Liquidity, Volatility and Information Asymmetry

We tend to take many things in trading for granted, and I think that liquidity and price discovery are two things that we rarely think about, but let's imagine for a second, that we trade E-minis but we can't see realtime price

and when we call our broker, she quotes us 1% bid-ask spread...
obviously we will not be able to trade like that and make money...

This is why price discovery is crucial for practitioners (no matter whether they are large hedge funds or retail investors)...

Luckily in normal market conditions we are awash with liquidity. most liquid assets are trading at the minimum bid-ask spread, but as we all know, there are no free lunches in financial market... so you probably ask where can be the downside for the deep liquidity that we get

well... the reason that we (as market takers) get such a deep liquidity (and minimal transaction costs) is because our orders are valuable for market makers (banks, large HFT firms, dealers/brokers, etc...), so they are willing to do anything to get this information...

Think about any app that you have on your phone/desktop (FB/google/Twitter)...

The reason that those services are free is because our information is much more valuable than any subscription cost... The same goes for our orders and orderbook distribution..

This is information asymmetry in essence... When the market marker see the entire orderbook picture they pretty much have the the treasure map, as we can operate with very little surprises, and occasionally front-run clients' orders...

Now, you probably think - "that's not really fair... If they have my orders i'm giving them a free option...." well you are kind of right, but otherwise they will be reluctant to show liquidity...

The thing about information asymmetry is that sometimes market marker tend to

go on the borderline between front running clients' orders and price manipulation... back in the early 2000s two large scandals in FX and Libor market set precedence with regards to price rigging (and sent few traders to jail), so nowadays dealers really try to avoid that

practice... But when you are sitting on the sell-side, and you know that there is a large barrier/stop/trigger close to the market it's pretty easy to "drive" the market to that level (had one or two occasions with some large US bank that hunted my triggers back when FX was

volatile)

Dealers will actually go a long way in sourcing information about our trades and orders. Some dealers will show a very tight bid/ask spread just to win a trade as this trade will help them with their price discovery. Think about the following example: Jim is an expert

SPX vol trader, and his dealer knows that when he buys gamma it tends to perform, and when he sells gamma market just get stuck in a range... given that Jim ask for a two-way the dealer has no idea whether he wants to buy or sell, so to win the price the dealers is inclined

to show a choice price just to win the trade...

Now you ask how all this is at all related to volatility... well, order book information has everything to do with volatility... when you look at @SqueezeMetrics / @nope_its_lily / @spotgamma you are basically sourcing orderbook

information using publicly available data for your trading (while the entire market is probably doing the same..)... when we, as a herd act based on that information we create volatility (that's reflexivity for you...). Assume that we had zero information to based our trading

on, and I doubt that we would have seen that kind of volatility and price action...

To sum things up, liquidity and price discovery is a double edge sword. While it makes our trading more efficient, we end up paying for it without realizing that...

Just my 2c...