How to understand adding or removing “liquidity” in stock markets with market/non-market orders?
Not all limit orders add liquidity, but all market orders remove liquidity presuming there is liquidity to remove. A liquidity providing order is one that is posted to the limit book. If an order, even a limit order, is filled before being posted to the limit book, it removes liquidity. Liquidity is measured by a balance and abundance of quantities posted on the limit book and the best spread between the lowest ask and the highest bid.
I don't have all the answers. On a illiquid stock, such situations do arise and there are specific mechanisms used by exchanges to match the order. It is generally not advisable to use market order on illiquid stock. There are lots of different variations here. I guess this comes down to specifications for individual exchanges, but I'm wondering if there's a standard here or a way to approach it from basic rules that clears up all these situations. There are quite a few variations and different treatments. Market order that are placed when the market is closed or just around market opening are traded at Market Open price that each exchange has a formulae to calculate. In the process Market Buy are matched to Market Sell at the Exchange calculated price. Not all order get matched and there could be spill over's. These are then matched to limit orders. Is this determined based on which sell order came first, or based on which would result in the best deal for the incoming buyer? Generally Market orders have highest priority of execution. Typically this isn't a random order- having a small volume just means it's not showing on the chart, but it is a vlid price point. Same thing would've happened if it would've been a very large order that shows on the chart. Consider also that this could have been the first one of many transactions that go far below your stop point - would you not have wanted it to be executed then, at this time, as it did? Would you expect the system to look into future and decide that this is a one time dip, and not sell; versus it is a crash, and sell? Either way, the system cannot look in the future, so it has no way to know if a crash is coming, or if it was a short dip; therefore the instrcutions are executed as given - sell if any transfer happens below the limit. To avoid that (or at least reduce the chance for it), you can either leave more distance (and risk a higher loss when it crashes), or trade higher volumes, so the short small dip won't execute your order; also, very liquid stocks will not show such small transaction dips. Not really. This just shows you might be able to fill huge orders a little less cheaply now, but then somebody else gets to fill it at a better price and the HFT/Market Maker took on some risk for some profit. That's pretty much the definition of providing liquidity. How is this raising prices? It's not. Raising prices would be if HFT bought like 2mil worth of stock and just held it for some time, then tried to sell it to you later at a better price, but that's just investing. I would say the most challenging fact for this assertion is that HFT firms operate with extremely limited capital bases. For a stock with say 10m shares ADV, even a very large and successful HFT strategy might use a position limit of no more than 5000 shares.  That is to say if you sum up and net the buys and sells for a stock across the day the HFT firm will never exceed 10,000 shares (2x position limits assuming it completely flipped) on a stock that trades 10,000,000 shares on a given day. The high volumes are attained through high turnover, the strategy might trade up to 500,000 shares (or 5% of the volume) attaining a 50x turnover.  But that brings me back to the original point. In the market microstructure literature market impact generally has been found to scale linearly or even sub-linearly for net volume executed.   If I alternate between thousands of 1 lot buy and sell orders, it would be very difficult for me to move the market because the market impact of every one of my buy orders roughly cancels the market impact of my almost exactly equal number of sell orders.   There might be a higher-order mechanism at work, but I'm genuinely curious what you think it might be. How could strategies that attain such small net positions have such out-sized impact on market direction? "I'm not sure the term actually has a clear meaning. We can think of ""what does this mean"" in two ways: its broad semantic/metaphorical meaning, and its mechanical ""what actual variables in the market represent this quantity"". Net buying/selling have a clear meaning in the former sense by analogy to the basic concept of supply and demand in equilibrium markets. It's not as clear what their meaning should be in the latter sense. Roughly, as the top comment notes, you could say that a price decrease is because of net selling at the previous price level, while a price rise is driven by net buying at the previous price level. But in terms of actual market mechanics, the only way prices move is by matching of a buyer and a seller, so every market transaction inherently represents an instantaneous balance across the bid/ask spread. So then we could think about the notion of orders. Actual transactions only occur in balance, but there is a whole book of standing orders at various prices. So maybe we could use some measure of the volume at various price levels in each of the bid/ask books to decide some notion of net buying/selling. But again, actual transactions occur only when matched across the spread. If a significant order volume is added on one side or the other, but at a price far away from the bid/offer - far enough that an actual trade at that price is unlikely to occur - should that be included in the notion of net buying/selling? Presumably there is some price distance from the bid/offer where the orders don't matter for net buying/selling. I'm sure you'd find a lot of buyers for BRK.A at $1, but that's completely irrelevant to the notion of net buying/selling in BRK.A. Maybe the closest thing I can think of in terms of actual market mechanics is the comparative total volumes during the period that would still have been executed if forced to execute at the end of period price. Assuming that traders' valuations are fixed through the period in question, and trading occurs on the basis of fundamentals (which I know isn't a good assumption in practice, but the impact of price history upon future price is too complex for this analysis), we have two cases. If price falls, we can assume all buyers who executed above the last price in the period would have happily bought at the last price (saving money), while all sellers who executed below the last price in the period would also be happy to sell for more. The former will be larger than the latter. If the price rises, the reverse is true." Market Capitalization is the product of the current share price (the last time someone sold a share of the stock, how much?) times the number of outstanding shares of stock, summed up over all of the stock categories. Assuming the efficient market hypothesis and a liquid market, this gives the current total value of the companies' assets (both tangible and intangible). Both the EMH and perfect liquidity may not hold at all times. Beyond those theoretical problems, in practice, someone trying to buy or sell the company at that price is going to be in for a surprise; the fact that someone wants to sell that many stocks, or buy that many stocks, will move the price of the company stock. You can execute block trades on the options market and get exercised for shares to create a very large position in Energy Transfer Partners LP without moving the stock market. You can then place limit sell orders, after selling directly into the market and keep an overhang of low priced shares (the technical analysis traders won't know what you specifically are doing, and will call this 'resistance'). If you hit nice even numbers (multiples of 5, multiples of 10) with your sell orders, you can exacerbate selling as many market participants will have their own stop loss orders at those numbers, causing other people to sell at lower and lower prices automatically, and simultaneously keep your massive ask in effect. If your position is bigger than the demand then you can keep a stock lower. The secondary market doesn't inherently affect a company in any way. But many companies have borrowed against the price of their shares, and if you get the share price low enough they can get suddenly margin called and be unable to service their existing debt. You will also lose a lot of money doing this, so you can also buy puts along the way or attempt to execute a collar to lower your own losses. The collar strategy is nice because it is unlikely that other traders and analysts will notice what you are doing, since there are calls, puts and share orders involved in creating it. One person may notice the block trade for the calls initially, but nobody will notice it is part of a larger strategy with multiple legs. With the share position, you may also be able to vote on some things, but that solely depends on the conditions of the shares. Differences in liquidity explain why American-style options are generally worth more than their European-style counterparts. As far as I can tell, no one mentioned liquidity in their answer to this question, they just introduced needlessly complex math and logic while ignoring basic economic principles. That's not to say the previous answers are all wrong - they just deal with periphery factors instead of the central cause.  Liquidity is a key determinant of pricing/valuation in financial markets. Liquidity simply describes the ease with which an asset can be bought and sold (converted to cash). Without going into the reasons why, treasury bills are one of the most liquid securities - they can be bought or sold almost instantly at any time for an exact price. The near-perfect liquidity of treasuries is one of the major reasons why the price (yield) of a t-bill will always be higher (lower yield) than that of an otherwise identical corporate or municipal bond. Stated in general terms, a relatively liquid asset is always worth more than an relatively illiquid asset, all else being equal.  The value of liquidity is easy to understand - we experience it everyday in real life. If you're buying a house or car, the ability to resell it if needed is an important component of the decision. It's the same for investors - most people would prefer an asset that they can quickly and easily liquidate if the need for cash arises.  It's no different with options. American-style options allow the holder to exercise (liquidate) at any time, whereas the buyer of a European option has his cash tied up until a specific date. Obviously, it rarely makes sense to exercise an option early in terms of net returns, but sometimes an investor has a desperate need for cash and this need outweighs the reduction in net profits from early exercise.  It could be argued that this liquidity advantage is eliminated by the fact that you can trade (sell) either type of option without restriction before expiration, thus closing the long position. This is a valid point, but it ignores the fact that there's always a buyer on the other side of an option trade, meaning the long position, and the right/restriction of early exercise, is never eliminated, it simply changes hands. It follows that the American-style liquidity advantage increases an options market value regardless of one's position (call/put or short/long). Without putting an exact number on it, the general interest rate (time value of money) could be used to approximate the additional cost of an American-style option over a similar European-style contract. Limit books are managed by exchanges. If an order is not immediately filled, it is sent to the book.  From there, orders are generally executed on price-time-priority.  The one major exception is the precedence hide-not-slide orders have over earlier placed visible slidden limit orders since unslidden orders are treated like a modification/cancellation. To an exchange, a modification is the same as a cancellation since it charges no fees for placing or canceling orders, only for trades.  The timestamp is reset, and price-time-priority is applied in the same way, so if a modified order isn't immediately filled, it is sent back to the book to be filled in order of price-time-priority. "I've alway thought that it was strange, but the ""price"" that gets quoted on a stock exchange is just the price of the last transaction. The irony of this definition of price is that there may not actually be any more shares available on the market at that price. It's also strange to me that the price isn't adjusted at all for the size of the transaction. A transaction of just 1 share will post a new price even if just seconds earlier 100,000 shares traded for a different price. (Ok, unrealistic example, but you get my point.) I've always believed this is an odd way to describe the price. Anyway, my diatribe here is supposed to illustrate the point that the fluctuations you see in price don't really reflect changing valuations by the stock-owning public. Each post in the exchange maintains a book of orders, with unmatched buy orders on one side and unmatched sell orders on the other side. If you go to your broker and tell him, ""fill my order for 50,000 shares at market price"", then the broker won't fill you 50,000 shares at .20. Instead, he'll buy the 50 @ .22, then 80 @ .23, then 100 @ .30, etc. Because your order is so large compared to the unmatched orders, your market order will get matched a bunch of the unmatched orders on the sell side, and each match will notch the posted price up a bit. If instead you asked the broker, ""open a limit order to buy 50000 shares at .20"", then the exchange will add your order to the book: In this case, your order likely won't get filled at all, since nobody at the moment wants to sell at .20 and historically speaking it's unlikely that such a seller will suddenly appear. Filling large orders is actually a common problem for institutional investors: http://www.businessweek.com/magazine/content/05_16/b3929113_mz020.htm http://www.cis.upenn.edu/~mkearns/papers/vwap.pdf (Written by a professor I had in school!)" "For stock options, where I'm used to seeing these terms: Volume is usually reported per day, whereas open interest is cumulative. In addition, some volume closes positions and some opens positions.  For example, if I am long one contract and sell it to someone who was short one contract, then that adds to volume and reduces open interest.  If I hold no contracts and sell (creating a short position) to someone who also had no contracts, then I add to volume and I increase open interest. EDIT: With the clarification in your comment, then I would say some people opened and closed positions in that one day.  Their opening and closing trades both contribute to ""volume"" but they have not net position in the ""open interest.""" "This is a great question precisely because the answer is so complicated. It means you're starting to think in detail about how orders actually get filled / executed rather than looking at stock prices as a mythical ""the market"". ""The market price"" is a somewhat deceptive term. The price at which bids and asks last crossed & filled is the price that prints. I.e. that is what you see on a market price data feed. ] In reality there is a resting queue of orders at various bids & asks on various exchanges.  (source: Larry Harris. A size of 1 is 1H = 100 shares.) So at first your 1000H order will sweep through the standing queue of fills. Let's say you are trading a low-volume stock. And let's say someone from another brokerage has set a limit order at a ridiculous price. Part of your order may sweep through and part of it get filled at a ridiculously high price. Or maybe either the exchange or your broker / execution mechanism somehow will protect you against the really high fill. (Let's say your broker hired GETCO, who guarantees a certain VWAP.) Also people change their bids & asks in response to what they see others do. Your 1000H size will likely be marked as a human counterparty by certain players. Other players might see that order differently. (Let's say it was a 100 000H size. Maybe people will decide you must know something and decide they want to go the same direction as you rather than take the opportunity to exit. And maybe some super-fast players will weave in and out of the filling process itself.) There is more to it because, what if some of the resting asks are on other venues? What if both you and some of the asks match with someone who uses the same broker as you? Not only do exchange rules come into play, but so do national regulations. tl;dr: You will get filled, with price slippage. If you send in a big buy order, it will sweep through the resting asks but also there are complications." "Exchange A has 100 shares of a stock at $10, the next 100 shares cost $10.01. Exchange B has the same pricing structure.  A fund manager wants to buy 200 shares of the stock, and decides that buying 100 shares at $10 from each exchange will be cheaper than staying in one exchange and paying $10.01 for the second half of his order.  The manager places two separate orders. Let's say the first order reaches exchange A, and the trade executes at $10. Traders (algorithms) on exchange B see this happen, and adjust their price up to $10.01 accordingly. Now, when the manager's order reaches exchange B, there will no longer be any shares trading at $10.  Some people say that this is front running, but if the manager only wanted 100 shares, the price would have still shifted. Some say this creates a more efficient market with tighter spreads due to the decreased risk to the market maker, but it also means the aggregate bid-ask offers across multiple exchanges are not necessarily accurate, creating a ""false liquidity"". You can decide for yourself whether or not this is a good thing." Depends on when you are seeing these bids & asks-- off hours, many market makers pull their bid & ask prices entirely.  In a lightly traded stock there may just be no market except during the regular trading day. You said the decision will be made by EOD. If you've made the decision prior to the market close, I'd execute on the closing price.  If you are trading stocks with any decent volume, I'd not worry about the liquidity.  If your strategy's profits are so small that your gains are significantly impacted by say, the bid/ask spread (a penny or less for liquid stocks) I'd rethink the approach. You'll find the difference between the market open and prior night close is far greater than the normal bid/ask.