We were very happy to hear the question “which of the following is not a characteristic of a perfectly competitive market?” during our latest weekend webinar. The reason we were so excited is because answering a question like this is our bread and butter. While some of you might be saying this isn’t a crazy or an extra special question, we believe having the proper understanding of this simple question can be the difference between one investor making money and another losing money. We kid you not.
Here we go…answer to the question “which of the following is not a characteristic of a perfectly competitive market?”
What Are Competitive Markets?
Okay back to our example of competitive markets…let’s meet out two players:
- $SPY – SPDR S&P 500 ETF Trust
- $VOO – Vanguard Index Funds: Vanguard S&P 500 ETF
For starters, they pretty much do the same thing except VOO slightly lags SPY because they take more of a management fee.
Not a huge deal but I love taking a jab at Vanguard by showing VOO in red/green getting slightly outperformed by SPY in pink.
We keep on getting off base. We want to answer the question “which of the following is not a characteristic of a perfectly competitive market?”
Competitive markets are very liquid markets with a lot of participation and competition for order flow. Why is there so much competition for order flow? Because any size can be filled at mid-price for liquidity providers and counterparties can easily hedge any position or trade in an instant. Liquidity is where the competition is.
If we were to look at the options markets and look at the width of the bid/ask spreads, we would be able to see if either SPY or VOO were to be competitive. Remember the bid is what someone is willing to pay for, and the ask is what someone is willing to sell for. If these numbers are close, there is a lot of agreement on price. If they are far apart, nobody has any confidence in true fair value. And what happens when the bid/ask spread if wide? You must take an immediate loss to be filled on a position.
Again, all we need to do is to look at the bid/ask spreads. Let’s start with VOO:
On the left side we see calls and on the right side, we see puts. The $220, which is the first out of the money calls, has $0.65 between the bid and the ask while the $215 put has a $0.60 wide bid/ask spread. We would see this as a completely non-competitive market because there is no competition to fill any trades with markets this wide. But what about SPY?
This is what competitive markets look like. We have the $237 calls $0.03 wide and we have the $236 put $0.02 wide. This screams competitions because market makers and liquidity providers are literally competing for orders here. Anyone making any trading with any size in SPY does not have to take a loss to be filled on a trade.
This competition, which will not surprise anyone, leads to the following volume numbers for VOO and SPY options markets:
Exactly my point, competitive markets lead to liquidity, which is the number one most importance concept in investing and trading.
Which of the Following is Not a Characteristic of a Perfectly Competitive Market?
Wide markets are not a characteristic of perfectly competitive markets. Why? Because nobody is confident in fair market value. What makes a market perfectly competitive? Fair markets and a ton of liquidity 🙂