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.
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:
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.
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:
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.
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.