Key Takeaways
- Markets exist to match buyers and sellers through continuous auction processes
- Price discovery happens through the interaction of limit orders and market orders
- Understanding market structure reveals the inherent challenges day traders face
Understanding How Markets Actually Work
Client Question: "How does day trading even work? Where does the money come from?"
Before you can explain day trading to clients, you need to understand the basic mechanics of how markets operate. This isn't just academic—it's the foundation for explaining why certain trading behaviors succeed or fail.
What is Market Microstructure?
Market microstructure refers to the mechanics of how trading actually happens—how orders are matched, how prices are discovered, and who participates in the process.
Think of it like understanding how an auction works before bidding. The rules of the game matter enormously.
The Order Book: Where Prices Come From
At any moment, a stock has two prices that matter:
| Term | Definition | Example |
|---|---|---|
| Bid | The highest price someone is willing to pay | $50.00 |
| Ask (or Offer) | The lowest price someone is willing to sell | $50.05 |
| Spread | The difference between bid and ask | $0.05 |
The order book is the collection of all outstanding buy orders (bids) and sell orders (asks) at various price levels. This is where price discovery happens.
Two Types of Orders
Limit Orders - "I'll buy/sell only at this price or better"
- Patient approach
- You become a "liquidity provider"
- No guarantee of execution
Market Orders - "I'll buy/sell right now at the best available price"
- Immediate execution
- You "take" liquidity
- You pay the spread
Why This Matters for Day Traders
Here's the key insight: every market order pays the spread.
When a day trader buys a stock at $50.05 (the ask) and immediately tries to sell it, the best available price is $50.00 (the bid). They've instantly lost $0.05 per share—before the stock has moved at all.
This is the first hidden cost of day trading, and it compounds with every trade.
The Continuous Auction
Unlike a traditional auction with a start and end, stock markets run continuous double auctions during trading hours. Buyers and sellers are constantly submitting orders, and whenever a buyer's price meets a seller's price, a trade executes.
This creates opportunities for:
- Price gaps when news hits
- Rapid price movements when many orders hit at once
- Arbitrage for those fast enough to spot price discrepancies
Professional Framing
When explaining this to clients, emphasize that day trading isn't just about predicting direction—it's about overcoming the mechanical costs built into market structure.
"The market is like a casino where the house edge is the bid-ask spread. Every trade you make, the house takes a cut. To win, you need to not just be right about direction—you need to be right enough to overcome those costs."
If a stock has a bid of $25.00 and an ask of $25.08, what is the immediate cost to a day trader who buys at the ask and then sells at the bid?