Playing the game

Short term competitive pricing

     In this article I consider the buying and selling of financial instruments for reasons other than dividends, interest or capital appreciation, and put forward an idea that trends, over random price changes, are caused by the competitive activities of participants. Then I consider a methodology for minimising risk and maximising profits in a market of random volatility.

     Prices, dividends, interest and capital appreciation are all subject to risk. A long term strategy can be badly hurt by crashes, panics or short term price movements. For example a buy and hold portfolio losing 20% or more of its value in only a few months, due to volatility and adverse market conditions. Due to volatility it is often profitable to have an appreciation of general conditions and market activity.

     Prices generally follow the line of least resistance. Yet the line of least resistance to just exactly who?

     The heart of pricing is competitive activity. People explain price movements by arguing that there are more sellers than buyers, or more buyers than sellers in a market. Why this is the case often becomes clear after the event. Some ask the question "How do prices move at all, if every purchase matches a sale and every sale a purchase?" In fact, prices move precisely because every buyer must find a seller, or alternatively every seller must find a buyer, and buyers and sellers can be matched at different price levels depending on who is out there.

     So lets look at a possible trading methodology:

     When there are lots and lots of buyers for a security, there are higher and higher bids made until some bids exceed offer prices, so offer prices immediately match the pressure upwards, the path of least resistance is upwards. When there are lots and lots of sellers, there are lower and lower offers made until some fall below the bid prices, so bid prices immediately match the pressure downwards, and the path of least resistance is downwards. The nature of this competition means bids and offers can be priced competitively, or not, causing continual resetting of prices.

     Actually changing prices have different implications for different buyers and different sellers. In a move downwards, some sellers may decide not to compete with other sellers and resist offering prices below a certain level. Other sellers may carry on offering lower and lower prices to remove any risk of holding the instrument. If at some point all immediately available buyers are satisfied, prices will either have to continue lower (with still more sellers than buyers), or if enough sellers have resisted lower offer prices, the level will come when buyers find themselves outnumbering sellers. At this point, then instead of a few buyers indirectly competing with each other and chasing down offer prices from sellers, there are now alot more buyers than sellers, and buyers then must directly compete with each other by raising bids in order to attract sellers out of the marketplace. Conditions have changed from sellers competing together to conditions where buyers compete. Up go the bids. At some point the bids may meet the offer level acceptable to the resistant sellers. They may decide to start putting out offers again. Are there now more buyers than sellers, or not? How was this move started? Does this explain why participants ought to sell into a falling market, and buy into a rising market? In this particular case, there were originally more sellers than buyers, say because of unfavourable economic conditions, buyers would have acted in a way which forced sellers to lower prices... Then at levels of offer price resistance, either the lack of buyers forces sellers to reconsider their resistance, or if buyers are attracted by lowered prices, is it in sufficient number and at a sufficient level to change perceptions so that more and more buyers chase up their bids? In other words, is this a buyer or a sellers market? Are you confused... or contrarian?

     This whole group dynamic is a complex picture of buyers and sellers either competing or not competing with other buyers and sellers and each other, and price moves are about the scarcity and surplus of either buyers or sellers. If there is a surplus of sellers, there is a scarcity of buyers, so prices fall; and if there is a scarcity of buyers, there is a surplus of sellers, so prices fall. And vice versa. Can it be said that if there was no scarcity or surplus then there would be no price changes? Which is the reason why prices fall - A scarcity of buyers or a surplus of sellers?

      The nature of all this competition creates a spread of deals at different sizes and at different prices. It also creates volatility in an asset. Perhaps there are two types of volatility. Volatility caused by the scarcity of buyers, so that low demand for buying causes prices to fall. Or volatility caused by the surplus of sellers, so although there is healthy demand for buying, it is higher demand for selling that causes prices to fall. What will the nature of the competition, and so the volatility, be tomorrow?

     So why are buyers and sellers competing together?

      Take the EUR/USD currency pair. There are several levels of competitive activity going on in the marketplace, and close to perfect information, certainly no one person can overly influence the price.

     Generally prices follow a line of least resistance to these competitive forces. If prices move randomly then it must be because the competition to set prices is random and volatility is random. But if price changes are random then are price changes independent of buyers and sellers? Saying price changes are random is saying that demand and supply is random. Just how much is this the case?

     If you have enjoyed reading this, and have any comments, please get in touch!