research methodology in market microstructure kee h. chung state university of new york at buffalo
TRANSCRIPT
Research Methodology in Market Microstructure
Kee H. Chung
State University of New York
at Buffalo
What is market microstructure?
Traditional asset pricing aims to understand what should be the price of a security.
It does not, however, address how prices adjust to reflect news.
Nor does it explain how investors’ subjective assessment of a security “get into” the price.
In practice, news and investors’ valuations are incorporated into security prices through trading.
This means that the specific trading rules, and the strategies traders develop in response to these rules, will affect how asset prices change over time in response to new information.
“Market microstructure is the study of the process and outcomes of exchanging assets under explicit trading rules.” (Maureen O’Hara, a former president of the American Finance Association)
Market microstructure has a profound impact on the real world – on traders, broker/dealers, exchanges, regulators, and policy makers alike.
Why do we care?
Data guided by theory, theory guided by data
Market design issuesAgency auction marketDealer marketElectronic limit order books
Market performance issues• Transaction costs• Shock absorption/resiliency• Trading halts
Efficiency – welfare issues• Is insider trading bad?
Topics to be covered
Part I: Foundation and ProtocolsOrders and order propertiesMarket structureOrder-driven marketsDealer markets
Part II: Analytics and ModelsInformed trading and market efficiency Bid-ask spreadsMeasurement of trading (execution) costAdverse selection modelsSpread component models
Part III: Select Topics Trade classification Nasdaq controversy, stock price clustering,
and SEC market reforms Order preferencing Market structure and execution costs High frequency trading (HFT) Market segmentation: Efficiency vs
competition Minimum price variation (tick size) and
decimalization
Part III: Select Topics (Continued) Competition in dealer market Intraday patterns and test of alternative
theories Spread and depth: Joint decision variables Trades, information, and prices Commonality in liquidity Liquidity and asset pricing Market microstructure and interactions with
other areas
Chapter 4 Orders and Order
Properties
Orders Orders are instructions to trade that
traders give to brokers and exchanges that arrange their trades.
Orders always specify• The security to be traded• The quantity to be traded• The side of the order (buy or sell)
Orders may specify• Price specifications• How long the order is valid• When the order can be executed• Whether they can be partially filled or not
Who uses orders? Traders that either do not have direct
access to the markets, or do not have the time to monitor the markets use orders.• Have to anticipate what is going to happen.• Have to clearly delineate contingencies. Use
standard orders to avoid mistakes.
Traders who use orders are at a disadvantage vis-à-vis professional traders.
• Risk of misunderstandings• Conflicts of interest• Speed of reaction to changing market
conditions• Cancellations can be time consuming• Access to order flow information
Some important terms 1
Bid: buy order specifying a price (price is called the bid).
Offer: sell order specifying a price (price is called offer or ask).
Best Bid: standing buy order that bids the highest price bid.
Best offer: standing sell order that has the lowest price offer.
Some important terms 2
Dealers have an obligation to continuously quote bids and offers, and the associated sizes (number of shares), when they are registered market markers for the stock.
Their quotes also have to be firm during regular market hours.
Some important terms 3 Public orders with a price limit can also
become the market bid or offer if they are at a better price than those currently quoted by a registered market maker.
The market’s best bid and offer constitute the inside market, the best bid/ask, or the BBO. The best bid and offer across all markets trading an instrument is called the NBBO.
Some important terms 4 The difference between the best offer and
the best bid is the bid/ask spread, or the inside spread (touch).
Orders supply liquidity if they give other traders the opportunity to trade.
Orders demand liquidity (immediacy) if they take advantage of the liquidity supplied by other traders’ orders.
What are agency/proprietary orders? Orders submitted by traders for their own
account are proprietary orders.• Broker-dealers and dealers.
Since most traders are unable to directly access the markets, most order are instead agency orders.• Presented by a broker to the market.
Market ordersInstruction to trade at the best price
currently available in the market.
• Immediacy• Buy at ask/sell at bid => pay the bid/ask
spread• Price uncertainty
Fills quickly but sometimes at inferior prices.
Used by impatient traders and traders who want to be sure that they will trade. It is usually thought that insiders use that type of order.
When submitting a market order execution is nearly certain but the execution price is uncertain.
Takes liquidity from the market in terms of immediacy. They then pay a price for immediacy, which is the bid-ask spread.
Market order: Example 1
Suppose that the quote is 20 bid, 24 offered. Suppose that the best estimate of the true value of the security is 22.
A market buy order would be executed at 24 for a security worth 22.
The price paid would be 24 and therefore the price of immediacy would then be 2.
Market order: Example 2
A market sell order would be executed at 20 for a security worth 22.
The price received would be 20 and therefore the price of immediacy would then be 2.
The price of immediacy is the bid-ask spread.
Price improvement
Price improvement is when a trader is willing to step up and offer a better price than that of the prevailing quotes (at order arrival).
Who benefits from price improvement? Who loses from price improvement?
Market impact Large market orders tend to move prices.
Liquidity might not be sufficient at the inside quotes for large orders to fill at the best price.
Prices might move further following the trade.• Information and liquidity reasons.
Market impact: Example For example, suppose that a 10K share
market buy order arrives in IBM and the best offer is $100 for 5K shares.
Half the order will fill at $100, but the next 5K will have to fill at the next price in the book, say at $100.02 (where we assume that there is also 5K offered).
The volume-weighted average price for the order will be $100.01, which is larger than $100.00.
Limit orders A limit order is an instruction to trade at
the best price available, but only if it is no worse than the limit price specified by the trader.
• For a limit buy order, the limit price specifies a maximum price.
• For a limit sell order, the limit price specifies a minimum price.
Limit orders: Examples If you submit a limit buy order for 100
shares (round lot) of Dell with limit price of $20. This means that you do not want to buy those 100 shares of Dell at a price above $20.
If you submit a limit sell order for 100 shares (round lot) of Dell with limit price of $24. This means that you do not want to sell those 100 shares of Dell at a price below $24.
If the limit order is executable (marketable), than the broker (or an exchange) will fill the order right away.
If the order is not executable, the order will be a standing offer to trade.• Waiting for incoming order to obtain a fill.• Cancel the order.
Standing orders are placed in a file called a limit order book.
Limit price placement: (from very aggressive to least aggressive)
Marketable limit order: order that can immediately execute upon submission (limit price of a buy order is at or above the best offer),
At the market limit order: limit buy order with limit price equal to the best bid and limit sell order with limit price equal to the best offer,
Behind the market limit order: limit buy order with limit price below the best bid and limit sell order with limit price above the best offer.
Market Microstructure Seminar - T&E Chapter 4
Market Microstructure Seminar - T&E Chapter 4
A standing limit order is a trading option that offers liquidity
A limit sell order is a call option and a limit buy order is a put option. Their strike prices are the limit prices.
A limit order is not an option contract (not sold).
The option is good until cancelled or until the order expires.
The value of the implicit limit order option increases with maturity.
Why would anyone use limit orders?
The compensation that limit order traders hope to receive for giving away free trading options is to trade at a better price.
However, options might not fill (execution uncertainty).• Chasing the price.
Limit order traders might also regret having had their order filled (adverse selection)…• What could cause a limit order to regret
obtaining a fill?• How would this fact affect strategies
involving limit orders?
Market Microstructure Seminar - T&E Chapter 4
Market Microstructure Seminar - T&E Chapter 4
Market Microstructure Seminar - T&E Chapter 4
Stop orders
Activates when the price of the stock reaches or passes through a predetermined limit (stop price). When the trade takes place the order becomes a market order (conditional market order).
Buy only after price rises to the stop price. Sell only after price falls to the stop price.
Stop orders are typically used to close down losing positions (stop loss orders).
Mainly used on market orders and few on limit orders.
Example: Suppose that the market for Dell is currently 20 bid, 24 offered.
Suppose that you place a stop loss order for 1,000 shares of Dell at a stop price of 15.
Suppose that after having placed that order, the market falls to: 13 bid, 15 offered. The bid price passed your stop price.
Your order is then executed at 13 provided there is enough quantity at that price.
The stop price may not be the price at which you are executed, as above.
Difference between stop orders and limit orders
The difference lies in their relation with respect to the order flow.
A stop loss order transacts when the market is falling and it is a sell order. Therefore such an order takes liquidity away from the market (it must be accommodated so it provides impetus to any downward movement).
A limit order trades on the opposite side of the market movement. If the market is rising, the upward movement triggers limit sell orders.
Outstanding limit orders provide liquidity to the market.
Tick-sensitive orders Traders who want to condition their orders
on the last price change submit tick-sensitive orders.• Uptick = current price is above the last
price• Downtick = current price is below the last
price• Zero-tick = current price is the same as
last price
Tick-sensitive orders
Do tick-sensitive orders demand or supply liquidity?
How do tick-sensitive orders compare to limit orders?
How are tick-sensitive orders affected by the minimum price-increment?
Order validity and expiration instructions Day orders (DAY) Good-till-cancel (GTC)
orders Good until orders Good-this-week
(GTW) orders, good-this-month (GTM) orders
Immediate-or-cancel (IOC) orders
Fill-or-kill (FOK) orders, good-on-sight orders
Good-after-orders Market-on-open
(MOO) orders Market-on-close
(MOC) orders
Quantity instructions
All-or-none (AON) orders
Minimum-or-none (MON) orders
All-or-nothing, and minimum acceptable quantity instructions
Other order instructions Spread orders Display instructions
• Hidden/Ice-berg/reserve orders Substitution orders
Special settlement instructions• Regular-way settlement• Cash settlement• How do these affect the cost of trading?
Chapter 5
Market Structures
Trading sessions
Trades take place during trading sessions.
• Continuous market sessions • Call market sessions
Continuous markets
Traders may trade at anytime while the market is open.
Traders may continuously attempt to arranger their trades.
Dealer markets or quote driven markets are, by definition, continuous markets.
Pros and cons of continuous markets Pros for continuous markets
• Traders can arrange their trades whenever they want.
• Information may be incorporated very fast into prices.
Cons for continuous markets• more volatile
Call markets Traders may trade in call markets only
when the market is called.
You may have all securities called at the same time or only some. The market may be called several times per day.
Used to open sessions in continuous markets (Bourse de Paris, NYSE,…). Also used for less active securities, bonds,….
Pros and cons of call marketsPros for call markets
• Focus the attention of traders on the same security at the same time.• Less volatility
Cons for call markets
• Information may need a lot of time to be incorporated into prices.
Execution systems
The execution system matches the buyers with the sellers.
quote-driven markets
order-driven markets
brokered markets
hybrid markets
Quote-driven dealer markets
In pure quote-driven markets, dealers participate in every trade.
Dealers provide all the liquidity and quote bid and ask prices. Those quotes are firm for some specified size, i.e., the dealers must honor them.
If the investor wants to trade a different size, there will be negotiation between the investor and the dealer.
Buy orders decrease the dealer’s inventory position whereas sell orders increase the dealer’s inventory position.
The dealer can then attract or reject order flow given her inventory position. The bid-ask spread’s placement will then reflect her inventory position.
When the dealer’s inventory position is low, she sets both a high bid price and a high ask price.
When the dealer’s inventory position is high, she sets both a low bid and a low ask.
Examples of Dealer Markets:
• NASDAQ• London International Stock Exchange
(SEAQ)• OTC Bond Markets• Foreign Exchange Markets
General features of a dealer market Multiple dealers, geographically dispersed,
electronically linked. No consolidation of trading: No “floor”. Virtually all customer trades are with a dealer. The dealer is the intermediary. Customers rarely trade against other customers. Dealers trade among themselves. Regulation and transparency are poor relative to
floor markets. Dealers may compete among themselves, but have
a lot of information and market power relative to customers.
Dealer market: NASDAQ/SEAQ
Two or more market makers per stock Trades were mainly phone negotiated Roughly 95% of the volume went
through MM book No central limit order book. Small order execution automated, but
not larger orders. Complete decentralization
Dealer obligations
Provide quotes during trading hours Offer “best execution” Report trades in a timely manner Fair communication
In an order-driven auction market, all traders issue orders to the exchange.
Buyers and sellers regularly trade with each other without the intermediation of dealers.
But dealers may choose to trade. Order driven markets may be organized as
continuous markets or as call markets.
Order-driven markets (Ch. 6)
Brokered markets
Brokers match up buyer and seller.• Search is often required to match buyer
and sellers for less liquid items, and for large blocks of securities
• Brokers specialize in locating counterparts to difficult orders
• Concealed traders• Latent traders
Examples of brokered markets include:• Block trading (stocks and bonds)• Real estate• Business concerns
Hybrid markets
Hybrid markets mix aspects of the various structures.
The most common hybrid markets are those with dealer-specialists.
These markets are order-driven auction markets in which the specialist must provide liquidity under some circumstances.
Most US stock exchanges and options exchanges have specialist systems.
Market information systems
It is of utmost important that orders are not lost and that order instructions are understood.• Ticker symbols• Order routing systems• Order presentation systems• Messaging systems
The information created by trading is valuable.• Market data systems report trades to the
public• Broadcast services
Price and sale feeds Ticker tapes Quotation feeds
Transparency is a key feature of markets.• Ex ante vs. ex post transparency
Chapter 6Order-driven Markets
Order-driven markets
Most important exchanges are order-driven markets.
Most newly organized trading systems are electronic order-driven markets.
All order-driven markets use order precedence rule and trade pricing rule.
Examples of pure order-driven markets- Tokyo Stock Exchange,
- KSE, KOSDAQ
- Paris Bourse,
- Toronto Stock Exchange,
- Most Future Markets,
- Most European Exchanges for equities (Milan, Barcelona, Madrid, Bilbao, Zurich,….)
Types of order-driven markets
Oral auctions
Rule-based order matching systems• Single price auctions• Continuous order book auctions• Crossing networks
In order-driven markets, trading rules specify how trades are arranged:
- order precedence rules: match buy orders with sell orders
1. Price priority2. Time precedence or time priority
- trade price rules: determine the trade price1. Uniform pricing rule (single price auction)2. Discriminatory pricing rule
Oral auctions Used by many futures, options, and stock
exchanges.• The largest example is the US government long
treasury bond futures market (CBOT, 500 floor traders).
Traders arrange their trades face-to-face on an exchange trading floor.• Cry out bids and offers (offer liquidity)• Listen for bids and offers (take liquidity)• “Take it” = accept offer• “Sold” = accept bid
Open outcry rule – the first rule of oral auctions
• Traders must publicly announce their bids and offers so that all other traders may react to them (no whispering…).
• Traders must also publicly announce that they accept bids/offers.
• Why is this necessary?
Order precedence rules• Price priority
Should a trader be allowed to bid below the best bid, above the best ask in an oral auction?
• Time precedence Is time precedence maintained for subsequent
orders at the best bid or offer? Why? Why not? How can a trader keep his bid or offer “live”? The minimum tick size is the price a trader has to
pay to acquire precedence.
• Public order precedence Why do you think this is necessary?
Trade pricing rule
• Trades take place at the price that is accepted, i.e., the bid or offer.
• Discriminatory pricing rule.Why do you think it is called
discriminatory? Who gets the surplus?
Trading floors
• Trading floors can be arranged in several rooms as on the NYSE, with each stock being traded at a specific “trading post.”
• Trading floors can also be arranged in “pits” as in the futures markets.
Rule-based order-matching systems
Used by most exchanges and almost all ECNs.
Trading rules arrange trades from the orders that traders submit to them.
No face-to-face negotiation. Most systems accept only limit orders.
• Why do you think most systems are reluctant to accept market orders?
Orders are for a specified size. Electronic trading systems process the
orders. Trades may take place in a call, or
continuously.• A new order arrival “activates” the trading
system. Systems match orders using order
precedence rules, determine which matches can trade, and price the resulting trades.
Order precedence rulesPrice priority
• Market orders always rank above limit orders.
• Limit buy orders with high prices have priority over limit buy orders with low prices
• Limit sell orders with low prices have priority over limit sell orders with high prices.
Time precedence• Under time precedence, the first order at
a given price has precedence over all other orders at that price. Gives orders precedence according to their time of submission.
• The pure price-time rule uses only price priority and time precedence.
• Floor time precedence to first order at price. All subsequent orders at that price have parity (Oral auction)
Display precedence• Why do markets use display
precedence?Size precedence
• Some markets give precedence to small orders, other markets favor large orders (NYSE).
Public order precedence • Public orders have precedence over
member orders at a given price.
Trades are arranged by matching the highest ranking buy orders with the highest ranking sell orders.
Order precedence rules are used to rank orders.
Order precedence rules vary across markets. However, the first rule is almost always price priority.
Trade pricing rules
Single price auctions use the uniform pricing rule. Most continuous order-driven markets use the discriminatory pricing rule.
All matched orders are executed at the same price.
This rule is used for opening markets in many equities markets, following trading halts for many continuous markets, and in the AZX,….
Uniform pricing rule
In a continuous market trade takes place when an incoming order is matched with a standing limit order.
Under the discriminatory pricing rule, the trade price is the limit price of the standing limit order.
Discriminatory pricing rule
Example – Pure price-time precedenceTime Trader Buy/Sell Size Price
12:02 Sammy Sell 100 $20.05
12:06 Steve Sell 200 $20.06
12:15 Bern Buy 500 $20.06
12:16 Susie Sell 300 $20.08
12:20 Ben Buy 200 Infinite
12:21 Bob Buy 100 $20.08
12:24 Sandy Sell 500 $20.12
12:25 Bev Buy 500 $20.08
12:27
12:27
Bill
Seth
Buy
Sell
200
200
$20.05
$20.10
Example – the order bookSellers Buyers
Trader Size Price Size Trader
Sammy 100 $20.05 200 Bill
Steve 200 $20.06 500 Bern
$20.08 100 Bob
Susie 300 $20.08 500 Bev
Seth 200 $20.10
Sandy 500 $20.12
Infinite 200 Ben
Clearing the order book with a call at 12:30
Sellers Buyers
Trader Size Price Size Trader
Sammy 100 0 $20.05 200 Bill
Steve 200 100 0 $20.06 500 Bern
$20.08 100 Bob
Susie 300 0 $20.08 500 200 Bev
Seth 200 $20.10
Sandy 500 $20.12
Infinite 200 0 Ben
Trades in the example - call
Buyer Seller Quantity Price?
Ben Sammy 100 Infinity, $20.05
Ben Steve 100 Infinity, $20.06
Bob Steve 100 $20.08, $20.06
Bev Susie 300 $20.08
Example–the order book after the call
Sellers Buyers
Trader Size Price Size Trader
$20.05 200 Bill
$20.06 500 Bern
$20.08 200 Bev
Seth 200 $20.10
Sandy 500 $20.12
Example - What should be the price/prices?
Possibilities include:• Infinite• $20.05• $20.06• $20.08
The price/prices depends on the trade pricing rules.
What should be the price/prices?
Single price auctions use the uniform pricing rule: • Everyone gets the same price.
Continuous two-sided auctions and a few call markets use the discriminatory pricing rule.• Trades occur at different prices.
Crossing networks use the derivative pricing rule.• The price is determined by another market.
Uniform pricing rule
All trades take place at the same “market clearing price.”• The market clearing price is determined
by the last feasible trade.Matching by price priority implies that
this market clearing price is also feasible for all previously matched orders.
In Example 1, the last feasible trade is between Bev and Susie, so the market clearing price is $20.08.• Sam, Steve and Susie are happy with a
market clearing price of $20.08 since they were willing to sell at $20.08 or lower.
• Ben, Bob, and Bev are happy to with a market clearing price of $20.08 since they were willing to buy at $20.08 or higher.
If the buy and sell orders in the last feasible trade specify different prices, the market clearing price can be at either the price of the buy or the price of the sell order.
The trade pricing rules will dictate which one to use.
Supply and Demand
The single-price auction clears at the price where supply equals demand.
• At prices below the market clearing price, there is excess demand.
• At prices above the market clearing price, there is excess supply.
Single price auctions maximize the volume of trading by setting the price where supply equals demand.
• Because prices in most securities markets are discrete, there is typically excess demand or excess supply at the market clearing price.
• In the Example, what is the excess demand or supply?
The single price auction also maximizes the benefits that traders derive from participating in the auction.
• Trader surplus for a seller = the difference between the trade price and the seller’s valuation
• Trader surplus for a buyer = the difference between the buyer’s valuation and the trade price.
• Valuations are unobservable, but we may assume that they at least are linked to limit prices.
Example: Demand and Supply
$20.04
$20.05
$20.06
$20.07
$20.08
$20.09
$20.10
$20.11
$20.12
$20.13
0 300 600 900 1200 1500
SupplyDemand
Discriminatory Pricing Rule
Continuous two-sided auction markets maintain an order book.
• The buy and sell orders are separately sorted by their precedence.The highest bid and the lowest offer are
the best bid and offer respectively.
• When a new order arrives, the system tries to match this order with orders on the other side. If a trade is possible, e.g., the limit buy
order is for a price at or above the best offer, the order is called a marketable order.
If a trade is not possible, the order will be sorted into the book according to its precedence.
Discriminatory Pricing Rule
Under the discriminatory pricing rule, the limit price of the standing order dictates the price for the trade.
If the incoming order fills against multiple standing orders with different prices, trades will take place at multiple prices.
Continuous trading @12:02Sellers Buyers
Trader Size Price Size Trader
Sammy 100 $20.05
$20.06
$20.08
$20.08
$20.10
$20.12
Infinite
Continuous trading @12:06
Sellers Buyers
Trader Size Price Size Trader
Sammy 100 $20.05
Steve 200 $20.06
$20.08
$20.08
$20.10
$20.12
Infinite
Continuous trading @12:15
Sellers Buyers
Trader Size Price Size Trader
Sammy 100 0 $20.05
Steve 200 0 $20.06 500 200 Bern
$20.08
$20.08
$20.10
$20.12
Infinite
Continuous trading @12:16
Sellers Buyers
Trader Size Price Size Trader
Sammy 100 0 $20.05
Steve 200 0 $20.06 500 200 Bern
Susie 300 $20.08
$20.08
$20.10
$20.12
Infinite
Continuous trading @12:20
Sellers Buyers
Trader Size Price Size Trader
Sammy 100 0 $20.05
Steve 200 0 $20.06 500 200 Bern
Susie 300 100 $20.08
$20.08
$20.10
$20.12
Infinite 200 0 Ben
Continuous trading @12:21
Sellers Buyers
Trader Size Price Size Trader
Sammy 100 0 $20.05
Steve 200 0 $20.06 500 200 Bern
Susie 300 100 0 $20.08 100 0 Bob
$20.08
$20.10
$20.12
Infinite 200 0 Ben
Continuous trading @12:24
Sellers Buyers
Trader Size Price Size Trader
Sammy 100 0 $20.05
Steve 200 0 $20.06 500 200 Bern
Susie 300 100 0 $20.08 100 0 Bob
$20.08
$20.10
Sandy 500 $20.12
Infinite 200 0 Ben
Continuous trading @12:25
Sellers Buyers
Trader Size Price Size Trader
Sammy 100 0 $20.05
Steve 200 0 $20.06 500 200 Bern
Susie 300 100 0 $20.08 100 0 Bob
$20.08 500 Bev
$20.10
Sandy 500 $20.12
Infinite 200 0 Ben
Continuous trading @12:27
Sellers Buyers
Trader Size Price Size Trader
Sammy 100 0 $20.05 200 Bill
Steve 200 0 $20.06 500 200 Bern
Susie 300 100 0 $20.08 100 0 Bob
$20.08 500 Bev
Seth 200 $20.10
Sandy 500 $20.12
Infinite 200 0 Ben
Summary continuous tradingBuyer Seller Size Price Bid Offer
$20.05x100
$20.06x100
Bern Sammy 100 $20.05
Bern Steve 200 $20.06
$20.06x200
$20.06x200 $20.08x300
Ben Susie 200 $20.08
$20.06x200 $20.08x100
Bob Susie 100 $20.08
$20.06x200
$20.06x200 $20.12x500
$20.08x500 $20.12x500
$20.08x500 $20.10x200
Discriminatory vs. uniform pricing rules
Taking the orders as given, large impatient traders (e.g., liquidity demanders: marketable limit orders) prefer the discriminatory pricing rule (to exploit better price).
Taking the orders as given, standing limit order traders (liquidity suppliers) prefer the uniform pricing rule (to maximize surplus).
However, orders are not given.• Limit order traders tend to price their orders
more aggressively under the uniform pricing rule.
• Can you explain this prediction?• Why would large traders want to split their
orders when trading under the uniform pricing rule?
• What role can trading halts have in affecting the pricing rules?
Continuous versus call markets The single price auction produces a larger
trader surplus than the continuous auction when processing the same order flow (example).• Concentration of order flow increases
total trader surplus.• In practice, traders will not send the
same order flow to call and continuous markets.
The single price auction will typically trade a lower volume than the continuous auction.
• In our example, both trade 600 shares…• See textbook example (Table 6-7 & 6-8)
However, there is another benefit of the continuous market – it allows traders to trade when they state their demands.
Additional examples
Example 2: Batch market and surplus
Example 3: Batch and continuous: Trading volume
Continuous systemIn that case orders are arranged as soon as they arrive if
they can be matched with outstanding orders.
At 10:00, Sean submits the first order (a limit buy order with price 200 for 300 shares). As the book is empty, his order will have to wait in the order book.
At 10:02, Siobhan submits the second order (a limit sell order with price 201 for 200 shares). As the maximum price for the limit buy order is lower than the minimum price for the limit sell order, those two orders cannot be matched. As a result, the market is 200 bid for 300, 200 offered at 201. The bid-ask spread is 1.
Electronic trading platforms Centralized order-driven market with
automated order routing. Decentralized computer network for
access. Member firms act as brokers or principals. No designated market makers Central limit order book/information
system/clearing and settlement Off-book trading is sometimes significant
The (limit order) book
The broker might have other limit orders besides ours. A collection of unexecuted limit orders is a “book”.
The book may have buy and sell orders. In US futures pits, each broker may have
his/her own book. In many other markets, the book is
consolidated: all unexecuted limit orders are recorded in one book.
The electronic limit order book All orders are limit orders. The book is electronically visible. “Anyone” may enter an order. There has to be some established
relationship for clearing and credit purposes. The electronic limit order book is probably
the most common form of new market organization today, but it is far from universal.
The Island ECN (now INET)
Island is a limit order market Island is an Electronic Communications
Network (ECN) It has no trading floor. All orders are sent
electronically.
A survey of usage Some markets have a single consolidated
limit order book, where everything happens.
This is mostly true of the Tokyo Stock Exchange, Euronext, the Singapore Stock Exchange, the Taiwan Stock Exchange, etc., etc.
Other markets are fragmented.
There are multiple limit order books in different physical venues (or computers).
In addition to the Island ECN, there is a limit order book for IBM at the New York Stock Exchange, the Boston Stock Exchange, the Pacific Stock Exchange, etc., etc.
The largest (deepest) limit order book for IBM is at the NYSE.
Different markets/different solutions
The pit markets in US futures exchanges do not have a centralized limit order book.
The Chicago Board Options Exchange does have a centralized book (run by a clerk).
The NYSE has a limit order book, run by the specialist. (But there are other books in NYSE-listed stocks on regional exchanges and other dealers.)
NASDAQ has multiple books.
Terminology
A centralized limit order book is often referred to as a “CLOB” (pron. kl.b)
Hard CLOB: All activity is forced (by law) through the book.
Soft CLOB: A CLOB exists, but trades can take place outside of it.
Limit order books: The problem areas Electronic limit order books are the
predominant continuous trading mechanism.
They do not seem to work well, however, in all circumstances. These include large trades, low activity securities and market breaks (“crashes”)
In these circumstances, some sort of active marketmaking presence (a dealer) seems to be necessary.
Chapter 10
Informed Traders and Market Efficiency
Informed traders
Acquire and act on information about fundamental values.
Buy (sell) when prices are below their estimates of fundamental value.
Include value traders, news traders, information-oriented technical traders, and arbitragers.
Fundamental values
The true values Not perfect foresight values Prices are said to informative when they
are equal to fundamental values Fundamental values are not predictable
(why?) Price changes in efficient markets are not
predictable (why?)
Informed traders make prices informative Because they buy (sell) when price is below
(above) their estimates of fundamental value, their trading move prices toward their estimates of fundamental value.
When informed traders accurately estimate values, their trading makes prices more informative.
The market price is more informative (accurate) than individual value estimatesV = the true fundamental value,
P = the market price,
vi = value estimate of trader i; vi = V + ei, where E(ei) = 0,
Di = trader i’s desired position in the security;
Di = a(vi – P), where a is a constant.
From ∑ Di = ∑ a(vi – P) = 0 (i.e., zero net supply), we have
∑ a(vi – P) = 0 → a∑(vi – P) = 0 → ∑(vi – P) = 0 → ∑vi – ∑P = 0
→ ∑vi = ∑P = N * P → P = (1/N) ∑vi
P = (1/N) ∑vi = (1/N) ∑(V + ei) = V + eM, where eM = (1/N) ∑ei ≈ 0.
Informed trading strategies Must minimize price impact to maximize
profits. Trade aggressively when their private
information will soon become common knowledge.
Trade slowly when their private information will not soon become common knowledge.
Trade aggressively when other traders will act on the same information.
Liquidity and Predictability-Strategic Trading with Private Information and Price Impact
If you buy a contract, you receive $1 with a probability of π and zero with 1- π.
The market price of the contract is
P = 0.3 + ¼(Q/L), where Q is your trade size and L denotes liquidity.
Your profit = πQ – PQ = πQ – [0.3 + ¼(Q/L)]Q
Your profit is maximized when Q = 2L(π – 0.3)
Your maximum profit = L(π – 0.3)2
Styles of informed trading
Value traders – all information News traders – new information Information-oriented technical traders –
predictable price patterns Arbitragers – relative instrument values
rather than absolute instrument values
Informed trading profits
Precise and orthogonal estimates Impossibility of informationally efficient
markets (Grossman and Stiglitz) Three forms of efficient markets
hypothesis
Chapter 11
Order Anticipators
Order Anticipators
Front runners, Sentiment-oriented technical traders, Squeezers, Manipulation of stop orders
They do not make prices more informative or markets more liquid.
Tick size is important. They are all parasitic traders.
Front Runners Front running aggressive traders
• Profit from the price impact of aggressive traders. Discuss example.
• Illegal when they violate a confidential brokerage relationship.
Front running passive traders• Quote matching or penny jumping. Discuss
example.• Extract option values of the standing orders.
Front Running and Market Efficiency Make prices less informative when they
front run uninformed traders. Make prices more informative when they
front run informed traders. Long-run effect of informed traders may be
to make market prices less informative!• Why? Because traders invest less in
information due to smaller profits.
Front Running and Liquidity
Front runners make markets less liquid. They benefit the traders with whom they
trade when they improve prices to step in front of other traders.
They do so at the expense of the traders they front run. (Extracting option values)
Some traders become less aggressive when confronted with front runners.
Sentiment-Oriented Technical Traders They try to predict the trades that
uninformed traders will decide to make. They profit from the price impact of
uninformed trades. Their trading make market prices less
informative because they try to trade before uninformed traders.
They make markets less liquid for the traders they front-run.
Squeezers
They try to monopolize one side of a market so that anyone who must liquidate a position on the other side must trade with them.
Make prices less informative due to price manipulation.
Illegal in the US.
Manipulation of Stop Orders
“Gunning the market” Push prices up or down to activate stop
orders. Stop orders then accelerate those price
changes. They close their positions at a profit by
trading with the stop orders! Use example. Illegal in the US. But almost impossible to
enforce.
Chapter 13 &14
Dealers and Bid-Ask Spreads
A broker acts as an agent for a customer,representing customer orders in the market (e.g., a real estate broker).A dealer takes the other side of customer trades (e.g., a used-car dealer).Much of US securities regulation applies to both brokers and dealers. The US Securities and Exchange Commission (SEC) refers to such people as “broker-dealers”. In fact, broker and dealer functions are quite distinct.
What defines a dealer?
Dealer quotes
Dealer spread vs. inside spread One-sided vs. two-sided market Firm vs. soft quotes Quoted vs. realized spread Best execution rule Order preferencing
The bid-ask spread The bid-ask spread is the difference
between the ask price and the bid price (quoted spread).
The quoted spread gives an estimation of the remuneration of the service provided by dealers to traders. The remuneration increases with the spread.
Dealers make money by buying low and selling high. They lose money when market conditions lead them to buy at high prices and sell at low prices.
The realized spread (difference between the price at which dealers effectively buy and sell their securities) is the true remuneration of providing liquidity.
The realized spread
Dealer inventories Inventories are positions that dealers have
on the security they trade. They may hold a long position or a short position.
Target Inventories are positions that dealers want to hold.
Dealers’ inventories are in balance when they are near the dealers’ target levels and out of balance otherwise.
Inventory risk
For risk averse dealers any difference between inventories is costly.
They then require compensation for absorbing transitory mismatches in supply and demand over time (transitory risk premium).
The larger the mismatch, the greater the risk the dealer must assume and the greater the compensation required by dealers.
Dealer inventory control Dealers may act to control their inventories. As dealers’ prices affect other traders’
trading decisions, the placement of the dealers’ bid-ask spread may be used to control their inventories.
When dealers’ inventories are below (above) their target inventories, they must buy (sell) the security.
Dealers increase their prices (bid and ask) when they want to increase their inventory.• Higher bid prices encourage traders from selling
to them and higher ask prices discourage traders from buying from them.
Dealers decrease their prices when they want to decrease their inventory.• Lower bid prices discourage traders from selling
to dealers and lower ask prices encourage traders from buying from the dealers.
Depth (size) control
Inventory risk Diversifiable inventory risk
• When future price changes are independent of inventory imbalances
• Can be minimized by dealing in many instruments
Adverse selection risk• When future price changes are inversely related
to inventory imbalances• Arises when dealers trade with informed traders
Adverse selection losses Informed traders buy when they think that
prices will rise and sell otherwise. When dealers trade with informed traders,
• prices tend to fall after the dealers buy and rise after the dealers sell (i.e., future price changes are inversely related to inventory imbalances)
• their realized spreads are often negative.
Dealer optimization problem Dealers always gain to liquidity-motivated
transactors.
Dealers can balance the losses made on informed trading with the profits made on uninformed trading.
Dealer optimal responses when sold to an informed trader
Raise ask price and lower ask size Raise bid price and increase bid size Buy from another trader at his ask price Buy a correlated instrument
Dealer optimal responses when bought from an informed trader
Lower ask price and raise ask size Lower bid price and reduce bid size Sell to another trader at his bid price Sell a correlated instrument
Dealer optimal responses when the next trader is an informed traders Ask price = the best estimate of
fundamental value, conditional on the next trader being a buyer. (regret-free price)
Bid price = the best estimate of fundamental value, conditional on the next trader being a seller.
Because dealers generally do not know whether the next trader is well informed, they use the probability that the next trader is well informed.
Bid/ask spreads – Chapter 14
The spread is the compensation dealers and limit order traders receive for offering immediacy.
The most important factor in order placement decision (market vs. limit orders)
The most important factor in dealer’s liquidity provision decision
The most important chapter of the book.
Dealer spreads
Monopoly dealers Low barriers to entry in most markets In many markets, dealers face competition
from public limit order traders Normal vs. economic profits – Dealers
earn only normal profits in competitive dealer markets
Components of the spread Transaction cost component
• Transitory spread component• Covers the normal costs of doing business,
monopoly profits, risk premium• Responsible for bid-ask bounce
Adverse selection component• Compensate dealers for losses to informed
traders• Permanent spread component
Two explanations for adverse selection component Information perspective
• The difference in the value estimates that dealers make conditional on the next trader being a buyer or a seller
Accounting perspective• The portion of the spread that dealers must
quote to recover from uninformed traders what they lose to informed traders
V = the unconditional value of a securityP = the probability that the next trader is an
informed traderV+E = the value of the security when an
informed trader wants to buyV-E = the value of the security when an
informed trader wants to sellThe next trader is equally likely to be a buyer
or a seller.
Definition and assumption
Conditional expectation of the security value given that the next trader is a buyer
= (1-P)V + P(V+E) = V + PE
Conditional expectation of the security value given that the next trader is a seller
= (1-P)V + P(V-E) = V - PE
Adverse selection component of the spread = (V + PE) – (V - PE) = 2PE
Information model
Accounting modelLet B is the dealer’s bid price and A is the dealer’s ask price.
Conditional expectation of dealer profit given that the next trader is a seller
= (1-P)(V-B) + P[(V-E) - B] = V - B – PE.Conditional expectation of dealer profit given that the next
trader is a buyer = (1-P)(A-V) + P[A - (V+E)] = A - V – PE.Since the next trader is equally likely to be a buyer or a
seller, the expected dealer profit is = ½(V – B – PE) + ½(A – V – PE) = ½(A – B) – PE.
Finally, setting ½(A – B) – PE = 0, we obtain A – B = 2PE.
Uninformed traders lose to informed traders When uninformed traders use limit orders
• Informed traders trade on either the other side or the same side, depending on their private information.
• Uninformed traders either regret trading or regret not trading.
When uninformed traders use market orders• Pay large spreads (due to informed trading)
Determinants of equilibrium spreads in continuous order-driven markets
Information asymmetry among traders (+++) Time to cancel limit orders (++) Volatility (++) Limit order management costs (+) Value of trader time (+) Differential commission between limit and
market orders Trader risk aversion (+)
Cross-sectional determinants of equilibrium spreads – Primary
Information asymmetry Volatility
• Limit order option values increase with volatility• Inventory risks increase with volatility• Asymmetry problem increases with volatility
Utilitarian trading interest• Utilitarian traders are uninformed - lower adverse selection• High volume stocks have lower order processing costs, smaller
inventory risks, more limit order trading, smaller timing option value, and more dealer competition
An example: I buy 100 shares of ABC. When I decide to buy the shares, the market is
50 bid, 51 offered. I actually buy at 51.20, paying a $29 commission.
Cash outflow = 5,120 + 29 = 5,149 When I make the decision to sell, the market is 54 bid, 54.50 offered. I
actually sell at 54, paying a $29 commission.
Cash inflow = 5,400 – 29 = 5,371
My net cash flow is 5,371 – 5,149 = 222. [A return of 4.31%(= 222/5,149)]
In my paper portfolio, I buy and sell at the midpoint of the bid and ask quotes at the time I decide to trade.
I buy 100 shares at 50.50 and sell at 54.25 = 375 (a 7.43% return)
The implementation shortfall is 375 – 222 = 153 (ignoring interest)
Alternatively, the implementation shortfall is 7.43% – 4.31% = 3.12%
Further analysis The cost of a trade is explicit cost + implicit cost
Explicit cost: commission (net of any rebates of goods or services, “soft dollars”)
Implicit cost: the cost of interacting with the market.
The initial purchase was made $0.70/sh above the BAM, so the implicit cost = $70
The final sale was made $0.25/sh below the BAM, so the implicit cost = $25
The implicit cost computed with respect to the BAM is the effective cost. The effective cost is a useful measure for market orders.
Effective cost
The effective spread
Effective spread = 2 x effective cost
For the initial purchase, the effective spread
= 2 x $0.70 = $1.40 / share.
Intuition
The quoted (posted) spread is 51 – 50 = 1. If a buyer pays $0.70 above the BAM and sells $0.70 below the BAM, they are effectively facing a bid-ask spread of $1.40.
Realized cost and realized spread
For executed trades, the realized cost is the transaction price relative to the BAM at some time subsequent to the trade.
This impounds price movements after the trade (including the price impact due to the information in the trade).
Realized cost and realized spread
An interpretation of the realized cost This cost can be interpreted as the profit realized
by the other (contra) side (e.g., dealer) of the trade, assuming the contra side could lay off the position at the new BAM.
Example• The dealer sells to the customer at 100.09.• Five minutes later, the market is bid 100.02, 100.12
offered (BAM = (100.02+100.12)/2 = 100.07.)• The realized cost is 0.02.• This would be the dealer’s profit if he could reverse
the trade (purchase the stock) at the subsequent BAM.
SummaryQuoted Spread = (Ask – Bid)
= [(Ask – M) + (M – Bid)],
where M = (1/2)(Ask + Bid) = the midpoint of the bid and ask.
Effective Spread = 2Abs(T – M) = 2D(T – M)
= 2 x Effective Cost,
where T = the transaction price,D = +1 for customer buy order and
-1 for customer sell order.
Price Impact = D(M+ – M).Price Impact measures decreases in M following
customer sells and increases in asset value following customer buys, which reflect the market’s assessment of the private information the trades convey. Such price moves constitutes a cost to market makers, who buy prior to price decreases and sell prior to price increases.
Realized Spread = Effective Spread - Price Impact= 2D(T – M) - 2D(M+ – M) = 2D(T - M+) = 2 x Realized Cost= Market making revenue, net of losses to better-informed traders
The effective cost of a sequence of market orders Oftentimes traders break up large orders into smaller
ones, and feed them to the market over time. In a sequence of orders, the cumulative price impact
means that later orders will trade at worse prices than early ones.
For a buy sequence, the effective cost is:(volume weighted average purchase price) –(BAM prevailing at time of trading decision)
Suppose the BAM is 10.00. We buy 100 shares at 10.10, 500 shares at 10.25 and 400 shares at 10.50.
• The vol wtd average purchase price is 10.335/share.• The effective cost is $0.335 per share.
Inferring impact costs from effective and realized spreads
Suppose the BAM = $10.00. We want to buy 1,000 shares.
The effective cost of one 1,000 share order is $0.30/sh. If we split the order into two 500 share trades, we pay
500 x ($10.00 + $0.20) + 500 x ($10.00 + $0.35)
= $10,275 Relative to the initial midpoint, the trading cost is 275
($0.275/sh)
Measuring market impact
Statistical tools from time series analysis attempt to correlate orders with subsequent price movements. See Chung et al. (2004)
General considerations.• Market impact is not the same for all orders in all
markets.• Large orders have higher impact than smaller orders.• Orders perceived as originating from “smart” traders
will have high impact.• Orders that execute in markets that cater to retail
investors will have low impact.
Measuring the cost of limit orders For a single limit order there are no summary
measures comparable to effective and realized spreads.
Market orders always execute. The only issue is price.
Limit orders often don’t execute.• How should we account for an order that wasn’t filled?• What is the cost of a delayed execution?
It is possible to measure the effective cost of strategies that use limit orders if the strategy ensures an (eventual) execution.
The cost of a first-limit-then-market strategy Situation: the trader must fill an order by some pre-set time (like the
close of trading). Strategy
• First use limit orders at (or away from) the market.• If a limit order doesn’t execute within some pre-set time, replace it with a
more aggressively priced order.• Repeat.• If no limit orders have been filled by the end of the day, switch to a market
order.
Example: It’s 10am. I have to buy 100 shares by today’s close. The market is 20.50 bid 20.60 offered.
• I put in a buy limit order at 20.50.• If the order hasn’t executed in 30 minutes, I’ll cancel and replace with a
buy limit order priced at 20.51, etc.• If no fill by the close, I’ll cancel the limit order and submit a market order.
Adverse selection model &
Components of bid-ask spreads
(see lecture notes)
Chapter 20Volatility
Volatility Fundamental volatility is due to
unanticipated changes in instrument values • Price changes due to adverse selection
spread component contribute to fundamental volatility
Transitory volatility is due to trading activity by uninformed traders
Fundamental volatility factors
Unexpected changes in Interest rates and credit rating (bonds) Factors that affect firm value (stocks) National inflation rates, macroeconomic
policies, and trade and capital flows (currencies)
Cash market supply and demand (commodities)
Other factors that affect fundamental volatility Storage costs
High storage costs → small inventories
→ demand shocks → high price volatility Perishable goods Fundamental uncertainties
• High PE ratios, high political risks, highly leveraged firms
Transitory volatility Arises when the demands of impatient
uninformed traders cause prices to diverge from fundamental values.
These price changes are transitory because prices eventually revert to fundamental values.
The transaction cost component of the bid-ask spread contributes to transitory volatility (i.e., bid-ask bounce).
Bid-ask bounce causes negative serial correlation in transaction price changes. See Roll’s model.