Why Is Price Discovery Important?

Takeaways

• What is price discovery

• How to benefit

• Understand the risks

What is price discovery?

Price discovery is the price which a buyer and a seller are willing to pay. Anyone who plays strategy games such as poker or chess, will know about hiding your intentions until the proverbial check mate. The same happens when two participants are looking to agree a bargain on the stock market.

If other traders find out you have a large buy order, they will position themselves against you by purchasing it first. They can then sell it at a (small) profit when your order hits trading screens. A hedge fund manager who manages trillions of dollars of assets, therefore uses dealers to ensure that you/their portfolio managers gets the best price possible.

How do dealers ensure best price execution?

Experienced dealers will know how to get the best price possible through having a few tricks up their sleeve. Firstly they will often know who is interested in selling them the stock their fund manager has asked them to buy.

This is though seeing previous trades during the day or week. Rather than place a (large) buy order on the London stock exchange (LSE) for all to see, they will ring the counter party firm directly. They can do a deal between them and will then declare it to the LSE as a 'off order book' transaction.

The old boy network

Other tactics dealers will use, is to speak to several other dealers and split a large order among them. They are not supposed to split orders, but they all do! Many dealers get to know each other and will help each other out.

This includes suggesting another dealer who may be interested in the shares if they are not. Other strategies are to use iceberg or limit orders. With a limit order you are setting a price at which you will sell/buy. In effect you are saying: this is my best price, match it!'

Finally, iceberg orders are also popular. They are so called because you only show part of the order to the market (90% of an iceberg is underwater). If you had an order to deal a large amount of shares in a smaller less liquid stock, say 100,000, you would not want to reveal it to the market. If you did, you would see it rise 2/3% in minutes, making it more expensive for you. Therefore dealers split the order in tranches of say 5,000 - 10,00. Once one tranche has dealt, the next one is shown to the market. Some savvy dealers will work out that if the same amounts of the same share keep appearing regularly, there is a big iceberg order dealing. They will therefore try and deal against you. So a sensible dealer will not divide into exact tranches of 5,000 to 10,000, but split it in say 4,998 / 4,500 / 7,345 lots.

Prices behaving badly

Price discovery can be so challenging that stock brokers have created places to trade on the quiet. An example is dark pools. They are private exchanges where usually large (institutional) investors can trade large amounts of shares without revealing themselves. I.e. neither counter party knows who the other one is.

Price discovery has its grey areas.

This achieves the same effect as the iceberg order described earlier. An asset manager can sell a large amount of shares without the market knowing and therefore getting a better price.

Due to their lack of transparency, conflicts of interest can emerge. For example, an institution might be selling shares in the public market and letting everyone know they are doing it, whilst quickly buying back twice as much in a dark pool. They would end up paying a much better price.

Price discovery problems

In recent years, there have been a number of occasions where distorted prices have created problems. In 2010, the Hound of Hounslow manipulated prices by 'spoofing' the market and allegedly creating the flash crash!

Another example is the rise of high frequency traders and the damage to markets. In Michael Lewis' excellent book, Flash Boys he describes asset managers' 'million dollar problem'. Large asset managers have seen many times how the price of a share 'jumps' in the seconds before they place their trade, losing them money in the process.

Finally in March 2020, during the Coronavirus inspired sell off, Bond ETFs faced such a wave of selling that the spread between their price and NAV diverged substantially. (as much as 4 to 6% in the case of some iShares and Vanguard bond ETFs). So abnormal was this, that Vanguard felt obliged to comment about it on their web-site.

Conclusion

Understanding how price discovery works on the stock market is half the battle. Using this knowledge in day to day trading will save you pennies over time.

Take care of the pennies and the pounds will take care of you.

Limit orders are available to any retail investor. Indeed during the sell off in March 2020, limit orders were the best way to protect yourself from receiving a poor price, as many online brokers struggled to give you a live price.

Knowing when to trade also helps. The greatest liquidity is early to mid-afternoon UK time, as US traders join UK and European traders, this makes price discovery easier. In turn this will mean getting a better price!