Wednesday, September 9, 2009

Which of the 2 quote prices (bid/ask) can I get? An easy rule

When working out pricing scenarios, always remember there's the bid and ask; always remember whether you are market maker or taker.
* only the dealer can buy low sell high
* both dealer and client can trade with another dealer by accepting the inferior prices.

--
Say you see a quote for a commodity like silver at 1.2345/47. Treat the base currency as a base/precious metal like Silver or Gold (strictly qualifies as Commodity). Clearly the market maker is bidding at the lower 1.2345 price and offering at the higher 1.2347 price.

   Market makers always want to buy-low, sell-high

You can't do that, because you are market taker. Market takers have to buy-high, sell-low. More simply,

  Client get the worse of the 2 prices quoted.

This is so that the market maker can make a profit to cover her risk/cost of making the market. If client take the other price, then it would be a free lunch for all.

* if clients buy, clients buy at the higher (worse) of the 2 price quoted
* if clients sell, clients sell at the lower (worse) of the 2 price quoted

This Easy Rule is relevant in FX, commodities, stocks, futures, IRS, bonds..

Now, after a dealer gets a position (say long  EUR, short  USD), she could close it by calling another market-maker, but giving up her market-making advantage and accepting the worse prices proposed by the counter dealer. The better alternative for her is price shading. This way she still enjoys her market-maker advantage.

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