Market Microstructure: Understanding How Markets Work
Introduction to market microstructure - how prices are formed, bid-ask spreads, order flow, market makers, and the mechanics of trading in Indian markets.
Introduction: The Hidden Mechanics of Markets
“Behind every stock price you see is a complex web of orders, algorithms, and market structure that determines how and why prices move.”
Market microstructure is the study of how markets work at the granular level—how orders interact, prices form, and trades execute. Understanding these mechanics can improve your trading and help you avoid costly mistakes.
What is Market Microstructure?
Definition
Market microstructure studies the process by which investors’ latent demands are ultimately translated into prices and transactions.
Key Questions
| Question | Area |
|---|---|
| How do prices form? | Price discovery |
| Why do prices differ from fair value? | Market friction |
| What determines bid-ask spread? | Transaction costs |
| How does information enter prices? | Information efficiency |
| Who provides liquidity? | Market making |
Why It Matters
| For | Importance |
|---|---|
| Traders | Better execution, lower costs |
| Investors | Understanding price movements |
| Regulators | Market design, fairness |
| Firms | Optimal order strategies |
Price Discovery
What is Price Discovery?
The process by which market prices are determined through the interaction of buyers and sellers.
Price Discovery Mechanisms
| Mechanism | How It Works |
|---|---|
| Continuous auction | Ongoing order matching |
| Call auction | Orders collected, single price |
| Negotiated | Bilateral bargaining |
| Quote-driven | Dealers provide prices |
Indian Market Mechanism
Pre-Open Session (9:00-9:15):
- Call auction
- Opening price discovered
- Single equilibrium price
Normal Trading (9:15-3:30):
- Continuous auction
- Price-time priority
- Real-time matching
Opening Price Calculation
Algorithm:
- Collect all orders by 9:08
- Calculate volume at each price
- Find price maximizing traded volume
- If tie, minimize imbalance
- If still tie, closest to previous close
Example:
| Price | Buy Volume | Sell Volume | Tradeable |
|---|---|---|---|
| ₹102 | 1,000 | 5,000 | 1,000 |
| ₹101 | 3,000 | 4,000 | 3,000 |
| ₹100 | 5,000 | 3,000 | 3,000 |
| ₹99 | 7,000 | 1,000 | 1,000 |
Opening Price: ₹101 or ₹100 (maximum tradeable = 3,000)
The Order Book
Order Book Structure
Bid Side (Buyers):
| Price | Quantity | Orders |
|---|---|---|
| ₹99.95 | 5,000 | 12 |
| ₹99.90 | 8,000 | 23 |
| ₹99.85 | 3,000 | 8 |
Ask Side (Sellers):
| Price | Quantity | Orders |
|---|---|---|
| ₹100.00 | 2,000 | 5 |
| ₹100.05 | 4,000 | 11 |
| ₹100.10 | 6,000 | 15 |
Key Metrics
| Metric | Value | Meaning |
|---|---|---|
| Best Bid | ₹99.95 | Highest buy price |
| Best Ask | ₹100.00 | Lowest sell price |
| Spread | ₹0.05 | Difference |
| Bid Depth | 16,000 | Total buy volume |
| Ask Depth | 12,000 | Total sell volume |
Order Book Dynamics
What Happens When:
| Event | Impact |
|---|---|
| Large buy order | Bid depth increases |
| Market buy | Ask side depleted |
| News release | Both sides reprice |
| Uncertainty | Spread widens |
Bid-Ask Spread
What is the Spread?
The difference between the best ask (lowest sell) and best bid (highest buy) price.
$$Spread = Best\ Ask - Best\ Bid$$
Spread Components
| Component | Description |
|---|---|
| Inventory cost | Risk of holding position |
| Adverse selection | Trading with informed |
| Order processing | Transaction costs |
| Competition | Number of market makers |
Spread Variations
| Factor | Effect on Spread |
|---|---|
| High liquidity | Narrow spread |
| Low liquidity | Wide spread |
| High volatility | Wider spread |
| Large tick size | Minimum spread |
| More competition | Narrower spread |
Indian Market Spreads (Typical)
| Stock Type | Spread |
|---|---|
| Nifty 50 stocks | 0.01-0.05% |
| Midcap | 0.05-0.15% |
| Smallcap | 0.10-0.50%+ |
| Illiquid | 1%+ |
Impact on Trading
Round-Trip Cost: $$Cost = Buy\ at\ Ask + Sell\ at\ Bid = Spread$$
Example:
- Buy at ₹100.05 (ask)
- Sell at ₹99.95 (bid)
- Loss: ₹0.10 (0.1%)
Implication: You start every trade “underwater” by the spread amount.
Liquidity
What is Liquidity?
The ability to buy or sell quickly at a price close to the true value.
Dimensions of Liquidity
| Dimension | Measure |
|---|---|
| Tightness | Bid-ask spread |
| Depth | Order book volume |
| Resilience | Speed of price recovery |
| Immediacy | Execution speed |
Measuring Liquidity
Volume-Based:
- Daily turnover
- Number of trades
Spread-Based:
- Quoted spread
- Effective spread
Impact-Based:
- Market impact cost
- Implementation shortfall
Liquidity Providers
| Provider | Role |
|---|---|
| Market makers | Continuous quotes |
| Arbitrageurs | Cross-market liquidity |
| Institutional investors | Large passive orders |
| Retail investors | Diverse order flow |
Market Impact
What is Market Impact?
The price change caused by your own trading activity.
Types of Impact
| Type | Description |
|---|---|
| Temporary | Price bounce back |
| Permanent | Information reflected |
Market Impact Model (Simple)
$$Impact = k \times \sqrt{\frac{Volume}{ADV}}$$
Where:
- k = stock-specific constant
- Volume = your trade size
- ADV = average daily volume
Example
| Parameter | Value |
|---|---|
| Your order | 50,000 shares |
| ADV | 500,000 shares |
| k | 0.1 (assumed) |
| Impact | 0.1 × √(0.1) = 0.0316 = 3.16% |
Minimizing Impact
| Strategy | How It Helps |
|---|---|
| Split orders | Reduce per-order size |
| Trade over time | Average out impact |
| Use limit orders | Avoid market impact |
| Dark pools | Hidden liquidity |
| Algorithms | Optimize execution |
Information and Prices
Efficient Market Hypothesis
Forms:
| Form | Information Reflected |
|---|---|
| Weak | Past prices |
| Semi-strong | All public information |
| Strong | All information (including private) |
Information Asymmetry
Informed vs Uninformed Traders:
| Trader Type | Information | Timing |
|---|---|---|
| Informed | Has superior info | Trades ahead of news |
| Uninformed | Public info only | Trades randomly |
Adverse Selection
The Problem:
- Market makers don’t know who’s informed
- If they trade with informed, they lose
- They widen spreads to compensate
- Everyone pays more
Order Flow Information
Interpreting Order Flow:
| Signal | Possible Meaning |
|---|---|
| Large buy orders | Informed buying? |
| Bid depth decreasing | Buyers pulling back |
| Spread widening | Uncertainty increasing |
| Volume spike | News or informed activity |
Trading Mechanisms
Order-Driven vs Quote-Driven
| Aspect | Order-Driven (India) | Quote-Driven |
|---|---|---|
| Prices set by | Incoming orders | Dealer quotes |
| Execution | Order book matching | Against dealer |
| Transparency | High | Lower |
| Examples | NSE, BSE | Forex, bonds |
Auction Mechanisms
| Type | Description | Use |
|---|---|---|
| Continuous | Ongoing matching | Normal trading |
| Call/Batch | Periodic matching | Open/close |
| Sealed bid | Hidden bids | IPO |
Price Priority Rules
Indian Markets:
- Price priority (best price first)
- Time priority (first-in-first-out at same price)
Market Quality Measures
Key Indicators
| Measure | What It Shows |
|---|---|
| Spread | Transaction cost |
| Depth | Capacity to absorb orders |
| Volatility | Price stability |
| Efficiency | Information incorporation |
Benchmarks
| Metric | Good | Poor |
|---|---|---|
| Spread (liquid stock) | <0.05% | >0.20% |
| Daily volume | High relative to outstanding | Thin |
| Price discovery | Matches fundamentals | Disconnected |
Key Takeaways
- Price discovery – How market finds equilibrium price
- Order book – Queue of bids and asks
- Spread is cost – You pay spread to trade
- Liquidity varies – Large caps tight, small caps wide
- Market impact – Large orders move prices
- Information asymmetry – Informed traders vs market makers
- Mechanism matters – Order-driven auction in India
Disclaimer
This article is for educational purposes only. Understanding market microstructure helps in trading but doesn’t guarantee profits. Markets are complex and unpredictable. This is not trading advice.
Frequently Asked Questions
Q: Why does the spread exist? A: Market makers/liquidity providers face risks (inventory, adverse selection) and costs. The spread compensates them for providing liquidity.
Q: How can I see the order book? A: Trading platforms show top 5-20 levels of the order book. Full order book (Level 3) may require special subscriptions.
Q: Does low spread mean I should trade? A: Low spread means lower transaction cost, which is good. But it doesn’t tell you about direction or value—spread is about cost, not opportunity.
Q: Why do spreads widen during volatility? A: Market makers face higher risk when prices are volatile. They widen spreads to compensate for the increased probability of loss.
Q: How do algorithms use microstructure? A: Algos optimize execution by reading order book, estimating impact, splitting orders, timing execution, and finding hidden liquidity.
Understanding market microstructure is like understanding the plumbing of a building—invisible when it works, but essential for everything to function properly.