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Futures Trading Strategies: Price Discovery

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If you have ever bought a house or bartered for a loaf of bread at a farmer’s market, then you have participated in the process of price discovery. Essentially, anything with palpable value has a point at which it is readily exchanged for a premium. Price discovery is the mechanism by which this premium, fee, or cost is determined.

Price Discovery in the Digital Age

From the first futures markets at the Dojima Rice Exchange to the American commodities pits of the 1990s, price discovery has had a long and storied history. Currently, it’s conducted in the digital marketplace, where participants execute futures trading strategies of all shapes and sizes in an attempt to secure market share. While the technology and means of asset pricing has changed dramatically over the years, one thing hasn’t ― business transpires at a point where buyers and sellers agree it should.

The late 20th century marked the heyday of the open-outcry auction system of trade. Participants conducted business in a variety of locales, with venues in New York and Chicago being the most prominent. It was on these markets where the pricing of almost everything under the sun was derived, including commodities, stocks, bonds, and currencies.

Under open outcry, the process of price discovery was conducted by exchanging hand signals, yelling quotes, and writing fill tickets. The success of your futures trading strategies depended upon your acumen as a trader, how loud you could yell, and who you knew in the pit. Now, trade takes place at near light speeds between participants around the globe. The digital marketplace has changed the game in two key ways, each altering price discovery:

  • Size: Since the dawn of electronic trade (mid 1980s), the markets have grown exponentially in terms of dollar value and traded volumes. For futures and options alone, more than 25 billion contracts changed hands for the year 2017.
  • Liquidity: The enormous traded volumes ensure consistent depth-of-market and liquidity throughout a variety of exchange-based offerings. This provides traders with a diverse array of viable products featuring an adequate degree of asset pricing efficiency.

These attributes of modern trade are viewed by many to boost the efficiency of price discovery and, thus, the opportunities available in the financial markets. However, some market observers believe that the integrity of price discovery has been undermined by the digital marketplace. Citing unethical futures trading strategies such as quote stuffing or spoofing as being prima facie evidence, detractors view security pricing as being routinely manipulated.

In practice, a trader can take either viewpoint. But, given the size and interest in the modern marketplace, it’s hard to argue that trade is headed back to the open outcry pits anytime soon.

It’s All about Order Flow

Order flow is a term used to describe the placing of buy and sell orders upon a market by active participants. It’s the driving force behind price discovery — an intense real-time negotiation.

In the contemporary digital markets, traders can send and cancel large quantities of orders instantly, via the click of a mouse. Subsequently, order flow is enhanced and impacts price discovery in a collection of unique ways:

  • Tighter bid/ask spreads: Consistent order flow tightens bid/ask spreads by matching an
    abundance of buyers and sellers seamlessly.
  • Volatility: A sudden spike in order flow is capable of driving price directionally, creating volatility and wide trading ranges. This can bring strong opportunities to trend and range traders alike.
  • Slippage: Liquid markets typically feature consistently strong order flow and, in turn, depth. With no shortage of buyers and sellers eager to conduct business at each price point, the probability of receiving desirable fills is augmented substantially.

The ultimate impact of order flow on price discovery is increased and consistent liquidity. If there are an abundance of active buyers and sellers, then tight spreads, reduced slippage, and pricing volatility set the table for any number of futures trading strategies to be executed successfully.

Putting Your Futures Trading Strategies to the Test

Price discovery and order flow are complex, nuanced subjects. For more information on these concepts and how to become a futures market participant, schedule a free, one-on-one consultation with a market pro at StoneX today.

Download the eBook: Futures and Options Strategy Guide