By Richard Bloch
And now, a somewhat more philosophical perspective on the markets. Bo Peng says that the market price is an “illusion,” pointing out that while it’s tempting to view the market for a specific stock as a flow of continuous prices, that really isn’t the case at all – especially when high frequency trading algorithms are running.
The notion of market price is never what we assumed it to be. It’s not continuous. It jumps all the time. And except for the singular points of quotes appearing, which has a mathematical measure of precisely 0 (a set of points on a presumed line), it doesn’t even exist.
And I think this deserves repeating: the probability of hitting a quote is mathematically zero.
He even created the “Peng Uncertainty Principle.”
The Market Price cannot be determined unless with a trade, which will inevitably change the state of the presumed market and is by definition always in the past. To be precise, Market Price cannot be defined except in the posteriori sense.
That’s a lot like the Heisenberg Uncertainty Principle in physics, which suggests it’s impossible to measure both the position and momentum of a sub-atomic particle with certainty because the act of measuring one thing affects the other.
So if you put in a bid or offer for a stock, that act in and of itself (a form of “measuring” the market) affects the market itself.
The bigger your order, the more it could impact the market. So in reality, the meaning of “market price” depends on quantity as much as it does price. At any point in time, the market for 100 shares of Amazon (AMZN), for example, would be different than for say, 10,000 shares.
I often get filled at various prices and quantities when buying or selling even a modest quantity of shares in one order (when I don’t tick the AON box). So what was the “real” price? Who knows – and does it even matter?
Streaming quote waves or particles?
The field of quantum mechanics is weird because light, for example, sometimes behaves like a wave and sometimes like discrete particles (photons).
Your data feed may be described as “streaming quotes,” and it may look like a continuous stream, but it isn’t.
Both market transactions and the order book of buy/sell orders behave like particles, not like waves. Bo explains:
The fundamental flaw in Continuous Price Assumption is no longer just theoretical, it has resulted in the invalidation of the very notion of market price.
If that assumption were ever considered valid, it’s only been recently. Just go back to a decade or so when stocks were traded in fractions. You wake up in the morning and the market for Alcoa (AA), might be “12-7/8 bid / 13 ask.” So you can buy shares for 13 or sell them for 12-7/8.
OMG! What’s a trader to do? The spread’s a whole 12 and half cents wide! Today’s market would grind to a screeching halt with spreads like that.
The HFT speed limit
The age of high frequency trading (HFT) – with pricing in tenths of a cent and trading depending on milliseconds – makes markets seem continuous, but it’s just an illusion.
Fortunately, there’s a speed limit to high frequency trading. Quantum theory predicts that the smallest possible unit of time is called Planck Time – about 10 -43 seconds.
If you can get a faster execution than that, then you’ve violated the laws of physics.
