©r. schwartz equity markets: trading and structureslide 1 topic 6

©R. Schwartz Equity Markets: Trading and Structure

Topic 6


How Buyers & SellersMeet Each Other


ECONOMICS 101

PRICE

SELL

QUANTITY

BUY

Q*

P*

0

The perfectly liquid, frictionless market solution

The closest thing to it is a Call AuctionThe closest thing to it is a Call Auction


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

The limit order book brings

buyer& seller together


10:50 10:55 11:00

PublicBuyer

PublicSeller

DealerBuys

DealerSells

Dealer Intermediation

Dealer provisionof immediacybrings buyer

& seller together


10:50 10:55 11:00

PublicBuyer

PublicSeller

A Call Auction

A meeting pointin time can bring multiple buyers &

sellers together


How a Call Auction Works


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

PriceO 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* =


Call Auction Limit Order Books

Sparser Book

Thicker Book


When Calls Are Used

• Market Openings• Market Closings (MOC & LOC orders)• Nasdaq’s Crosses (open and close)• Intra-day At a predetermined time To reopen the market after a trading

halt


Calls Auctions And…

• Electronic technology• The time clock – Jim Ross’s piece in the text• Who gets price improvement – Al Berkeley’s piece in the text


Benefits

• Focused liquidity – especially small & mid caps

• Control price volatility • Fair• Harder to manipulate• Lower order handling costs• A price discovery mechanism


Problems

• Does not offer immediacy• Bookbuilding


Order Handling DifferencesCall vs Continuous Trading

• Market orders – infinitely aggressively priced limit orders• Limit orders – can expect to be price improved

Who provides liquidity to whom in a call?


Types of Calls

• Price Scan Auction• Sealed Bid Auction• Crossing Network• Open Limit Order Book Auction – TraderEx


Optimal Order Placement


How to Submit a Buy Order: Calls are the only game in town

Your Reservation Price = $12Your Reservation Price = $12 Limit Price Clearing Price Surplus $11.10 $11.20 $0.00 $11.10 $11.10 $0.90 $11.10 $11.00 $1.00

Limit Price Clearing Price Surplus $11.20 $11.30 $0.00 $11.20 $11.20 $0.80 $11.20 $11.10 $0.90

Why not $11.30 or higher?


How to Submit a Buy Order: Calls are the only game in town

Your Reservation Price = $12Your Reservation Price = $12

Conclusion

Limit Order Price = Reservation Price = $12

(Or one tick below)


How To Submit A Buy Order To ACall That Is Followed By

Continuous Trading


Question: Would You Prefer To

1.Execute at $12.00 or not at all?

2 Execute at $11.90 in call or at $11.90 in continuous with 0.99 prob?

3. Execute at $11.90 in call or at $11.80 in continuous with 0.90 prob?




How to Submit a Buy Order: Call Followed by Continuous

(Answers to Questions 2 – 4)(Answers to Questions 2 – 4)

= $0.20 x 0.50 = $0.100

Expected Surplus at $11.80

=Surplus at $11.90 = $0.100

Q5

= $0.20 x 0.10 = $0.020


>Surplus at $11.90 = $0.100

Q4

= $0.20 x 0.90 = $0.180


<Surplus at $11.90 = $0.100

Q3

= $0.10 x 0.99 = $0.099


>Surplus at $11.90 = $0.100

Q2

Continuous AuctionCall Auction


How to Submit a Buy Order: Call Followed by Continuous

0.80$0.50$0.40$11.50$11.60

0.75$0.40$0.30$11.60$11.70

0.67$0.30$0.20 $11.70$11.80

0.50$0.20$0.10$11.80$11.90

NA$0.10$0.00$11.90$12.00

ContinuousCall

Breakeven Probability

of Executing in

Continuous

Surplus in Continuous

Surplus in Call

Price

Finding the Optimal PriceFinding the Optimal Price


How to Submit a Buy Order:Continuous Followed by Call


• Your time frame is the trading day

• You place a day order that must be filled by 4:00 pm

• As the day progresses, all else equal, you are more apt to place a market order than a limit order

• There is a closing call

• Your limit order in the closing call would be one tick below your reservation price ($12)


Continuous Followed by Call

• E(S) = [Pr x SCont] + [(1-Pr) x E(SCall)]• SCont = surplus if order executes in cont. market • E(SCall) = expected surplus from the call• SCall = max(0, PR – PCall)• Because (1-Pr) x E(SCall) >0, you are more apt to place a limit order in the continuous market when it is followed by a closing call• Remember the gravitation pull effect

S = your surplus from tradingPr = prob your limit order executes in cont. market


A Call’s Contribution to Market Quality


Let’s Focus on Volatility

• The opening spike: Price discovery

• The closing spike: End of day impatience to Get the job done

• What does this imply about market structure?

• A natural experiment: Nasdaq’s closing/opening crosses (call auctions) introduced in March/October of 2004


The Nasdaq Study*

• 52 large cap Nasdaq firms

• Time period: Feb 04 and Feb 05

• We examined per day:

390 1-minute intervals (9:30-16:00)

30 10-second opening intervals (9:30-9:35)

30 10-second closing intervals (15:55-16:00)

• Volatility measured by high-low range for the interval

**“Market Structure and Intra-day Price Volatility:“Market Structure and Intra-day Price Volatility:An Event Study on Nasdaq’s Crosses”An Event Study on Nasdaq’s Crosses”

Michael Pagano, Lin Peng, and Robert SchwartzMichael Pagano, Lin Peng, and Robert Schwartz


Nasdaq Volatility Differences BetweenFeb 2004 and Feb 2005One-minute Volatility

wr ange

0

20

40

60

i nt er val

0 30 60 90 120 150 180 210 240 270 300 330 360 390

60 bps60 bps Feb 2004 (Pre-Calls) Feb 2004 (Pre-Calls)r ange

0

20

40

60

i nt er val

0 30 60 90 120 150 180 210 240 270 300 330 360 390

60 bps60 bps Feb 2005 (Post-Calls) Feb 2005 (Post-Calls)


r ange

0

10

20

30

40

i nt er val

0 6 12 18 24 30 36 42 48 54 60

Nasdaq Volatility Differences Between

Feb 2004 And Feb 200510-Second Volatility

r ange

0

10

20

30

40

i nt er val

0 6 12 18 24 30 36 42 48 54 60

40 bps40 bps Feb 2004 (Pre-Calls) Feb 2004 (Pre-Calls)5 Min After

Opening5 Min Before

Close

40 bps40 bps Feb 2005 (Post-Calls) Feb 2005 (Post-Calls)5 Min After

Opening5 Min Before

Close

©r. schwartz equity markets: trading and structureslide 1 topic 6

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