This post will examine the way a price is formed on an exchange, and also show you how to trade on an exchange, whether you are trading stocks, options, or bitcoins.
What is an exchange? An exchange is an organized market where things are traded. An exchange is a bit different from an informal market because an exchange provides a venue, standard rules, and becomes the host that participants can trust. In an informal market, traders must rely on the credit worthiness of each other in order enforce agreements. An exchange provides a middleman function that facilitates trade. The venue (whether its physical or digital) provides a place where traders can go to view prices and volume, and get information on the underlying market. Standard rules means that traders don’t have to negotiate specifics each time they make a transaction on an exchange, they can simply rely on the exchange’s standard rules, this promotes fungibility of the underlying things being traded.
Exchanges make money by charging fees to users. This usually comes in the form of a fee per transaction, but can also come in the form of a fee for the right to participate or to provide brokerage services (historically referred to seats). Exchanges do not get involved as principals or agents. The principals to each transaction are the proprietary traders and the agents are the brokers working for their clients. This way, the exchange does not take positions, and so does not take any market risk. Sometimes, a clearinghouse is used by an exchange in order to store the credit risk of market participants. A clearinghouse provides another layer of security to market participants, and especially in markets with leverage such as futures/options, a clearinghouse reduces credit risk and allows participants to trade anonymously, which further facilitates trade.
So you have some basic understanding of free market economics, and you want to get involved, where do you begin? One of the greatest strengths of our modern world is that anyone with access to a computer and an internet connection can get involved in trading on exchanges. With the advent of crypto currencies, there are very low barriers to entry. If you want to trade stocks on recognized exchanges such as NYSE and Euronext, you will need to hold an account with a registered broker in your jurisdiction. This can be difficult if you live outside of a rich country, but anyone can open an account on a crypto currency exchange such as Bitfinex, Poloniex, and Deribit.
Once you have decided which exchange you want to trade on and what your trading strategy might be (write it down or e-mail it to yourself), you will need to open an account and make a deposit to the exchange. In the case of a crypto currency exchange, all that you’ll need to disclose about yourself is a username/e-mail/password. Your account may be restricted in some ways (maybe deposit/withdrawal limits) unless you disclose more information, but an anonymous account is a possible way to start. Once your account is opened, you will need to make a deposit. You’ll need to navigate the process the exchanges provides to you.
After you’ve made a deposit, you can enter the market and make some trades. Whatever your goals might be, you’ll need to begin by be offering what you have deposited for sale, or putting up your deposited funds as collateral to make a trade. Let’s walk through an example using a deposit of bitcoins on Bitfinex. The first thing you need to do is obtain some bitcoins, then you’ll need to open an account with Bitfinex and send those bitcoins to your Bitfinex account. Once your bitcoins are being held in your Bitfinex account, you can trade those bitcoins for another currency on the exchange. You can begin to offer to sell your bitcoins for ether on Bitfinex by finding the market for that pair, and viewing the current order book.
The order book for eth/btc on Bitfinex will show all the bids and offers for that pair. The bids are the amounts/prices that other traders are willing to buy, and offers are the amounts/prices that other traders are willing to sell. If you want to sell btc for eth, then you will place an order to sell, and join the offers. If the highest bid is 13 and the lowest offer is 14, then this means the market price will fall someone between those two prices. If you want to sell at the market, you can enter an order to sell your bitcoins at a price of 13 and this will result in a “fill” because you have taken your order “to the market” and “hit the bid”. If you decide that a price of 13 is too low, maybe you think a price of 13.50 is the price you want, then you can enter an order to sell your bitcoins for 13.50 and this will result in your order being the best offer, and make the current market 13 bid and 13.50 ask. Your offer to sell at 13.50 will join the order book until which time another trader decides to make an exchange with you at this price.
As you can see, exchange prices do not arrive out of thin air. Prices are determined by the interaction of buyers and sellers, bids and offers. There is no central authority that determines prices in a free market on a fair exchange. There may be factors that can influence the decisions of traders, but they are still free to determine the prices they are willing to buy and sell for.
Continuing with the example above. If the current market is 13 bid and 14 ask, and you decide that your bitcoins are worth more than 14, you can enter an order for a higher price, at whatever level you decide. You can even offer to sell your bitcoins for 16, 50, 1,000, or any number, and your order will join the order book. If you choose to offer your bitcoins for sale at 20, your order will join the offer side of the order book until which time you cancel/change it or another trader buys your bitcoins from you at that price. Remember, if the market is currently 13 bid and 14 ask, traders will only buy your bitcoins at 20 when 20 is the best offer. This means that all the other offers in the order book between 14 and 20 must either be cancelled or filled, basically, the price must rise to 20 for your order to be filled.
At first, you might be confused by the functioning of a free market, but I think once you make some trades and see how an exchange operates, you will become more comfortable with the strategies that other trades and market participants discuss.