1.6 Trading in Financial Markets

While nearly all the trades on the NYSE used to execute through a specialist, the emergence of electronic trading has reduced the specialist’s role. Today, so many orders are submitted by so many different investors that some orders will execute electronically. Figure 1.1, for example, shows the average daily volume (number of shares traded) on the NYSE from 1960 to 2005. In 1960, the average daily trade volume on the NYSE was 3 million shares. By 2005, the volume had increased to nearly 1.8 billion shares. Since 2005, the average daily trading volume has continued to increase. This increase in volume suggests that more and more trades occur each year and that financial markets are becoming increasingly liquid.

There are several different types of orders used by investors, but we will focus on the two most common types: market orders and limit orders. Market orders are time-sensitive, while limit orders are price-sensitive. Recall our example in the previous section about a $100 stock. If an investor submitted a market order to buy the $100 stock, the execution price would be at the current ask price, which, in our example, was $100.03. However, the investor could instead submit a limit order to buy at a price of $100.00. In this case, the order would not execute until the specialist was willing to lower the ask price to $100.00 or a different investor submitted a limit sell order with a price of $100.00. If the latter were to occur, the limit sell order at $100 and the limit buy order at $100 would cross and execute without the specialist quoting different ask or bid prices. Much of the trading that occurs on the NYSE (and many other markets) is accomplished because limit buy orders and limit sell orders cross and execute.

As we discussed in the previous section, financial markets reduce the cost for companies to obtain financing through issuing either bonds or stocks. This happens primarily because financial markets provide much-needed liquidity. In the last several years, providing liquidity has become the full-time job of several high-frequency traders. These high-frequency traders, which are mostly computers acting according to complex trading algorithms, will submit thousands of limit orders in a minute or two—on both the buy and the sell side. Their objective is to pick up a $0.01 or $0.02 bid-ask spread millions of times in a day.