How Financial Markets Work

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Financial Markets, regardless of the asset, represent the buying and selling of risk. People sell when they believe the risk is too high. They buy when the risk seems low.

Forget about assets and liabilities. Each stock, bond, futures contract, option, and even the currency to purchase it represents a basket of risk. Much like the Quantum Theory of Matter, where particles have wave-like properties, assets also have features of liabilities.

Assets, Liabilities, and Equity

In accounting terms, assets represent something of value, such as stock and cash. A Liability is money owed at a future date with equity representing the amount left over after subtracting the liabilities from the assets.

These clean-cut definitions work great for balance sheets and bank statements. However, they are not sufficient for financial portfolios due to the nature of risk.

For example, consider a typical brokerage account. Here cash is deposited and used to purchase exchange-traded assets such as stocks. The money utilized to buy shares is at risk of inflation. After purchase, the stock is at risk of losing value too. Since the cash and stock can both loose value, they have some probability of moving from an asset to a liability.

Supply and Demand

An exchange such as the New York Stock Exchange (NYSE) functions similar to an auction. Its purpose is to facilitate trade between buyers and sellers. To purchase an asset, with few exceptions, one must be willing to sell and vice versa. Price fluctuations result from supply and demand.

In economic theory, supply and demand describe the interaction between the sellers and the buyers for a specific asset. These forces pull against each other until equilibrium occurs. This balance is the current market price.

That demand is from buyers who believe the asset has low risk. In turn, the supply is from sellers who surmise the same asset is high risk.

Buyers and Sellers

In 1979 psychologists Amos Tversky and Daniel Kahneman coined the term loss aversion. A phenomenon that declares losses to have twice the significant psychological impact of equivalent gains.

Loss aversion explains why some people are willing to buy while others sell the same asset. Consider a person holding a stock. As it drops in value a few points, the fear of loss says, "sell it now before things get worse."

In contrast, a person with a large amount invested into a stock watches it fall in price. They succumb to the economic concept of sunk cost fallacy where a person continues a behavior due to previous investments. As a result, they buy more of the declining stock.

Dealers Market

The NASDAQ for stocks and the CME Group for commodities are dealers markets. Here the dealer buys and sells assets directly to market participants. Giving a bid price and an ask price. A transaction occurs when a buyer accepts the ask price, or a seller takes the bid price.

The dealer acts as a market maker. Their job is to maintain liquidity. Meaning they are almost always willing to sell an asset for one amount and buy it for another. Making money from the spread between the bid and ask prices.

Liquidity

Liquidity refers to how quickly a buyer can match with a seller. Exchanges use electronic means to unite buyers and sellers almost instantly. Be it with a market maker or a third party. Otherwise, transactions would occur like eBay, where sellers wait for an interested buyer to bid.

The speed of transactions is essential since price swings can occur in seconds. Also, the very act of buying or selling assets on an exchange can influence the market.

To protect from influencing the market, exchanges employe statistical arbitrage. This strategy aims to reduce the risk of market movement by opening both a long position and a short position simultaneously, allowing large block transactions without significantly affecting market prices.

While You Were Sleeping

In actuality, during a late lunch or dinner, depending on where you live. Between 4:00 PM Eastern Time until around 8:00, some investors are busy making after-hours trades. Unlike day-time trading, these transactions occur outside of the exchange, directly between buyers and sellers.

Using Electronic Communication Networks (ECN) that display the best available bid and ask quotes from participants, these investors can act upon late-breaking news. This trading is why the price cited at the close is often different from the next days opening quote.

The Foolish Media

When a news anchor says, "the market is up today." They are usually referring to an index such as the Dow Jones Industrial Average (DJIA) or the S&P 500. Not the stock market as a whole.

Short term price changes often occur due to news and social media. For example, when Elon Musk, CEO of Tesla, proclaimed the stock to be too expensive via Twitter. The price temporarily lowered. However, the direction of a price movement is not always as expected by the news received.

The same phenomenon occurs with required reporting. Just as a company or financial agency's announcement begins, the associated asset's price will move quickly. News outlets such as Bloomberg sell the results ahead of time. However, it is illegal to act upon until the official report is made public.

Risk and Return

Risk is the possibility that an investment's actual gains will differ from an expected return. The probability that an investment will perform worse than anticipated is never zero. However, this uncertainty is not something to be feared.

There is a symbiotic relationship between risk and return. The higher the uncertainty, the greater the potential results. In other words, risk is the currency used to buy higher return probability.

Price Movements

To understand why an asset is moving upward or down, one must determine the cause. French Mathematician Benoit Mandelbrot discovered through his scientific study of markets, "In the real world, causes are usually obscure." He concludes, "The precise market mechanism that links news to price, cause to effect, is mysterious and seems inconsistent."

Mandelbrot noted that short term price movements exhibit far more randomness than previously suspected. Unlike what many investors claim, market prices do not fit a normal distribution or bell curve. Instead, they follow a power law. A functional relationship between two quantities, where a relative change in one amount results in a proportional change in the other amount, independent of the initial size of those quantities.

"There were far too many big price swings to fit a bell curve," Benoit remarked after a study on 100-years of market prices. He agreed that prices tend to move upward over time. The problem, he suggested, "is the bumpy ride to get there."

Conclusion

You just read a brief overview of how financial markets work. The subject itself has filled volumes of books. Meaning several aspects are missing for the sake of simplicity. To summarize, consider the following:

Financial markets are not fair. The opportunities you have through a brokerage account are much less than institutions have. Everything from transmission speed to information flow favors the most significant players.

Multiple factors influence financial markets. The assets traded in these markets are priced based upon market sentiment and not the actual value of what they represent. For example, a fundamentally sound company can see shares value decline due to market factors.

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© 2020 Todd Moses

The strategies discussed are for illustrative and educational purposes and are not a recommendation, offer, or solicitation to buy or sell any currency or to adopt any investment strategy. There is no guarantee that any strategies discussed will be useful. Todd Moses is not a licensed securities dealer, broker, or US investment adviser or investment bank.