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Money, Banking & Finance Lecture 4. The Theory and Practice of Equity Trading. Aims. Examine the process by which investment decisions are translated into the action of buying or selling shares. Understand how a trading environment operates and how the players interact.
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Money, Banking & FinanceLecture 4 The Theory and Practice of Equity Trading
Aims • Examine the process by which investment decisions are translated into the action of buying or selling shares. • Understand how a trading environment operates and how the players interact. • Appreciate how the actions of traders influence the market. • Examine the Trader-Ex software for training of stock-market traders.
Trading and Investing • Important distinction between Investing and Trading. • Trading is about converting an investment decision at the least cost point. • Trading is also about price discovery. The investment manager will have an idea of the equilibrium price but this could change in a dynamic and fast moving situation. • Trading is also about finding price discrepancies and exploiting these for profit
Investment Decisions Time Taken by Fund Managers to make buy/sell decision Score 5 = very frequently (75 – 100% of the time); 1 = never Source: Schwartz R and Steil B (2002), “Controlling Institutional Trading Costs: We have met the enemy and it is us”, Journal of Portfolio Management, 23, 3, 39-49
Trading and Time • Investment decisions are made in discrete time. • Trading decisions are made in continuous time. • Once a decision to invest has been activated to a trade, time takes on a different meaning. • The trader wants to satisfy the instruction before the end of the trading day and show a good performance. • Performance can be measured in terms of opportunity cost and/or actual cash surplus.
Bid-Ask Spread • A bid order is an offer made by a trader to BUY a security. • An ask order is the price a trader is willing to SELL a security. Sometimes called the OFFER price. • A bid or an ask can stipulate the amount the trader will buy or sell and this is called a LIMIT ORDER. • A market sell is a willingness to accept a bid order and a market buy is a willingness to accept an ask.
Order Arrival • Orders to buy and sell will arrive during the market day. • The Trader may be a short-term trader with orders to work for a client or working for a pension fund or hedge fund. • Traders don’t have the luxury of time. Their decision is to buy sell or wait • To gauge the market – the balance of buy and sell orders • At above equilibriumprices the arrival rate of sell orders are faster than the arrival rate of buy orders. • Similarly at prices below some notional equilibrium, the arrival rate of buys are greater than sells.
Ask Bid Sells Buys Price Discovery P*
Informed Traders • Informed Traders – agents who trade knowing that the current price level has diverged from the fundamental. • Buy orders are sent to market if P* > P • Sell orders are made when P* < P. When P* > P(offer) or P* < P(bid). • In the theoretical world of costless trading, complete markets, instantaneous information dissemination, price adjustments are instantaneous. • In reality prices adjust rapidly with ‘new’ news, but news could be changes in fundamentals, uncertainty, rumour or noise. • The informed Trader will exploit information and act with a short lag to news about fundamentals.
Liquidity Traders • Idiosyncratic reasons for trade. • Orders are two-sided. They can be market orders or limit orders and arrive randomly. • Sometimes called ‘noise traders’. • Liquidity traders differ in that they issue both market and limit orders but informed traders submit market orders only. • Liquidity traders will not drive a price back to some previous level or reinforce a trend because informed traders drive the price to equilibrium.
Technical (Momentum) Traders • These Traders are prevalent in the market. • Market technician – using chartist analysis • Algo trader – using a black-box device • Arbitrageur – exploit price inefficiencies to profit. • Market maker or Day Trader – profiting from the bid-ask spread or profiting from changing market conditions to buy low and sell high.
P* Is there a trend/ pattern? Is p*>offer or p*<bid? What Drives a Market? Liquidity Order Flow Momentum Informed Quotes, Prices, Volume Trading Mechanism Order Book, Market Makers, Call Auction
TraderEX Purpose • Make trading decisions • Understand price discovery 3) Evaluate trading rules for: • market participants • market quality • intermediaries and dealer roles 4) Compare alternative market systems 5) Have Fun
Computer’s Role Establish “market background” • Generate order flow • Update display and bid-ask quotes 2) Give participants orders to execute 3) Maintain transactions records for subsequent analysis on • Participants’ order placement decisions • Market quality (e.g., bid-ask spread)
Teaching Trading and Markets with TraderEx simulations(I) e.g., cardiff2 cardiff
Buy orders Market orders Limit orders Sell orders
Order book market Ask: 213 offered at 20.60 20.40 Bid for 59
Entering a limit order User has entered 2 limit orders to sell
User is entering a market order to sell Click to cancel your limit order to sell 10 at 19.90 (44) units ahead of your 10
Sold! Mark-to-market P&L = -2.00
Day’s High Price The Order Driven Market in TraderEx Your limit orders to sell Ask: 46 offered at 20.00 40 units ahead of your 10 Ticker of trades
Market Structures • Order-driven: Buy-side trader with large order • Quote-driven: Market maker/ liquidity provider • Order book w/ Periodic call auction (3x day) • Order book w/ Dark liquidity pool
Add 250,000 shares to portfolio’s holding of CAB “Take”/ Market Buy 5,000 shares of CAB Order to sell 5,000 shares of CAB executes at $48.10 Order driven market Buy-Side Trader (YOU) Investment Managers’ Decision Order Book Market Trade Occurs
Performance • Average Cost • You purchased 140,000 shares at 3.5 cents below VWAP • But 23.6 cents above the last price of the day. • Your P&L position is • -33
Buy side performance • P&L per share • = Mark-to-Market Price – Average Purchase Cost • Good trading:* • VWAP – Average Purchase Cost > 0 • Good stock selection: • Last Price – Price at time
Summary • We have seen that investing is not the same as trading • Investing is a strategic decision made by the portfolio manager. • Trading involves meeting the instructions of the portfolio manager at the least cost or best price. • The TraderEx software is a computer package that simulates trading in different market structures • It also allows for interactive trading in real time.