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gforrlDBuilding Betler Perfortn.tnce

COMMENTARY 78 OCTOBER 2OO3THE SEARCH ENGINE

A client recently asked what kind of discipline their desk needs to develop in order to becomeone of the top desks. Underlying the question is whether trading is an art or a science. Weacknowledge that there is art to determining changes in market sentiment. But good tradersalso have a disciplined process for determining Strategy and Tactics when accessing liquidity.Strategy is the determination of Urgency (aggressive market orders vs, limit orders) andExposure (hiding vs. going fcr the ful! monty). Tactics are the types of Orders and the broker -venues available once strategy has been determined. Broker selection comes from venue(commitments and relationships step in at this point) while prices are a function of Order tactic(arguing price at the last minute risks dimes to save pennies).

A recent Wall Street Journal article, carrying the heading"lt's time for the kiddies to get out of the pool," focusedon how different professional traders deal with today'smarkets. The difference? Experience. More specifically,experience in accessing liquidity at an acceptable price.Internet search engines lead to lower costs for those whoknow how to use them. In essence, the wider the search,the better the potential outcome. But market Iiquidity isnot as simple: prices do not stand sti'1, Search;ng forlower prices or more liquidity carries risks that prices maydrift away before the trade is executed, or worse, maymove away as a result of the search.Experienced traders often act as search engines.snooping through various market venues and players toseek liquidity. When volatility is low, all traders benefitfrom available time. When volatility spikes - as it did lastOctober - good traders stand out in their ability to rapidlyfind liquidity at a reasonable price.Expert traders divide the search engine task in two:determining strategy, and determining the tactics, both .venue and the right pace. Strategy is the big picture:think of this as the manager's motive for this order.Tactics are the tools used to implement the strategy.

Trading StrategyStrategy includes both Urgency, how quickly to trade,and Exposure, how to deal with size. The trader's #1task is to determine how quickly to work an order given

MarketOrderI dULIU-

the manager'smotive, theprevailingmarket trendand volume,and any antici---^r^l i^E^-Pciigu llllul-mation. Themost expensivetrades are oftenthose wherethe trader orthe portfoliomanager "argued" with the market over the conflicts

between price rationale and process discipline.While there are many variations, the primary tacticalmarket instructions are either market or limit. Urgent,liquidity-demanding traders use market orders to absorb

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whatever is available. As the chart above shows, theyare willing to pay the impact cost to trade quickly.Liquidity providers will use more limit orders. Less time-sensitive orders tend to favor limit order tactics, tradingoff speed for a hopefully better completion price, Ofcourse, an expert trader will vary the tactics as timeelapses and prices move, although size can be an issueeven when stocks are trendless.While small or liquid orders need to consider onlyurgency, order exposure tactics become increasinglyimportant as size grows and/or liquidity deteriorates.Traders in today's narrow spread/higher transparencymarkets are less willing to expose their orders. Inaddition, brokers are far less willing to commit capital toall but their verybest customers.Exposing orders atthe wrong time(e.9., mid-day) or tothe wrong crowd(e.9., an indiscretebroker, too manybrokers, to theworld) can lead tofront ru nn ing,chasing prices withlimit orders, andhigh costs even inthe absence ofworthwhile decision information. Traders need todetermine a strategy for exposing the order withoutroiling prices. For small cap stocks, reduced resiliencyadds to the exposure problem. In contrast to trading inlarge cap stocks, repeated trades in a small cap stockleads to "stickier" price moves, even after the traderbacks off. Therefore, even a 'non-exposing' strategythat takes advantage of available liquidity has to beweighed for its possible price impact.

Trading TacticsBuyside traders need to consider all three issues -urgency, size and liquidity - when determining bothtrading tactics (what orders) and venue (to whom toexpose orders). We begin by examining liquid orders.Rather than discuss the merits of each type, we will focusinstead on their applicability.The graph of order types has two parameters: urgencyand liquidity. For liquid orders, urgency is the primaryconsideration. Small or urgent liquid orders can betraded as market orders through either dealers or viaECN's, while larger orders may have to 'absorb'the order

books or rely on abroker for liquidity.Fnr locc I rrda ni^-A^.^ .,^-i^+i^^^utuut), vdt tdLtuilJof both VWAP andIimit orders allowflexibility shouldmarkets change.Smart ordermanagementalgorithms willallow both floatinglimits and ordersthat change tomarket orderswhen prices beginto move adversely.

As order size grows, order types become more complex.Urgent orders may require either broker or agencycapital via a block or secondary trade. Obviously, theconcession will be a function of both size and marketcapitalization; consistent with the risks of providingliquidity. But the potential reward for correct calls insmaller cap stocks is also much greater (Note: thebiggest rewards typically come from timely selling ratherthan buying). Exposure is not a significant issue forurgent orders; the desk's emphasis should be on findingliquidity within an acceptable horizon.

Because of time constraints, searchingability is limited and price is asecondary consideration. For thatreason, it is important to know whichbrokers are best at providing liquidity ata fair price on a consistent basis.

Basket/Program

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\rVe often find that using broker capital to initiate an orders a trading mistake. Brokers often suggest this to 'get an='t r the order, but the suggestion is not in the buyside's::s: -:srest Capital is fine for finishing an order, but,', -3- . s rsed to initiate it reduces the flexibilitv of where

to trade resiCua shares, and puts the desk into acompeting pos t on vrith the broker who needs to unwindthe initial trade at a minimal loss. Plexus finds that-^^ir,.^r +-^)^^ ^a-- .ho flrct rr:rlinn Lztr ara {^,,f +;m^- ^-tr)ruudr Lr duuS dilu Lr -, - tuul Lllllgs ilScostly as the initial trades and twice the expectedPAEG/L cost.For lower urgency trades, price is more important.Traders are willing to accept the chance of adverse pricemoves to keep impact low, But as size grows, exposurecreates its own price impact. Domestic brokers are lesslikely to frontrun stated client intentions than they oncewere due to improved market monrtoring, but theproblem has not completely gone away. Frontrunningappears much worse in non-US markets where shoppinginformation in exchange for increased commission flowremains a problem. Another danger is revealing yourintent to too many players, resulting in their moving theirprice targets away. After all, no one wants to be the firstfill against a very large block trade

losses to more knowledgeable traders. The trader andthe manager must be confident that the order reflectscorrect fundamentals. Exoosure also increases the riskof uncompleted trading when it establishes a floor orceiling for others to use advantageously. For thesereasons, large limit orders will exposeonly a modest number of shares withmost going to the reserve book. Thedownside is that exchanges provideprice, time, size priority - and reserveshares lose time priority to exposedothers arrivino at a later time.

Experienced traders will adjust their orders to eitherexpose or hide their interest depending on marketconditions. Today's markets are deepest at the open andthe close, so larger portions can be hidden in the crowd.During thin mid-day periods, the experienced tradershicje their orciers by using market orders to hit bicisioffers.They will also use fill-or-kill orders to absorb availablevolume. They may split orders into small chunks and useeither a single broker or multiple markets to captureliquidity without being too observable. The key is to beunpred ctable: orce the market figures you out. eitheryou pay up or walK away.Trading Venue

The other question is: Where do I trade? Note that wedon't ask 'with whom?' The answer to that ouestion isdetermined by venue, just as price is determined byorder type.

Urgency Liquidity xposurerokeia . Fuli ServlCe. Execution. Research. Service

L-liah -\ larr,| ,,v,, / LwYv l-.l in hHigh ) Low Ld gv Medium (if using 1broker)MediumMediumMed ) LowMed ) Low Med to SmallMed to Small. Bloomberg/lnstinet Fligj6llCmaltordeaa,\ > Low 1 Srrlf- butca'n trade laige i .q^ml-t--aim;i ii -"i6;volumes over time danger is being

n rori inla h loATS'S Low Med for Liqtidjty provtdlng AnonymousLow for Liquidity-demanding

eet-me Markets . LiquidNet Med ) Low I arno Aomi..mnnvm;i ;" - -expose size only tocounter party. Harborside

High (small orOeis) 5-t-ow Small---- Low - -- -May trade in size withCorporationsLimit traders want to maximize their exposure whilemarket traders want to minimize theirs. Exposing orders,.,,ill attract the other side, but also risks adverse selection

Traditional brokers are still the mainstay of the business,and remain the up-front providers of liquidity. But theyare often the most exoensive route in terms of market

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impact and commission. For small and less urgentorders, there are many alternative routes that offer lowercosts. These routes do not ouarantee execution.Technology has spawned alternatives to traditionalbrokerage and has increased the liquidity pool. But thegrowth is in terms of breadth and speed more than depth.Buyside traders have more places to search, but needhelp via automation to maximize their hits. When liquidityis found, traders also need to develop skills (both manualand automated) to mine the sources without tipping offcompetitors. Traditional brokers can multiply the trader'savailable search engines, but at the risk of exposure. Asurgency rises, the tradeoff is often justified.Our goal in this commentary is to introduce a systematic

approach to the trading process for the less experiencedtrader who needs a guide when markets become murky.This broader view may also provide some grist forexperienced traders who already function as effectivesearch engines, but who are open to tinkering asmarkets change.The process always starts with a trade-by-tradeunderstanding of the urgency and size issues. Thesedetermine the appropriate processes that the desk canuse. Order tactics, in turn, determine the market venuesthat represent the best alternatives. At that point, thesoecific broker route deoends on the desk'scommitments, who is already trafficking in the name, andthe desk's comfort with the specific broker (traditional orelectronic).

Plexus NewsPlexusis p/eased to announce that Marie Konstance has joined JPMIS as the head of Global Sales. We lookforward to a wealth of fresh ideas emanating from Marie's extensive knowledge and experience.

Re/ease 2 0 or our lceBreaker'dritt-down',":;.;.;;:::r.;;.:r..;;.""";r";;"n* ,", reviewing daity tradins activity was madeavailable last month. More detailed descriptions and instructions will be communicated very soon, or contact your consultantto get the latest information.t

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