market structure, trading, and liquidityslide 1 market structure, trading, and liquidity fin 2326...

Market Structure, Trading, and Liquidity Slide 1

Market Structure, Trading, and LiquidityFIN 2326

Dr. Michael Pagano, CFA

Adapted from Slides by:

Dr. Robert Schwartz © 2004Baruch College

and Wayne Wagner

President, Plexus Group


(1) Why Study Financial Market Structure?

(2) Overview of Market Structures & Trading Simulation

(3) From Information to Prices

(4) Liquidity Provision in Perfect & Imperfect Markets

(5) Strategic Use of Limit and Market Orders

(6) Market Intermediaries & the Evolution of Securities Markets

(7) Institutional Order Flow & Fragmentation

(8) Algorithmic Trading and Technical Analysis

(9) Trading Performance Measurement

(10) Regulation

Overview of Key Market StructureTopics


(1) Customers (Investors & Issuers)

(2) Brokers / Dealers

(3) Market Centers (Listings / Order Flow / Data)

(4) Benefits vs. Costs (Net Returns vs. Transaction Costs)

Topics 1 & 2

Getting a Grip on Trading


Fundamental Financing ChannelsFirm Investor

Firm InvestorIB / CB

Buyer Seller

Agent

Exchange

or Market Maker

Agent


The Equity Markets

U.S. Equity Market Centers National Markets: NYSE, Nasdaq, BATS, DirectEdge

Regional Exchanges: Boston, Chicago, National, and Philadelphia

Over-the-Counter Market (OTC) Alternative Markets (ATSs, ECNs), e.g.:

– INET (part of Nasdaq now)– Archipelago (part of NYSE Euronext now) – POSIT (Investment Technology Group)– Liquidnet– Pipeline– Broker-run Dark Pools (Goldman, Credit Suisse, etc.)


Trading Players

• Investors• Asset Exchangers• Bluffers• Uninformed traders• Speculators• Dealers• Brokers• Exchanges


Some Main Points to keep in mind

• Traders who seek profit create liquidity and price efficiency.

• Keep your eye on who has the information.

• All profits ultimately must come from uninformed traders.

• Comparative advantages and trading rules

determine trader profits in the long run.


Major Trading Issues

• Liquidity

• Informative Prices

• Volatility

• Transaction Costs

• Trading Profits

• Net Investment Returns


The Iceberg of Transaction Costs

Source: Plexus Group

Commission 5 ¢ (17 bp)

ImpactImpact10 ¢ (34 bp)10 ¢ (34 bp)

Delay23 ¢ (77 bp)

Missed Trades9 ¢ (29 bp)


Cost Components

• Total Cost = Commission + Impact (intra-day)

+ Delay (inter-day) approx. 157 bps

(one-way) 314 bps (round-

trip!)

• What is the cumulative impact on a 10% annual return over: 1, 5, and 10-year horizons?


Total Cost

Total Cost of Trading

0

50

100

150

200

250

Bas

is P

oin

ts

NASDAQ

NYSE

NASDAQ 43 71 85 134 230

NYSE 43 56 81 94 138

Giant Cap

Large Cap

Mid Cap

Small Cap

Micro Cap


Commissions

Commission Cost

0

25

50

75

100

125

150

Bas

is P

oint

s

NASDAQ

NYSE

NASDAQ 16 15 22 29 50

NYSE 12 15 20 26 39

Giant Cap Large Cap Mid CapSmall Cap

Micro Cap


Impact

Impact Cost

0

25

50

75

100

125

150

Bas

is P

oint

s

NASDAQ

NYSE

NASDAQ 16 28 33 37 42

NYSE 18 19 25 23 20

Giant Cap Large Cap Mid Cap Small Cap MicroCap


Inter-day Delay

Delay Cost

0

25

50

75

100

125

150

Ba

sis

Po

ints

NASDAQ

NYSE

NASDAQ 10 27 30 67 137

NYSE 13 22 37 46 79

Giant Cap

Large Cap

Mid CapSmall Cap

MicroCap


Getting a Grip on Trading (cont.)

• Order Flow & Order Arrival Rates

• Trading vs. Investing

• Trader Types: Informed / Liquidity / Technical

• Trading Simulation: Limit Order Books & Trading “Ecology”

• Bid-Ask Spread & Limit vs. Market Orders

• Liquidity (Time & Space) & Trading Performance


The Two Sides of the Trading Industry

• People and institutions who use market services are on the buy-side.

• Those who provide market services are on the sell-side.

• Both are customers of exchanges / markets.• These sides have nothing to do with whether you are a

buyer or seller of a specific security.


Buy-Side Players

• Individuals • Corporate pension fund

sponsors• Charitable trusts• Legal trusts• Endowments

• Investment managers• Corporate investment

funds• Insurance reserve funds• Governmental funds• Hedge Funds


Sell-Side Players

• Dealers trade for their own accounts (Principal)– Day Traders– Scalpers– “Locals”

• Brokers trade for other people’s accounts (Agent)– Retail and institutional– Full-service and discount

• Broker-dealers do both.– Specialists– Wire houses, regional firms, “internalizers”


Sell-Side Trade Facilitators

• Market Centers provide systems that help traders arrange their trades. – Note that market centers and brokers often compete with

each other.

• Clearing houses help settle trades and guarantee that traders will perform (NSCC).

• Depositories and custodians hold securities (DTC).


Goal of a Trading System

Bring customer orders together to make trades: At reasonable cost In a timely fashion At reasonable prices

Success depends on quality of a market’s structure: The systems, rules and protocols that determine how orders are handled and transformed into trades


Trading Mechanism

3 Sources of Orders

Informed

Is p*>offeror p*<bid?

What Drives a Market?

LiquidityOrder Flow

Quotes,Prices,Volume

Technical Trading

Is there a trend/pattern?

P*


The Big Problem

Enabling Buyers and Sellers, Large and Small, to Find Each Other

Two Dimensions Place Time


10:50 10:55 11:00

PublicBuyer

PublicSeller

LimitOrder

Executes

Placesa BuyLimit

Order

Order Driven Market

The limit order book brings

buyer& seller together




BIDS PRICE OFFERS

11.30 91

11.25 0

11.20 52

11.15 24

11.10 7

11.05

11.00

35 10.95

70 10.90

0 10.85

20 10.80

67 10.75

39 10.70

46 10.65

The Limit Order Book

Bid – Ask Spread(10.95 - 11.10)

Air Pocket

Air Pocket

Market Structure, Trading, and Liquidity Slide 25$21.00

$22.00

$23.00

$24.00

$25.00

$26.00

$27.00

$28.00

Ask

Bid

P*

Day 1 Day 2

P* and Best Bid and Offer Quotes


Topics 3 & 4 All About Liquidity

• Gross vs. Net Investment Returns ($1100 vs. $1067)

• Frictionless CAPM vs. Real-world Frictions

• Alpha = Rp – p (Rm – Rf) vs. Net Alpha = ( – TC)

• Info Types: – Market vs. Fundamental – Public vs. Private vs. Insider

• Divergent Expectations and Adaptive Valuations

• Liquidity: Depth / Breadth / Resiliency / Speed


All About Liquidity (cont.)

• Transaction Costs: Explicit vs. Implicit

• Explicit: Commissions / Exchange Fees / Taxes

• Implicit: – Bid-Ask Spread – Total Trading Cost = Delay + Impact + Opportunity Cost– Measures of Market Quality (e.g., Variance Ratio)

• Illiquidity & Transaction Costs affect:– Returns and Price Volatility (via bid-ask “bounce”)– Price and Quantity Discovery– Reduced portfolio net returns


All About Liquidity (cont.)

• Market Structure Types: – Continuous Order-Driven– Periodic Order-Driven Call Auctions– Continuous Quote-Driven (aka “Dealer markets”)– Negotiated Markets (e.g., ATS / block trader)– Hybrid Markets

• Random Walk vs. Illiquid Market “Symptoms”:

– Serial Return Correlation (Positive vs. Negative) – Time Scaling of Variance (e.g., Variance Ratio analysis)– Serial Cross-Return Correlation


What Do the Following Have in Common?

Without Gas, Neither Will Run


Order Flow is Gas For a Market

Order Flow = Liquidity

An excellent system will not operate if it does not receive

Critical Mass Order Flow“Order flow attracts order flow”


Liquidity

Attributes of a liquid asset Breadth: orders on the book exist at an array of

prices in the close neighborhood above and below the price at which shares are currently trading.

Depth: orders are of large size. Resiliency: price changes due to temporary order

imbalances quickly attract new orders to the market, thereby restoring reasonable share values.

Frequent trading (at high speed).


Price & Quantity Discovery

The most important objective of any market is to foster accurate price and quantity discovery

Much demand is latent – participants do not readily reveal their desires to buy or to sell

Traders instinctively know the price discovery problem. That is why technical analysis is widely used


Price Discovery is Difficult Because

Cannot assess share values with precision

Have divergent expectations Have adaptive valuations

Investors

Do analysts ever agree?


Difficulty of Assessing Share Valuations With Precision

Can a stock analyst say with precision that the expected growth

rate for XYZ is:

7.00%, not 7.55%?


Analyst Evaluation of XYZ

Dividend one year from now = $1.35

Appropriate cost of eq. cap. = 10%

(1) Growth rate (g) = 7.00%

(2) Growth rate (g) = 7.55%Share price if g =7.00% = $45Share price if g =7.55% = $55


Price Determination

V(H) = $55: The Bulls k percent

V (L) = $45: The Bears 1-k percent

What price(s) will prevail on the market?


10:50 10:55 11:00

PublicBuyer

PublicSeller

LimitOrder

Executes

Placesa BuyLimit

Order

Order Driven Market






BIDS PRICE OFFERS

11.30 91

11.25 0

11.20 52

11.15 24

11.10 7

11.05

11.00

35 10.95

70 10.90

0 10.85

20 10.80

67 10.75

39 10.70

46 10.65

The Limit Order Book

Bid – Ask Spread(10.95 - 11.10)

Air Pocket

Air Pocket


10:50 10:55 11:00

PublicBuyer

PublicSeller

DealerBuys

DealerSells

Dealer Intermediation

Dealer provisionof immediacybrings buyer

& seller together


View From a Market Maker’s Desk

Dealer Bid Dealer Ask

COD 26.00 CAT 26.20

DOG 26.00 COD 26.30

TUNA 25.90 DOG 26.30

CAT 24.80 TUNA 26.30


Order Driven Market

Best Ask 100 shs @ $20.00

Best Bid 200 shs @ $10.00

<Last sale $15


Best Public Ask 100 shs @ $20.00

Best Public Bid 200 shs @ $10.00

< Mkt order: Sell 100

< Sold @ $10

< #*@$%**

<Last sale $15

Thin Order Book


Dealer/Specialist “Makes” the Market



<Last sale $15Specialist Ask 100 shs @ $15.05

Specialist Bid 100 shs @ $14.95


Public Trades with Dealer



< Mkt order: Sell 100

< Sold @ $14.95

<

<Last sale $15Specialist Ask 100 shs @ $15.05

Specialist Bid 100 shs @ $14.95


Dealer Is Long 100 Shares



Specialist Ask 100 shs @ $15.05

Specialist Bid 100 shs @ $14.95 $14.90


10:50 10:55 11:00

PublicBuyer

PublicSeller

A Call Auction

A meeting pointin time can bring multiple buyers &

sellers together


The Electronic Call Auction

Orders that could otherwise be matched and executed are held for a big, multilateral clearing.

Clearings are held at pre-determined points in time (i.e., once an hour).

All crossing orders are executed at a single price:

– Buy orders at that price and higher execute

– Sell orders at that price and lower execute


O

The Batching of Customer Orders

••

O

•

•O

• O•

O

51

50

49

48

47

52

Question

How should these limit ordersbe integrated to produce a good

price?

1 2 3 4 5 6 No. Orders

Price O Offer• Bid


Cumulate The Buy Orders

• (1)

• (3+1=4)

• (4+1+5)

• (5+1=6)

••

•

•

•

•51

50

49

48

47

52

1 2 3 4 5 6 No. Orders

Price

• (1+2=3)

• Individual buy order

Cumulated buy orders at the price or better


Cumulate The Sell Orders

•

•

•

•

•

O(1)

O(2)

O(3)

O(4)

O(5)

51

50

49

48

47

52

1 2 3 4 5 6 Orders

Price

• Individual sell orderO Cumulative sell orders at the price or better


Match Cumulated Buy & Sell Orders

O

O

O

O

O

CUMULATED SELL ORDERS

•

•

••

• CUMULATED BUY ORDERS

51

50

49

48

47

52

1 2 3 4 5 6 Orders

Price

3

50P* =


Trading Costs

1. Explicit costs commissions taxes etc.

Execution Costs (the implicit costs of trading) Bid-ask spread Market impact Delay/Opportunity cost


Trading Costs and Volatility

1. The bid-ask spread2. Market impact3. Momentum trading4. Imperfect price discovery

Trading costscause prices to bounce between

higher and lower values


Trading Costs & Volatility

P*

= Implicit transaction cost of buy or sell = Transaction price (triggered by buy order)= Transaction price (triggered by sell order)= Magnitude of C= Unobserved, costless trading price

C

P*

Price

Time



P*

= Implicit transaction cost of buy or sell = Observed price of buy-triggered trade = Observed price of sell-triggered trade = C= Unobserved, costless trading price

C

P*

Price

Time


Trading Costs & Returns

Price

Time

P

T



P*

Which is more volatile:P* or the transaction price we

observe?

ObservedTransaction

Price

Price

Time


The Efficient Market Hypothesis (EMH)

Existing information cannot be exploited to realize above normal (risk adjusted) trading profits

• Weak forminformation = historical market information

• Semi-strong form information = weak form + publicly available info

• Strong formInformation = semi-strong form + private info

= the complete information set


Random Walk

If the EMH holdsIf the EMH holds

Security price changes (returns) Security price changes (returns) are notare not serially serially correlatedcorrelated

Ri,t ≠ f(ri,t-1)


Liquidity

CAPM, the frictionless environment

2 dimensions: risk and return

Liquidity is perfect and a stock can be traded immediately at its equilibrium value (P*)

Actual markets

3 dimensions: risk, return, and liquidity


Liquidity & Random Walk

Positive Intertemporal Correlation Sequential information arrival The limit order book Market maker intervention Inaccurate price discovery

Negative Intertemporal Correlation Bid-ask spread Market impact effects Inaccurate price discovery

Serial Cross-Correlation


INTRADAY VOLATILITYNYSE

October - December 1999

0.00%

0.40%

0.80%

1.20%

1.60%

Hal

f-Hou

r V

olat

ility

The First 1/2 Hour


January - May 2000

0

0.5

1

1.5

2

2.5

3

8:00

-8:3

0

8:30

-9:0

0

9:00

-9:3

0

9:30

-10:

00

10:0

0-10

:30

10:3

0-11

:00

11:0

0-11

:30

11:3

0-12

:00

12:0

0-12

:30

12:3

0-1:

00

1:00

-1:3

0

1:30

-2:0

0

2:00

-2:3

0

20:3

0-3:

00

3:00

-3:3

0

3:30

-4:0

0

4:00

-4:3

0

Ha

lf-H

ou

r V

ola

tili

ty

INTRADAY VOLATILITYLONDON STOCK EXCHANGE

The First 1/2 Hour


Prices (P)

P0 , P1 , P2 , … , PT

P0 P1 P2 PT

Time


Arithmetic Returns (P)

P0,1 = P1 – P0

P1,2 = P2 – P1

PT-1,T = PT – PT-1


Percentage Returns (r)

r0,1 = ( P1 – P0 ) / P0 = P0,1 / P0

r1,2 = ( P2 – P1 ) / P1 = P1,2 / P1

rT-1,T = ( PT – PT-1 ) / PT-1 = PT-1,T / PT-1


Price Relatives (PR)

PR0,1 = P1 / P0 = ( P0 + P0,1 ) / P0 = 1 + r0,1

PR1,2 = P2 / P1 = ( P1 + P1,2 ) / P1 = 1 + r1,2

PRT-1,T = PT / PT-1 = ( PT-1 + PT-1,T ) / PT-1 = 1 + rT-1,T

PR0,T = PT / P0 = (P1 / P0) * (P2 / P1) *…* (PT / PT-1)


Log Returns (R)

R0,1 = ln(P1/P0) = ln(P1) – ln(P0) = ln(1+r0,1)

R1,2 = ln(P2/P1) = ln(P2) – ln(P1) = ln(1+r1,2)

RT-1,T = ln(PT) – ln(PT-1) = ln(1+rT-1,T)

PR0,T = PT / P0 = (P1 / P0) * (P2 / P1) *…* (PT / PT-1)

R0,T = R0,1 + R1,2 +…+ RT-1,T =

Ri-1,i = ln(PT) – ln(P0)

R = ln(1+r) = ln(price relative)


Question:

Which of the following may be normally

distributed?

Pr

PR R


Two Period Log Returns

P2 = P0 ( 1 + r0,2 )

P2 = P0 ( 1 + r0,1 ) ( 1 + r1,2 )

1 + r0,2 = P2 / P0 = ( P1 / P0 ) * ( P2 / P1 ) =

= ( 1 + r0,1 ) ( 1 + r1,2 )

R0,2 = R0,1 + R1,2


Log Returns: Two Period Mean

Assume constant Mean:

E(R0,1) = E(R1,2)

E(R0,2) = E(R0,1) + E(R1,2)

E(R0,2) = 2E(R0,1)


Log Returns: Two-Period Variance

Var(R0,2)=Var(R0,1)+Var(R1,2)+2Cov(R0,1,R1,2)

Assume constant Variance:

Var(R0,1) = Var(R1,2)

For Cov(R0,1,R1,2) = 0

Var (R0,2) = 2 Var(R0,1)

In general… Var (R0,T) = T * Var(R0,1)

What if Cov(R0,1,R1,2) < 0 ?


Key Statistical Measures

Mean Return (via ln of Price Relative)

Variance and S.D. of Returns

Market Model Beta, R2, and Residual Variance.

Variance Ratio = Var (R0,2) / [2 * Var (R0,1)]

Volume-Weighted Average Price =

VWAP0,T = t=1,T wt * Pt

where, wt = Sharest / t=1,T Sharest


Additional Measures• Quoted Spread = (Ask – Bid)

• Effective Spread = 2 * (B/S) * (Pt – Quote Midpointt)

• Quote Midpoint = (Ask + Bid) / 2

• Realized Spread = 2 * (B/S) * (Pt – QMPt+n)

• Tot. Trans. Cost = Delay + Impact + Missed Trades

• Implementation Shortfall (IS) =

Beginning Portfolio Value – Ending Portfolio ValueIS = (B/S) * [(QMP0 - QMPt) + (Avg. QMPt,T – Avg. Pt,T)

+ (% Unfilled * (QMP0 - PT))]

where, 0 = time of initial request / t = first trade / T = last trade


Topic 5How to use Limit and Market Orders

• Limit Order Books / Market Makers / Hybrids

• Key Order Types:

– Limit orders: “make” liquidity / “patient”– Market orders: “take” liquidity / “impatient”– Stop Loss & Stop Limits: manage risk

• Limit Orders: ↓ Impact vs. ↑ Delay

• Limit Order Risks: Execution Risk and “Bagging”

• Price & Time Priority Rules reduce risk somewhat


How to use Limit and Market Orders (cont.)

• Break-even Probability of Limit vs. Market Orders

ProbB-E = (Preserve - Pmarket) / (Preserve - Plimit)

• Expected Gain = Probactual * (Preserve - Plimit)

• Equilibrium B-A spread size is determined by “Gravitational Pull” concept of limit vs. market

• Option Value of a Limit Order:– Bid Limit order = “short Put” (must buy from a seller)– Ask Limit order = “short Call” (must sell to a buyer)– The “Premium” received from these sales = B-A spread


Ecology of a Pure Order Driven Market

Limit orders be posted

Market orders be submitted

Participants meet to establish prices and trade. This requires:


Informational Change

Assume I have an open, unexecuted buy limit order on the book. If a news event occurs, it’s …

"Heads You Win, Tails I Lose”

Heads You Win: Bearish news has caused the price of the stock to fall and my limit order executes

Tails I Lose: Bullish news has caused the price of the stock to rise and my limit order doesn’t execute

So Why Did I Place That Limit Order?So Why Did I Place That Limit Order?


Compensation From a Liquidity Event

• A liquidity event that results in a price decline could cause my buy limit order to execute.

• After being driven down, price would revert back up.

• I profit as price mean reverts after my order has executed.

• Sufficient mean reversion can offset the costs that result from informational change.

Mean Reversion = Accentuated Volatility

They are the same thing!


Bid-Ask Spread

Compensation for

Risk of adverse informational change

Risk of limit order not executing

Gravitational Pull Effect


Market Ask

Market Bid

Gravitational Pull

Potential Buy Order 2

Potential Buy Order 1


Making the Trade

(based on Navarro chapters)


The Stock Market and Business Cycles

Stock Market is a leading economic indicator Different Sectors shine at various points during the business cycle.

Early / Middle / Late Bull Markets:Transportation / Capital Goods / Commodities

Early / Middle / Late Bear Markets:Consumer Staples / Utilities / Cons. Cyclicals


The Interest Rate Cycle & Yield Curve

Yield Curve can be a Leading indicator of both the Stock Market and Economy. Federal Reserve sets short-term rates but… Long-term rates set by investor expectations of economic growth and inflation. Bonds and Money Market instruments can be competitors to Stocks.Normal / Steep / Inverted / Flat Yield Curves:Middle Bull / New Bull / Bearish / Mixed


Managing Risk

3 Key Risks: Market, Sector, Company. Compute Reward-to-Risk Ratio for your trades / stocks:Ad hoc Rule of Thumb (3:1), Sharpe Ratio, Alpha, Beta. Diversification is very important (e.g., “no more than 20% in one sector”). “Never bet the farm!” “When in doubt, go flat.”


Managing Trade Execution

Market vs. Limit Orders Trading Range vs. Trending Markets Intelligent Stop Loss orders:

Set “loose stops” Avoid round numbers & technical nodes Use “trailing stops” to lock in gains

“Never turn a winner into a loser” “Never average down a loss” “Never churn your own portfolio”


Topics 6 & 7Market Intermediaries: Nuts & Bolts

• Broker vs. Dealer vs. Specialist

• Blurring of Lines between:

– Sell-side vs. Buy-side– Securities Exchanges vs. ECNs vs. ATSs

• NYSE Specialist vs. Nasdaq Mkt Maker vs. ECN / ATS

• NYSE Specialist: Positive & Negative Obligations

• Nasdaq MM: Proprietary dealers change quotes depending on their inventory position: ↑ B-A if INV < 0


Market Intermediaries: Nuts & Bolts (cont.)• Institutional Order Flow (Large Peg vs. Small Hole)

and Institutional Investors’ responses: – “Slicing and Dicing” – Greater control over order-routing (incl. “preferencing”)– Increased use of ECN and ATS services

• Market Maker (MM) Services: Immediacy / Liquidity / Animation / Price Discovery / P & Q Improvement

• MM Revenues: B-A spread / Trading Order Flow / Commissions

• MM Costs: Inventory Mgmt / Asymmetric Info / Order Processing = f (INV, AI, KL) / Q


The Eye of the Storm

The institutions are huge Markets are structured for retail order flow How can the big guys get the liquidity they need?

Dealer capital Place limit orders Trade negotiation (e.g., via “Dark Pools”) Not held (NH) orders (via Floor Brokers) Slice, dice and shred (via Algorithms)

Big Pegs and Tiny Holes


Remarks from John Phinney

• To a retail investor, the stock exchanges look like a vending machine!

• This is not the case for the institutional trader. As we know, the “peg” of institutional trading interest is much larger than the “hole” size of the exchange process.

* Remarks made at Baruch Conference, Coping With Institutional Order Flow, NYC, April 29, 2003

*


• The “meat grinder” appears clearly in all of our data sampling.

• Trading costs seem to be much more related to endogenous market factors, structure, and process, than to exogenous factors derived from investor behavior.

Remarks from John Phinney (cont.)


Phinney’s Meat Grinder Example1.8 Million Buy Order for Oracle,

August 15, 2002

Executions Number: 1,000+ Average size: 1,700 shares Largest : 64,000 shares Smallest: 13 shares 1000 shares or less 61% of execs

100 shares or less: 17% of execs

Time to complete: 51 minutes


Phinney’s Conclusion

It required a 1,000-to-1 reduction of the manager’s intent (and a significant amount of technology) to get trade pieces small enough to be digestible by the market.

It was a DFT


Market Maker Services

Immediacy

Supplemental liquidity

Price discovery

Animation


Immediacy

Market maker practices are designed to facilitate the rapid execution of customer orders

However, orders are commonly traded patiently (i.e., without immediacy)

Upstairs negotiation of large block trades

Breaking up large orders for submission over

time

Limit orders


Market Maker Costs

Inventory cost: Cost of carrying unbalanced inventory

Processing cost: Cost of labor, physical capital required to execute trades

Information cost: Cost of trading with better informed participant

Spread = f (INV, KL, AI) / Q


What Makes a Market Maker Successful?

Inventory control

Trading the order flow carefully

Ability to hide/disguise large positions

Knowledge of customers (source of the order flow) is also important in practice


Inventory Control in TraderEx

If P* jumps above your offer, your customers will, on net, be buyers and your inventory will fall

As your inventory falls, you raise your bid and offer

The higher bid attracts sellers and the higher offer discourages buyers

What happens to your inventory if your bid is raised above P*?

Your inventory is controlled by adjusting your bid and offer relative to the unobserved P*


Transparency

"Shares sold to a market maker are still for sale”

You do not want your inventory revealed by a trade publication

As a Market Maker, How Transparent Do You Want the Market To Be?

After you acquire a large inventory in the process of servicing a customer, you must work off that position


Knowing their customers

Offering an array of services

Developing customer relationships; this results in

Preferencing

Quote matching

A market spread that is greater than it would be in an order-driven environment

So, How Do Market Makers Compete?


Topic 8The Road to Tech. Analysis & Algo Trading

• Dynamic Price Discovery due to:– Large, complex information set– Divergent expectations and Adaptive valuations

• Quantity Discovery problems due to:– Institutional Order Flow and Bifurcation of P & Q discovery– Bookbuilding problem and Trade Clustering

• Technical Analysis to increase trading profits: S-T timing / “Trade the OF” / B-A Bounce vs. Momentum

• Algo Trading to reduce trading costs: automates “slicing & dicing”, “VWAP trades”, etc.


Some Observations

Trading occurs in bursts (trade clustering).

The bursts are commonly 2-sided.

But the large orders are not meeting each other efficiently.

There is a large latent demand to trade.


Some Conclusions

1.1. Big Trades Cluster in TimeBig Trades Cluster in Time

2.2. Two-Sided Clusters Are Common for Big OrdersTwo-Sided Clusters Are Common for Big Orders

Market Structure Objective: Bring Hidden Liquidity

“In From The Cold”

3.3. Institutional Orders are Portable in TimeInstitutional Orders are Portable in Time

4.4. Much Institutional Demand isMuch Institutional Demand is LATENTLATENT

This implies that


Some Technical Analysis Techniques

• Moving Averages• MACD and Cross-overs• Trendlines and Break-outs• Relative Strength (RSI)• Stochastics / Oscillators• Pattern Recognition (e.g., “head & shoulders”, “pennants”, etc.)• Point and Figure charts• Candlestick charts• Volume and Market Breadth• Money Flow statistics


Algorithmic Trading

Background

Market Maker Operations

Floor Broker Intermediation

Algorithmic Trading

An electronic intermediary


Which is Smarter?

Floor based trading and NH orders

Electronic systems and algorithmic trading

Or…

Kasparov vs. Deep Blue


The Raison d’être of Algorithmic Trading

o Dynamic price discovery

o The speed with which events can occur

o Exploit Market inefficiencies to ↓ costs


Topics 9 & 10Trading Performance Measurement

• Key Measures: P&L / Trading Surplus / Benchmarks (VWAP & Implementation Shortfall)

P&L = Cash Position + (Open Position * Bid Price)

Trading Surplus = (Preserve - Ptransaction) * Quantity

VWAP0,T = t=1,T wt * Pt

where, wt = Sharest / t=1,T Sharest

IS = (B/S) * [(QMP0 - QMPt) + (Avg. QMPt,T – Avg. Pt,T) + (% Unfilled * (QMP0 - PT))]

where, 0 = time of initial request / t = first trade / T = last trade


Trading Performance Measurement (cont.)

• Transaction Cost Analysis (TCA) typically focuses on Implementation Shortfall (IS) plus trading commissions to measure Total Trading Costs (TTC).

• Risk Management vs. Transaction Costs (e.g., limit

orders might lower cost but increase market risk).

• Best Execution: – Analyze processes vs. individual trades– Soft Dollars and Agency conflicts– New Regulatory Environment: MiFID in Europe and Reg NMS

in the U.S. – Market Centers’ responsibilities in this new environment


Best Execution

1975 Security Acts Amendments Retail vs. institutional order flow Execution price vs

Speed Certainty Anonymity Control Etc.

An order is multi-dimensional.


What is Best Execution?

• A snapshot assessment for a single, no brainer order?

– What about orders that are sliced & diced?

– Order that are market timed?

• Beating a performance benchmark?

• Quality of procedures followed?

• None of the above?

• Best Execution is better thought of as a process.


Impediments to Best Execution

• Soft dollar commitments

• Use of an erroneous benchmark

• Excessive pressure to trade quickly

• Imperfect market structure


Heart of the Problem

Outsourcing research, computer systems, and other support services to sell-side with client assets used as payments => Agency Problem!

(The costs are hidden)

Commission Bundling

Soft Dollars


Key Regulatory Topics

Soft Dollar Commissions and Preferencing

Best Execution procedures

Reg NMS, fragmentation, and competition

Level Playing Field: NYSE, Nasdaq, ECNs

Transparency and Market Access

Fairness for Retail vs. Institutional Investors

Rate of Technological Innovation

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Documents

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algorithmic trading

trading rules

market orders

market intermediaries

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