Trading Stories: How Markets Really Work (Chapter 2)
Chapter 2 of Trading and Exchanges is basically Larry Harris saying: “Let me show you what actually happens when someone trades.” And it is one of the most eye-opening chapters in the book, especially if you have only ever traded through an app where you tap “buy” and shares magically appear in your account.
Harris walks through a series of trading stories, each one showing a different type of trade in a different market. These stories are full of institutional detail, and Harris admits you might not understand everything on first reading. But the point is to give you a feel for the complexity and the human element behind every trade.
Jennifer Buys AT&T Stock
The first story follows Jennifer, a retail investor who wants to buy 200 shares of AT&T. Simple enough, right?
Not really. Jennifer calls her broker, who pulls up a quote screen showing bids and offers from multiple sources: the NYSE, regional exchanges, independent NASD dealers, and electronic communications networks. The best bid is $19.83 and the best offer is $19.85. Jennifer decides to place a day limit order to buy at $19.80.
Here is where it gets interesting. Even though AT&T primarily trades at the NYSE, her brokerage might not send the order there. It might go to a regional exchange or a dealer, depending on which market is quoting the best price and, notably, depending on cash payments and other inducements that dealers offer brokerages for their order flow.
Her order ends up going to the NYSE via SuperDot, where the AT&T specialist manages the trading. Since no one wants to sell at her price right away, the specialist puts her order in the limit order book. A few minutes later, a large seller sends a market order, and Jennifer’s order gets filled at $19.80.
But the story does not end there. Jennifer has to pay for the shares. Settlement happens three business days later. If she has not paid, her brokerage might lend her the money and charge interest, using her shares as collateral. If she does not pay at all, they sell the stock and charge her for any losses.
The whole point of this story: what feels like a simple buy involves brokers, specialists, limit order books, order routing decisions, settlement processes, and custodial arrangements. There is a lot of infrastructure behind that one tap on your phone.
Jennifer Sells Microsoft on Nasdaq
The second story flips things around. Jennifer wants to sell 100 shares of Microsoft, which trades on Nasdaq instead of the NYSE. The mechanics are different because Nasdaq is a dealer market. About 40 independent dealers publish quotes and compete for order flow.
When Jennifer places a market sell order, her brokerage’s system sends it to a specific Nasdaq dealer. Not necessarily the one with the best bid. Her brokerage picks a particular dealer because that dealer pays the brokerage for the order flow. The dealer buys Jennifer’s shares at the best bid price, even if the dealer’s own posted bid was lower.
This is payment for order flow in action, and it remains one of the most controversial aspects of market structure. Your brokerage makes money by sending your order to a specific dealer, and you might or might not get the best possible price.
Bob’s Institutional Trade in Exxon Mobil
This is where the chapter really comes alive. Bob works for a (fictitious) investment management firm and needs to buy 400,000 shares of Exxon Mobil, worth about $16 million. That is 5% of average daily volume. This is not something you can just throw at the market.
Bob’s process is methodical and fascinating:
First, he asks the portfolio manager why he wants to buy. If there is breaking news, Bob has to move fast. If the manager just thinks the stock is undervalued, Bob can be patient. The manager says undervalued, so Bob takes his time.
Bob checks recent price and trade history, looking for clues about whether other large traders are active. He calls a floor broker he trusts, without revealing his own intentions, and asks about market conditions in Exxon Mobil. The broker physically goes to the trading post on the NYSE floor to gather intelligence.
Then Bob sends his full order to POSIT, an electronic crossing network that matches institutional buyers and sellers anonymously. POSIT fills 48,000 of his 400,000 shares. Not great, but it is a start, and the trade was completely confidential.
Next, Bob contacts a Morgan Stanley sales trader who had posted an indication of interest. Through the broker’s intermediation, they negotiate a block trade for 200,000 shares at $39.87. The floor broker takes this to the specialist, who checks his limit order book, and the trade gets printed.
Bob then gives a market-not-held order for 80,000 shares to a Merrill Lynch floor broker, who stands in the crowd and fills it over the next hour in several pieces as prices move up. Bob finishes the remaining 72,000 shares when the broad market starts rising and the floor broker acts quickly to buy before index arbitrageurs push prices even higher.
Total average cost: $39.898 per share. The whole process took hours and involved multiple brokers, trading venues, and negotiation strategies.
The Small Nasdaq Stock Problem
Bob also has to sell 10,000 shares of United States Lime & Minerals, a tiny stock trading at $4.85 with an average daily volume of only about 1,000 shares. His order is ten times the daily volume.
Only three dealers are making a market. The spread is wide. Displayed size is tiny. Bob calls one dealer he trusts, asks for quotes on both sides (to hide whether he is buying or selling), and negotiates a sale at $4.75 for the full 10,000 shares.
This story illustrates something important: illiquid markets are a completely different world. You cannot just place a market order. You have to negotiate, manage information carefully, and accept that you will pay a significant cost for the difficulty of finding a counterparty.
The Very Large Block Trade
The most dramatic story involves selling 900,000 shares of a fictional company, Smithsonian Industries. The seller is the granddaughter of the deceased founder who needs to sell to pay inheritance taxes. Daily volume in the stock is only 60,000 shares.
Goldman Sachs block brokers take on the challenge. They research potential buyers using databases of institutional holdings, then selectively contact them. Every potential buyer asks the same questions: Who is selling? Why? Is there more coming? The brokers explain the inheritance tax situation and estimate a $1.50 per share discount to attract buyers.
After contacting 10 potential buyers in 15 minutes, they get commitments for 850,000 shares at $80. The remaining 50,000 shares get absorbed by limit orders on the specialist’s book, a floor broker’s client, and Goldman’s own account.
Within minutes, a CNBC commentator reports the block crossing the tape. This is how large trades actually happen. It is part salesmanship, part negotiation, part information management.
Futures, Options, Bonds, and Currency
Harris continues with stories from other markets. A soybean processor hedges its exposure with futures contracts on the Chicago Board of Trade, where traders communicate by shouting and hand signals in a physical pit. An investor uses put options to protect her Microsoft position while managing her tax liability. A bond trader negotiates a corporate bond purchase over the phone, with prices expressed as a percentage of face value and in basis points over Treasury yields. A company buys British pounds through a chain of intermediaries that each take a small spread.
Each story illustrates the same fundamental points: trading involves search, negotiation, risk management, and infrastructure. The specifics vary across markets, but the underlying economics are remarkably consistent.
Why These Stories Matter
Chapter 2 is Harris at his most practical. Before he gets into the theory, he wants you to see the reality. Markets are messy, human, and complex. Every trade involves a chain of decisions, and every participant in that chain has their own incentives.
If you have only ever traded on Robinhood, these stories might feel like they are from another era. And in terms of specific technology, they are. But the forces at work are identical. Your order still gets routed to a dealer who pays for the privilege. Large institutional orders still get broken up and executed carefully over time. Illiquid stocks still require negotiation and careful information management.
Understanding these mechanics does not just make you smarter about markets. It makes you a better trader. Because once you understand the game, you can play it more effectively.
Book Details
- Title: Trading and Exchanges: Market Microstructure for Practitioners
- Author: Larry Harris
- Publisher: Oxford University Press, 2003
- ISBN: 0-19-514470-8