This is a question I first encountered in college, where it was tinged with idealistic indignation at this glaringly capitalist phenomenon. Since I have continued to work in the industry I regularly encounter it in various forms, and it’s worth explaining in detail.
Capital markets are institutions that match capital suppliers (monied investors) with capital demanders (typically, businesses that need money to make money). Demanders attract suppliers by offering to pay them for the use of their capital. For example, a business might sell standardized instruments like stocks (which confer ownership and may pay dividends) or bonds (which pay interest). Secondary (trading) markets for these instruments tend to be pretty efficient, which means that on average there’s little money to be made by trading one stock or bond for another. In fact, trading in secondary markets is roughly a zero-sum game: every dollar earned by one trader comes out of the pocket of another. Which is why investors are encouraged to buy and hold, and why active trading tends to be a money-losing activity.
But there are enterprises that make large and consistent profits by actively trading stocks and bonds. This leaves many laypeople understandably confused: They are warned that if they actively trade they should expect to lose money, while professional trading operations consistently win money. So is trading profitable, or not?
In healthy capital markets, there are three legitimate ways to make money by trading: Providing liquidity, information, or insurance. (There are also some illegal ways, like manipulation.) Nearly everything the trading industry sells, and nearly every fee it collects, traces back to one of those three services. And if you’re not providing one of those services when you trade, then you’re probably paying for them.
The first service, liquidity, is the ability to conveniently value and exchange assets. The owner of a liquid asset knows at all times what the asset is worth, and can quickly sell the asset for close to its full value. Liquidity is the foundation of capital markets: investors supply a lot more capital when they are confident that they can get it back when they need it. Without liquid markets the gears of capitalism can grind to a halt. But liquidity doesn’t happen in a vacuum, and the suppliers of this metaphorical lubricant are paid for it. In the old days of centralized stock exchanges you could point to the front-line liquidity suppliers: specialists staffing the exchange stood ready to buy and sell stocks. They posted the prices at which they would buy (bid) or sell (offer) shares, and the cost of their service was baked into the difference between the bid and offer prices. Today’s stock exchanges are more complex and less centralized, but the fact remains that they depend on liquidity providers.
Another layer of liquidity waits outside the exchange to step in when the demand for liquidity exceeds what market makers can provide. Imagine that someone wants to sell a large amount of stock. As they begin to sell, the routine supply of buyers at the market price is exhausted – nobody is left willing to buy at that price. But lower the price and the stock begins to look like a bargain, which brings in a new supply of buyers. A trader who stands ready to buy when others are desperate to sell is supplying exactly what is scarce in such moments, and is paid for the service. Liquidity provision is a source of profit that can persist even in efficient markets – compensation for storing money and accepting risk when other participants are scrambling for cash.
The second service is information. Traders with special information indicating that a stock is undervalued can buy it, and if the information is correct then they will profit as the stock’s price moves towards its fair value. For example, an analyst might conclude that a company’s new product will be more successful than expected, and that its stock price has not increased to reflect that. If the analyst buys the stock, that purchase pushes the price up marginally – communicating the information to the market, but not in a way that produces any immediate profit for the analyst. The analyst’s profit is most likely realized when the information is proven correct: If the company’s earnings beat the consensus, its price will jump and the analyst can then sell for a profit. The difficulty is that this kind of edge tends to consume itself: public information is already incorporated into market prices. To make money trading on information you have to find a proprietary source – famous ones have included counting shipping containers moving through freight hubs. And information no longer pays once the source becomes widely known or available: the market price simply moves to incorporate it without any friction that a trader can exploit.
The third service is insurance, or the assumption of risk for a premium. This is subtly built into the prices of all investments, but risk can also be explicitly traded via derivative contracts like futures and options. Someone who wants to limit potential losses on a stock can buy an option. In that transaction, the option seller pockets the option’s premium in exchange for carrying its risk.
So who gets paid for providing liquidity, information, and insurance? In theory, anyone can, but it’s a competitive market that has grown increasingly dominated by professionals with tools and skills not available to lay investors. When you see a stock price dip can you tell whether the move was caused by someone demanding liquidity and not somebody trading with special information? Can you precisely calculate the “insurance” (risk) component of an asset’s price? Professional traders can. Or rather, any trader who can’t won’t stay in business for long.
It is worth stepping back to see what all of this accomplishes. In the normal course of events capital markets are like a nuclear reactor, pooling capital and exchanging risk to create heat that powers the economy – and yes, like a reactor, they occasionally melt down. But without the concentration and free exchange of capital and risk no heat is generated and economic development is stagnant. The profits earned in trading are what the economy pays to keep that reactor running, and, stripped to their essence, they are payment for just three things: liquidity, information, and insurance. If you’re trading without providing any of those services, then you’re probably paying for them.