A dealer facilitates market liquidity by intermediating between transactors to whom time is important in exchange for charging buyers a higher price than he pays sellers. A value-based investor may also fulfill this function, but at a larger bid-asked spread than that imposed by the dealer. Relative to the value-based investor, the dealer has limited capital, hence limited ability to absorb risk; he will thus limit the position—long or short—he is willing to take.
When the dealer’s position reaches a maximum, he will lay off to the only other transactor motivated by price—the value-based investor. The dealer’s price is tied to the value-based investor’s price at these layoff points. As the value-based investor shifts his prices in response to new information, the dealer’s interior prices shift along with his layoff prices.
An investor should realize that, when he trades with the crowd, he is trading at the value-based investor’s spread, which may be many times the size of the explicit dealer’s spread. More generally, the actions of the crowd—whether it is buying or selling, and in what volume—will determine whether the price of trading quickly is high or low, hence whether the value of his information justifies trading.
