CHAPTER 3

The Basics of Double Auction Markets in the Real World

While many textbooks would define liquidity as the readiness of an asset to be converted into cash, what exactly does this definition really mean to a trader who is looking to buy or sell (or short sell) a stock or commodity?

The practical use of this basic attribute of a market is often learned by newcomers to proprietary trading firms within their first week of training before beginning to trade live with the firm's capital, yet it's rarely taught to individual traders and investors whose own money is in the markets. Above all, the concept of a spread (a term generally used in finance to refer to the difference between the highest bid and the lowest offer on a market at any given time, though it depends on context) is distorted beyond recognition for those who began participating in the financial markets through retail foreign exchange dealers.

In foreign exchange (currency trading), the same mechanisms exist in a decentralized system, but the typical discussion of the spread is actually a reference to the artificially widened spread that a brokerage uses to charge a fee for its service in lieu of a commission charge. There is nothing inherently wrong with the practice (a similar practice is common in the bond markets), but the use of the term as a criterion for choosing a retail foreign exchange broker/dealer often distorts many beginners' concept of the actual spread in a natural market—especially in a centralized ...

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