trends : DAYTRADING Fundamentals -- Ignore unavailable to you. Want to Upgrade?

To: marketbrief.com who wrote (2146)	7/28/1999 1:36:00 PM
From: Bilow	Read Replies (4) \| Respond to of 18137

Hi marketbrief.com; Regarding liquidity, spreads, and volatility and scalping... As traders, one of the services we allegedly provide to the market is "more liquidity." This happens when we put out limit orders. Of course, when we take out limit orders we are removing liquidity from the market, and some traders trade using that technique. I have come to believe that some of the best trades occur when I "correct" the spread. That is, some other trader(s) have made the spread too small or too large, and you fix this. For instance, suppose XXYZ typically trades with a "real" spread of 1/2, and the currently has a quote of 15 by 15 1/2. Then an ISLD guy comes out with an offer at 15 1/16th. Instinctively, I, and all the other traders, will hit the offer at 15 1/16th, and then offer the shares out at 15 7/16th, trying to scalp the 3/8ths. Since the next order coming into the market is as likely to be a buy as a sell, this action provides you with about a 50% chance of making the 3/8ths. On the other hand, if the next order is a sell, you will have to sell to the next level down or so, and will probably lose no more than 1/4. Overall, on average, you make 1/16th on that sort of trade (i.e. 0.5 * 3/8 + 0.5 * - 1/4 = 1/16), so these scalps might return 6 cents per share (and therefore be very profitable to a scalper, who's costs are around 3 cents per share.) On the other hand, suppose a heavily traded stock, that normally has a spread of 1/16th temporarily widens out to 1/4, presumably due to some big player cleaning out the bids (or asks). In that case, all the traders will place limit orders reducing the spread. If you quickly get hit by someone's market order, you will probably be able to make a profit as the spread narrows. For example, a heavily traded stock ends up quoted 10 1/4 x 11. You place an order to short at 10 15/16. You get hit, and are now short. A few minutes later, the spread narrows to 1/8th, having evenly come in on both sides. This leaves the quote as 10 9/16 by 10 11/16. You cover your short by buying at 10 11/16th, leaving a profit of 1/4. Of course, if the guy who bought your 10 15/16 was the beginning of an elephant order, you are going to lose money. In any case, just like when you subtract liquidity from the market, it is all a game of probabilities. I'll post an explanation as to why stocks trade with particular spreads, as a consequence of the distribution and correlation of the incoming market orders in some later post... -- Carl