modern financial markets and trading mechanism - personal

Traders, and Trading Mechanism Markets, Orders and Order Properties

FE570 Financial Markets and TradingLecture 2. Modern Financial Markets and Trading Mechanism

(Ref. Larry Harris - Trading and Exchanges )

Steve Yang

Stevens Institute of Technology

9/4/2012


Outline

1 Traders, and Trading MechanismMarket ParticipantsTrade FacilitatorsTrading InstrumentsMarket Regulation

2 Markets, Orders and Order PropertiesMarketsOrders and Order Properties


Traders, and Trading Mechanism

Market Participants

Trade Facilitators

Trading Instruments

Markets

Market Regulation


Traders are people who trade. They may arrange their owntrades, they may have others arrange trades for them, or theymay arrange trades for others. Proprietary traders trade fortheir own accounts, and brokers arrange trades as agents fortheir clients. Brokers are also called agency traders,commission traders, or commission merchants.

The Buy Side of the trading industry includes individuals,funds, firms, and governments that use the markets to helpsolve various problems they face.

The Sell Side of the trading industry includes dealers andbrokers who provide exchange services to the buy side.

Dealers accommodate trades that their clients want to makeby trading with them when their clients want to trade.Brokers trade on behalf of their clients. They arrange tradesthat their clients want to make by finding traders who willtrade with their clients.


Example

Wirehouse: Traders often call large broker-dealerswirehouses. The word ”wire” in wirehouse once referred tothe telegraph. Following its invention, broker-dealers used thetelegraph to collect orders from branch offices in distant cities.Those who quickly adopted it were able to expand theirbusinesses substantially and thereby greatly increase theirprofits. The ability to communicate quickly was - and remains- very important in the trading industry.


TRADERTYPEInvestors

GENERICEXAMPLES

Individuals

Corporatepensionfunds

Insurance

Charitableand legaltrusts

Endowments

Moneymanagers

WHY THEYTRADETo move wealthfrom the presentto the future forthemselves orfor their clients

TYPICALINSTRUMENTSStocksBonds


TRADERTYPE

Borrowers....

Hedgers

GENERICEXAMPLES

HomeownersStudentsCorporations..

FarmersManufacturersMinersShippersFinancialinstitutions

WHY THEYTRADE

To movewealth fromthe futureto thepresent.

To reducebusinessoperatingrisk

TYPICALINSTRUMENTS

MortgageBondsNotes...

FuturescontractsForwardcontractsSwaps.


TRADERTYPE

Assetexchangers......

Gamblers

GENERICEXAMPLES

InternationalcorporationsManufacturersTravelers...

Individuals

WHY THEYTRADE

To acquirean assetthat theyvalue morethan theasset thatthey tender.

Toentertainthemselves

TYPICALINSTRUMENTS

CurrenciesCommodities......

Various


TRADERTYPE

Dealers

GENERICEXAMPLES

MarketmakersSpecialistsFloortradersLocalsDay tradersScalpers

WHY THEYTRADE

To earntradingprofits bysupplyingliquidity

WELL-KNOWNU.S. EXAMPLES

Spear Leads &KellogLaBranche &Co.Bernard L.MadoffInvestmentSecuritiesKnight TradingGroupTimberHillLLC


TRADERTYPE

Brokers

GENERICEXAMPLES

RetailbrokersDiscountbrokersFull-servicebrokersInstitutionalbrokersBlockbrokersFuturescommissionmerchants

WHY THEYTRADE

To earncommis-sions byarrangingtrades forclients


CharlesSchwab & Co.ETradeDreyfusBrokerageServicesAbel/NoserCorp.XpressTradeCargillFinancialMarkets Group


TRADERTYPE

Broker-dealers

GENERICEXAMPLES

Wirehouses

WHY THEYTRADE

To earntradingprofits andcommis-sions


Goldman SachsMerrill LynchSalomon SmithBarneyMorganStanley DeanWitterCredit SuisseFirst Boston


Topics: Many institutions help traders trade. Weintroduce exchanges, clearing and settlement agents,depositories, and custodians

Exchanges: provide forums where traders meet to arrangetrades.

Clearing Agents: match the buyer and seller records andconfirms that both traders agreed to the same terms.

Settlement Agents: help traders settle their trades. Whenboth sides have performed, the settlement agent gives thecash to the seller and the securities to the buyer.

Clearinghouses: clear and settle all trades in these derivativecontracts. They also usually guarantee that both parties willperform on their contracts.

Depositories and custodians: hold cash and securities onbehalf of their clients. They help settle trades by quicklydelivering cash and certificates to settlement agents.


Trading Instruments: The securities, contracts,commodities, and currencies that raders trade are collectivelyknown as trading instrument. Trading instruments vary bytype. They include: real assets, financial assets, derivativecontracts, insurance contracts, and gambling contracts.Financial instruments include financial assets, derivativecontracts, and insurance contracts.

Real assets

Financial assets

Derivative contracts

Insurance contracts

Hybrid instruments

Gambling contracts


Real assets: include physical commodities, real estate,machines, patents, and other intelectual properties. Realassets also include pollution credits, which are rights to emit aspecified quantity of a given type of pollution. Real assets areinstruments that would appear only on the asset side of abalance sheet.

CLASS INSTRUMENT CREATOR

Real assets Spot commodities Farmers, miners,manufactures

Intellectual properties Inventors and artistsReal estate BuildersPollution emission rights Governments


Financial assets: are instruments that represent ownershipof real assets and the cash flows that they produce. Stocksand bonds are financial assets because they representownership of the assets of a corporation. Other financialassets include currencies, warehouse receipts that representownership of physical commodities, and trust units thatrepresent ownership of the assets of a trust.


Financial Stocks and warrants Corporate issuersassets Bonds Corporate issuers, governments

Trust units TrustsCurrencies Governments, banks


Derivative contracts: are instruments that derive theirvalue from the values of the underlying instruments uponwhich they are based. They are contractual agreementsbetween buyers and sellers that specify the exchange ofcertain privileges and liabilities. Derivative contracts includeforward contracts, futures contracts, options, and swaps.


Derivative Futures contracts Sellerscontracts Forward contracts Sellers

Options SellersSwaps Sellers


Insurance contracts and gambling contracts areinstruments that derive their value from the outcomes offuture events. For example, the value of a fire insurancecontract on a building depends on whether the building burnsdown. The value of point spread bet on the Lakers dependson whether they win their basketball game by more than thespecified point spread. The distinction between an insurancecontract and a gambling contract depends on the reasons whypeople buy them.


Insurance Insurance policies Corporationscontracts Reinsurance contracts CorporationsGambling Numerous types Individualscontracts Bookies

CasinosRacetracks


Hybrid instruments defy easy classification because theyembody elements of more than one type of instrument. Forexample, some oil companies issue oil-linked bonds. Theinterest that they pay depends on the price of oil. Thesebonds are financial assets because they represent ownership ofthe assets of the firm in the event of bankruptcy. They alsoare derivative contracts because they derive at least part oftheir value from the price of oil.


Hybrid Warrants Corporate issuersinstruments Index linked bonds Corporate issuers

Convertible bonds Corporate issuers


Regulators create and enforce rules that facilitate trading.Good regulations help ensure that traders communicateeffectively with each other, that people do not defraud others,and that all things generally are as they appear. Legislaturesenact laws that directly regulate markets. They generallydelegate enforcement of these laws to various public andprivate regulatory agencies.

Government AgenciesSelf-regulatory OrganizationsOther Private Regulators

International Regulatory Organizations Although theycannot easily impose standards upon their members, theyprovide useful forums for sharing information about marketstructure and for exploring solutions to common regulatoryand operational problems. (Exp. the InternationalOrganization of Securities Commissions (IOSCO), the WorldFederation of Exchanges (WFE), and the InternationalCouncils of Securities (ICSA))


Governmental regulatory agencies Most countries havecreated governmental regulatory agencies to oversee tradersand trading practices. These agencies generally areindependent commissions. The main U.S. governmentalagencies that regulate trading are the securities and ExchangeCommission (SEC) and the Commodity Futures TradingCommission (CFTC).

The SEC regulates securities markets (stocks, bonds, warrants,investment company shares, and trust units), equity optionsmarkets, and cash-settled equity index options markets.The CFTC regulates commodity spot, forward, and futuresmarkets.

In addition to their regulatory functions, the SEC and CFTCcollect and disseminate information useful to traders,investors, speculators, and legislators.

Several other governmental organizations also regulatesecurities trading in the United States. The Federal ReserveBoard sets speculative margins - Reg T margins.


Self-regulatory Organizations or SROs: Private regulatoryagencies include exchanges, clearinghouses, and traderassociations. These organizations regulate their members tolower their costs of doing business together, to improve theirbusiness prospects, to ensure that no member hurts anothermember, and to provide quality assurances to their members’clients.

Exchanges primarily regulate their members’ trading practices.Their rules specify how their members arrange trades and howthey should relate to their clients.Clearinghouses primarily establish capital adequacy standardsand trade reporting practices for their members. They designtheir regulations to ensure that their members and theirmembers’ clients will honor their trading contracts.Trader associations regulate how traders relate to each otherand to their clients.The primary SROs that regulate brokers and dealers in theUnited States are Financial Industry Regulatory Authority(FINRA) and the National Futures Association (NFA).


Other Private Regulators: Several private agencies regulatetraders, issuers, and investment managers in the UnitedStates.

The Financial Accounting Standard Board - FASB setsaccounting standards by which firms must report theiraccounts. The SEC, which has ultimate authority forspecifying reporting standards for public firms, has recognizedthe FASB standards as authoritative since 1973.The Association for Investment Management and Research -AIMR sets performance reporting standards that manyinvestment managers use to report their results. Although thestandards are voluntary, many firms choose to comply in orderto satisfy their clients.Brokers commonly purchase insurance policies on behalf oftheir clients to ensure that their clients will not lose if thebrokerage goes bankrupt.The insurance companies that writethese policies regulate the brokers who purchase these policiesin order to minimize the probability that the brokers will fail.and thus impose costs on their funds.


Markets:

Quote-driven Dealer Markets

Order-driven Markets

Brokered Markets

Hybrid Markets


Quote-driven Dealer Markets: In pure quote-drivenmarkets, dealers participate in very trade. Anyone who wantsto trade must trade with a dealer. Either traders negotiatewith the dealers themselves, or their brokers, acting as theiragents, negotiate with the dealers. The dealers frequentlytrade among themselves, but public traders cannot trade witheach other.

Example: If Barbara wants to buy a security, she must find adealer who will sell it to her from his or her inventory.Likewise, if Saul wants to sell a security, he must find a dealerwho will buy from him to add to his or her inventory. AlthoughBarbara might be willing to buy the security directly fromSaul, in a pure quote-driven market they generally cannotarrange such trades.The Nasdaq Stock Market, the London Stock Exchange, theeSpeed government bond trading system, and the Reuters3000 foreign exchange trading system are examples ofquote-driven markets organized by a dealer association, anexchange, a broker, and an electronic data vendor.


Order-driven Markets: In order-driven markets, buyers andsellers regularly trade with each other. These markets havetrading rules that specify how they arrange their trades. Theirorder precedence rules determine which buyers trade withwhich sellers, and their trade pricing rules determine the tradeprices.

Auction Markets: Most order-driven markets are auctionmarkets. In an auction market, the trading rules formalize theprocess by which buyers seek the lowest available prices andsellers seek the highest available prices - price discoveryprocess.Market Structures: Order-driven market structures varyconsiderably. Some markets conduct single-price auction inwhich they arrange all trades at the same price following amarket call. Other markets conduct continuous two-sidedauctions, in which buyers and sellers can continuously attemptto arrange their trades at prices that typically vary throughtime. Still others conduct crossing networks, in which theymatch orders at prices taken from other markets.


Brokered Markets: Brokers actively search to match buyersand sellers in brokered markets. Most searches start whentheir clients ask them to fill their orders. Brokers, however,also initiate many searches when they suggest trades to theirclients.

The distinguishing characteristic of a brokered market is thebroker’s role in finding liquidity. In markets where tradersusually do not make public offers to trade, brokers must searchfor traders who will make those offers. These markets aretypically illiquid markets in which dealers will not normallytrade.Brokered markets are very common throughout the economy.They usually arise when the item traded is unique and whendealers will not hold inventories. The most important brokeredsecurities markets are those for large blocks of stocks or bonds.Real estate markets and markets for going business concernsare additional examples of brokered markets.


Hybrid Markets mix characteristics of quote-driven,order-driven, and brokered markets.

The New York Stock Exchange is essentially an order-drivenmarket, but it requires its specialist dealers to offer liquidity ifno one else will do so. The NYSE therefore has elements ofquote-driven market.The Nasdaq Stock Market is also a hybrid. Although it isessentially a quote-driven market, it requires its dealers todisplay, and in many circumstances to execute, public limitorders. The Nasdaq therefore has some elements of an orderdriven market.Since brokers sometimes arrange large block trades in boththese markets, they also have some characteristics of brokeredmarkets.


Orders and Order Properties

Market Orders

Limit Orders

Stop Orders

Market-If-Touched Orders

Tick-Sensitive Orders

Market-Not-Held Orders


Market Order is an instruction to trade at the best pricecurrently available in the market. Market orders usually fillquickly, but sometimes at inferior prices. Impatient tradersand traders who want to be certain that they will trade usemarket orders to demand liquidity.

Market Orders Pay the Spread The spread - actually half ofthe spread - is the price traders pay for immediacy when usingmarket orders.Price Improvement takes place when a trader is willing to stepin front of the current best price to offer a better price to theincoming market order. This often happens when the spread iswide and the incoming market order is small.Market Impact The price impact of a market order depends onthe liquidity available in the market. (Example: large, liquidmarkets with many active traders, traders may routinelyexecute very large orders without much price impact).Execution Price Uncertainty is due to quote changes that mayoccur between the submission of an order and its execution,and to the unpredictable price concessions that may berequired to fill large orders.


A Limit Order is an instruction to trade at the best priceavailable, but only if no worse than the limit price specified bythe trader. For buy orders, the trade price must be at orbelow the limit price. For sell orders, the price must be at orabove the limit price.

Limit Price Placement: Traders classify limit orders by wherethey place their limit prices relative to the market. The marketis the range of prices bounded above by the best offer (lowestprice) and below by the best bid (highest price).

LIMIT PRICEPLACEMENT BUY ORDERS SELL ORDERS

Above the best offer Marketable Behind the marketAt the best offer Marketable At the marketBetween the current In the market In the marketbest bid/offerAt the best bid At the market MarketableBelow the best bid Behind the market Marketable


Standing Limit Orders are trading options that offerliquidity. Since traders can choose whether they want to tradewith a standing limit order, standing limit orders are optionsto trade. In particular, sell limit orders are call options thatgive other traders opportunities to buy when traders want tobuy. Buy limit orders likewise are put options that give othertraders opportunities to sell when they want to sell. Theoption strike prices are the limit prices.

The Expected Compensation for Offering Liquidity: Thecompensation that limit order traders hope to receive forgiving away free trading options is a better price. Buyers whosubmit standing limit orders hope to buy at the bid. Sellerslikewise hope to receive the ask instead of the lower bid.The Risks of Using Standing Limit Orders: Traders facetwo risks when using standing limit orders. The first isexecution uncertainty. When prices move away from theirorders, limit order traders fail to trade and wish that they had.The second risk that the traders face when using standing limitorders is that they may trade and subsequently regret it - expost regret.


Stop Order instruction stops an order from executing untilprice reaches a stop price specified by the trader. Tradersattach stop instructions to their orders when they want to buyonly after price rises to the stop price or sell only after pricefalls to the stop price. Orders with stop instructions are callstop orders.

Stop Orders and Limit Orders: Novices often confuse stoporders with limit orders because both specify price conditions.The difference lies in the purpose of the specified price. A stopinstruction provides for the activation of an order when themarket price reaches or passes a specified stop price. Incontrast, a limit order can be executed only at a price equal toor better than a specified limit price.Stop Orders and Liquidity: Stop orders accelerate pricechanges. Prices often change because traders on one side ofthe market demand more liquidity than is available. Whenthese price changes activate stop orders, the stop ordersunfortunately contribute to the one-sided demands for liquidity.


Market-If-Touched Order (MIT) is a market order that isactivated when price reaches (touches) some preset touchprice. In contrast to stop orders, traders submitmarket-if-touched orders to buy when prices fall to their touchprices or to sell when prices rise to their touch prices.

MARKET PRICE WHEN THE ORDERORDER TYPE ON SUBMISSION CAN TRADE TRADE PRICEStanding limit Below $5 After price rises At or above the limitsell order with to or above the pricea $5 limit price limit priceMarket stop Above $5 After price falls Whatever the marketsell order with to the stop will bear after thea $5 stop price price order is activatedLimit-stop sell Above $5 After price falls At or above the limitorder with a $5 to the stop price pricelimit price and a $5 and is at or abovestop price the limit priceMarket-if-touched Below $5 After price rises Whatever the marketsell order with to or above the will bear after thea $5 touch price touch price order is activated


Tick-sensitive order is conditioned on last the last marketprice change. Traders classify prices by their relation toprevious prices. A buy downtick order can be filled only on adowntick or zero downtick price. The trade price much belower than the last different price. Likewise, a sell uptick ordercan be filled only on an uptick or zero uptick.

Market Impact The tick condition ensures that tick-sensitiveorders have no market impact. A broker holding a buydowntick order cannot bid up prices to encourage sellers.Instead, the broker must wait until someone is willing to tradeat a price lower than the last different price. Since tick orderscannot have market impact, traders cannot use them todemand liquidity.Dynamic Limit Order Tick-sensitive orders are essentially limitorders whith dynamically adjusting limit prices. A buydowntick order implements the following equivalent limit orderstrategy: Submit a buy limit order just below the last differentprice. If price rises, raise the limit price to a price just belowthe new price. If price falls, leave the limit price alone.


Example

Example 1 Julie wants to buy 100 shares of GE stock if itsprice drops to $19.25. What order would she submit toaccomplish her objective?

Example 2 John would like to buy Night Capital Group onlyif its price rises to $12, and then only if he can buy it for lessthan $13.5. What order would he submit to accomplish hisobjective?

Example 3 You want to buy Bank of America at less than theask price, but you are not available to cancel and resubmityour orders if prices rise. To achieve your objectives, whattype of order you would submit to your broker?


Validity and Expiration Instructions: Traders specifyvalidity and expiration instructions to indicate when theirorders are valid and when their orders expire.

INSTRUCTION TYPE DESCRIPTIONOpen orders are orders that have not yet been executed or canceled.Good orders are orders that can be executed.Day orders are valid for the trading day on which traders submit them.

They expire when the market closes if they have not been filled.Good-till-cancel orders are valid until the trader expressly cancels them.Good-until orders are good until a date specified by the trader.(GTW, GTM) (Not all brokers accept this order instruction)Immediate-or-cancel are orders that are valid only when they are presentedorders (IOC) to the market.Good-after orders are good only after some specified date. (Very rare).Market-on-open orders are market orders that a broker can fill only at the

beginning of the trading session. Traders usethese orders primarily in markets that openwith a single price auction.

Market-on-close orders are market orders that a broker can fill only atthe close of the trading session. Traders usethese orders in hoping to trade at the closing price.


Quantity Instructions: Traders specify quantity instructionsto indicate whether their brokers can arrange multiple tradesto fill their large orders. They usually do so to minimize thecosts that they pay to clear and settle their trades.

The most common quantity instructions are all-or-noneinstructions and minimum-or-none (minimum acceptablequantity) instructions. Brokers must fill all-or-none orders allat once. They can arrange multiple trades to fillminimum-or-none orders, but each trade must be larger thana minimum size that the trader specifies. In some markets,these two instructions are also known as all-or-nothing andminimum acceptable quantity instructions.


Other Order Instructions:Spread Orders Traders issue spread instructions when theywant to buy one instrument and simultaneously sell anotherinstrument. The two instruments usually are closely related.Display Instructions Traders give display instructions whenthey want to specify how their brokers should display unfilledportions of their standing limit orders. These instructionstypically tell brokers to show no more than some maximumquantity. Traders restrict the display of their orders when theyfear that showing their full sizes would cause the market tomove away from them.Substitution Orders Traders give substitution orders to theirbrokers when they want to invest or divest a specified amountby trading any of several securities. The brokers then use theirdiscretion to choose which securities to trade, based on whichones appear to provide the best prices.Special Settlement Instructions Traders attach specialsettlement instructions to their orders when they wantnonstandard settlement.

modern financial markets and trading mechanism - personal

Documents