THE CONTEXT OF TRADING: MARKET MICROSTRUCTURE Market microstructure ⇒ process that affect how trades are executed.. Not held mean not to trade at any specific price or time interval.. Ty
Trang 12 THE CONTEXT OF TRADING: MARKET MICROSTRUCTURE
Market microstructure ⇒ process that affect how trades are executed
IV = Intrinsic Value
2.1 Order Types
Requires prompt execution
Price uncertainty
Specific limit price for execution
Execution uncertainty
Additional Order Types
Variation of the market order
Not held mean not to trade at any specific price
or time interval
Executed at the opening of the market
Market on close order ⇒ executed at market close
Participate (don’t Initiate) Order
To capture a better price, broker waits for &
responds to initiate more active trades
Best Effort Order Undisclosed Limit Order/Reserve/ Hidden Iceberg Order
Gives the trader’s agent even more discretion
to work the order
Variation of a limit order
Instruction not to show more than some maximum unfilled order quantity
Types of Trades
Broker commits capital for the prompt execution of the trader’s order
Suitable when order size is large & more urgent
Order to trade in a specific basket of securities
Low cost strategy on a relative basis
Trang 22.2 Types of Markets
2.2.1 Quote-Driven (Dealer) Markets 2.2.2 Order-Driven Markets
Trades are executed with a dealer
Inside bid (ask) is the highest (lowest) bid (ask)
Closed-book market ⇒ where limit order book is not visible to public
Dealer’s role:
Ensure market continuity
Immediacy or bridge liquidity
Suitable in markets requiring negotiation
Some measures of trade costs:
Quoted bid-ask spread
Effective spread
Better representative of true cost because it captures both price improvement & market impact
Public limit orders establish transaction prices
Trade may be delayed or unexecuted (absence of
a dealer)
Traders can’t choose with whom they trade
2.2.3 Brokered Markets
Transactions take place through brokers away from public markets
These markets are suitable where:
Public markets are small
Illiquidity
Block transaction take place
2.2.4 Hybrid Markets
Combinations of the previously described market types
Example ⇒ NYSE (elements of batch auction, continuous auction & quote driven markets)
Types of Order-Driven Markets
Buy & sell order are batched & crossed at a specific point in time
Benefits
Avoid costs of dealers
Avoid market impact
Prevent information leakage
Anonymity
Low commissions
Drawbacks:
Execution uncertainty
No price discovery
Orders of multiple buyers compete for execution
Provide price discovery
The problem of partial fill
Batch action markets ⇒ trade occurs at a single price pre specified point in time
Continuous auction markets ⇒ trades occur at any time during the day
Electronic Limit-Order Markets
Computer based auctions that operate continuously within the day
In contrast to crossing networks these:
Operate continuously
Provide price discovery
Like crossing networks, these:
Provide anonymity
Are computer based
Trang 32.3 The Roles of Brokers and Dealers
Agent of the investment for commission
Provides following services:
Represents the order
Find the opposite side of trade
Supply market information
Provide discretion & secrecy
Supporting investment services
Supports the market mechanism
Adversial relationship b/w the trader & a dealer:
Difference in bid-ask spread preferences
Adverse selection risk ⇒ risk of trading with
a more informed trader
Buy side traders are often strongly influence sell side trade
2.4 Evaluating Market Quality
Characteristics of a liquid market:
Low bid-ask spread
Market depth ⇒ big trades tend not to cause large price movements
Resilient market ⇒ small & quickly correctable discrepancies b/w MV & IV
Factors contribute to liquid market:
Many buyers & seller
Different types of market participants
Convenience
Market integrity
Liquidity advantages:
Less price impact
Suitable for information motivated traders
Easy capita- raising by corporations
Pre-trade transparency ⇒ quick, easy, inexpensive & accurate information about quotes
& trades
Post trade transparency ⇒ quick & accurate details on completed trades
Assurity of Completion
All parties to trades will honor their commitments
Clearing entities can help ensure assurity of completion
Trang 43.1 Transaction Cost Components
Direct costs of trading
These include commission, taxes, stamp duties &
fees paid to exchanges
Bid ask spread
Market impact ⇒ effect of the trade on transaction prices
Missed trade opportunity costs ⇒ arise from failure to trade in a timely manner
Delay costs ⇒ inability to trade immediately due
to size & liquidity
3 THE COSTS OF TRADING
Measurement of Costs
Implicit costs are measured against some price benchmark:
One benchmark is the time-of-trade mid quote
Opening & closing prices (less satisfactory)
VWAP (when prices information is lacking)
Most exact approach ⇒ implementation shortfall
VWAP
Volume weighted Average price at which the security traded during the day
Easy to compute & understand
Best for comparing smaller trades in non-trending markets
Can be computed quickly
Ignores slippage & missed trade opportunity costs
Subject to gaming by delaying trades
Can be misleading
Not sensitive to trade size or market conditions
Implementation Shortfall Approach
Difference b/w money return on a paper portfolio & actual
portfolio’s return
Decision price is used for paper portfolio
Captures explicit & implicit elements of transaction costs
Four components:
Explicit costs
Realized profit/loss
Slippage cots
Missed trade opportunity costs
Implementation shortfall is adjusted for market movement
through market model
Disadvantages Advantages
Relate cost to the value of ideas
Recognizes tradeoff b/w immediacy & price
Allows attribution of costs
Not subject to gaming
Require extensive data
Unfamiliar evaluation framework for traders
Trang 53.2 Pre-trade Analysis: Econometric Models for Costs
Used to build reliable pre-trade estimates
According to market microstructure theory, trading costs are non-linearly related to these factors:
Stock liquidity characteristics
Risk
Trade size relative to available liquidity
Momentum
Trading style
Estimated cost function can be used:
To assess execution quality
Appropriate trade size to order
4 TYPES OF TRADERS AND THEIR PREFERRED ORDER TYPES
4.1 The Types of Traders
Act on information that has limited value if delayed
Focus on liquidity & speed of execution
Market orders & large block trades
Act on value judgments based on research
Price focus & infrequent trading
Use limit orders
Sometimes act as dealer’s dealer
Counterparties to more knowledgeable traders
Don’t want to reap information advantage
Time preference
Use market, market not held, best efforts, participate, principal traders, portfolio trades &
orders on ECNs & crossing networks
Much more concerned with cost of trading
Price preference
Use limit orders, portfolio trades & crossing networks
Use neither large not heavily concentrated order
5.1 Decisions Related to the Handling of a Trade
Small, liquidity trades ⇒ executed via direct market access &
algorithmic trading
Large information laden trades ⇒ executed via skills of senior trades
5 TRADE EXECUTION DECISIONS AND TACTICS
Trang 65.2 Objectives in Trading and Trading Tactics
5.2.1 Liquidity-at-Any-Cost Trading Focus 5.2.2 Costs-Are-Not-Important Trading
Used by information traders who trade in large block sizes & demand immediacy
Attract high commission rate brokers
Use expensive methods for timely execution
Market orders
Ordinary spreads & commission for speed of execution
5.2.3 Need-Trustworthy-Agent Trading Focus 5.2.4 Advertise-to-Draw-Liquidity Trading Focus
To execute large orders in thinly traded issues
Use of skillful brokers by placing a best effort, market not held or participate order
Trader loses control of the trade
Used for IPOs, secondary offerings & sunshine traders
Risk of front running
Little or no market impact if sufficient number of traders
5.2.5 Low-Cost-Whatever-the-Liquidity Trading Focus
Best suited for passive & value motivated investors
Limit orders
Traders may end up chasing the market
5.3 Automated Trading
5.3.1 The Algorithmic Revolution 5.3.2 Classification of Algorithmic &Execution Systems
Logic behind algorithmic trading ⇒ break large
orders into smaller orders to moderate price
impact
Constant monitoring required
Meat-grinder effect ⇒ in order to get done, large
equity orders are broken up into smaller orders
Logical Participation Strategies
Simple Logical Participation Implementation Shortfall Strategies
VWAP strategy, TWAP strategy (order in proportion to time) &
% of-volume strategy
Optimal trading strategy that minimizes trading costs
Specialized Strategies
These are:
Hunter strategies
Market on close algorithms
Smart routing
Other specialized strategies
Opportunistic Participation Strategies
Passive trading combined with the opportunistic seizing of liquidity
Trading over time
Trang 75.3.3 The Reasoning behind Logical Participation Algorithmic Strategies
Simple Logical Participation Strategies Implementation Shortfall Strategies
Breaking up the order into smaller sub-blocks yields a lower average market or price impact
To minimize market impact & missed trade opportunity costs
Trade heavily early in the trading day
Use an objective function that minimizes expected total cost & variance
Ideal for small, highly urgent orders
6 SERVING THE CLIENT'S INTERESTS
6.1 CFA Institute Trade Management Guidelines
Guidelines define best execution as:
To maximize the value of a client’s portfolio within stated objectives &
constraints
Four characteristics of best execution:
Can’t be determined independently
Can’t be known with certainty ex-ante
Measured on ex-post basis
Process, not an outcome
TMG are divided into the three areas:
Processes
Disclosures
Record keeping
6.2 The Importance of an Ethical Focus
Over time markets become adversial &
implicit costs
Interest of clients must honored & fiduciary duties must be meet appropriately by traders