Who are you up against when you make a trade?
You've put in some hard analysis with a share on your watchlist; you know the company accounts inside out; you reckon you've spotted hidden value that the masses have missed.
Cash is waiting. Time to go to the market and shout "Buy!"
'The Market'
It's easy to think of 'the market' as something ethereal: a hive mind automatically connecting buyers and sellers. But we're not talking about a god-like presence dispensing deal tickets by magic. People discuss 'the market' like a conscious entity: "the market thinks…"; "the market disagrees…"; "I will beat the market."
In truth, 'the market' has no opinion at all. 'The market' is nothing more than the collective actions of millions of competing players.
So let's have a look at the main types of player. Who are they, what do they want and what do they mean to an eager Fool with a bright idea?
Foolish Plankton
The first point is size. You, my friend, are plankton. When you dive into the market you will briefly swim alongside some extremely large and powerful creatures. Luckily these monsters aren't looking to feed on little old you; they're playing a bigger game. But their titanic battles sometimes cause turbulence in the water that can, from time to time, flutter your Foolish fins.
The 'monsters' are institutional investors. They're buying and selling for mutual funds, investment banks, pension funds and insurance companies. They make up (estimates differ depending on who you ask) around 70% of trades by value on the London Stock Exchange.
They tend to trade in large blocks, often using so-called 'algorithmic trading' software to process their orders. Around three-quarters of all trades on Wall Street were executed by computer in 2009.
Knowing this might help you visualise the other side of your deal: your order probably won't be matched with another small investor, but will be swept up, along with countless others, by a computerised strategy.
Types of Trader
Traders in the market tend to fall into one of four categories. Let's take them one by one:
Information motivated traders believe they know something special about a share. They need to get the deal done as quickly as possible before their information becomes generally known.
The sooner they trade, the greater their potential profits as other players catch up and follow their lead. This isn't the same as insider dealing! If you are the first analyst to draw a correct conclusion from publicly available data, then you will want to capitalise on your insight, and fast. It's only when you trade on information not in the public domain that you have broken the law.
Value motivated deals are where most Fools will be found: someone believes a share price is too low and sets a target price at which they think it represents 'value'. They are prepared to wait until a willing seller shows up at this price, even if this means their deal isn't matched for some time.
Straight away you can see that dealing is a balance between time and price. Do you need to prioritise speed of execution, or getting a particular price?
The quicker you need to buy, the more you are at the mercy of who is willing to match you at that precise moment. Conversely, the more you need a given price, the longer you might have to wait for it.
Luckily for both types of trader there is a third kind: liquidity motivated.
These are traders who are selling to liberate cash for some other purpose. Their decision to trade isn't driven by information or by value, but by their own circumstances. They tend to prioritise time ahead of price, and are often the counterparty (seller to buyers, buyer to sellers) to other deals.
Finally, passive traders play an interesting role. They will most likely deal for one of the large index tracking funds.
How large? Legal & General (LSE: LGEN) alone controls nearly 5% of the entire UK market though index trackers. They're a very significant player. But the unique nature of a tracking strategy makes their dealing patterns slightly odd: for example, should a new company enter the index, they have to buy some, regardless of the value it offers.
The market is nothing to be afraid of, but it's good to know who you're up against, and who you might be trading with, when you place that deal.
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