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Understanding Order-Driven Markets: Motivations, Pricing Dynamics, and Profit Opportunities

Explore the ecology of pure order-driven markets, learn about the motivations and factors driving the placement of limit orders, and understand the compensation for limit order traders. Discover how informational and liquidity events impact order execution and the accentuation of volatility. Gain insights into optimal order placement strategies and the concept of reservation price.

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Understanding Order-Driven Markets: Motivations, Pricing Dynamics, and Profit Opportunities

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  1. Topic 5 Order Driven Markets

  2. Some Participants Are looking to buy Are looking to sell Post limit orders Submit market orders Ecology of a Pure Order Driven Market Participants meet to establish prices and trade. This requires: An ecological balance is required for a market to function

  3. The Placement of Limit Orders

  4. Without sufficient limit orders, the order driven market would fail What motivates their placement? What Drives an Order Driven Market? Limit Orders!

  5. What Motivates/Deters the Placement of Limit Orders? Compensation For Limit Order Traders Results From the Pricing Dynamics of the Continuous Order-driven Market* How does this work? *Source: Handa & Schwartz, “Limit Order Trading,” Journal of Finance, December 1996, pp. 1835 - 1861.

  6. Information Change Assume I have an open, unexecuted buy limit order on the book. If a news event occurs, it’s … "Heads You Win, Tails I Lose” • Heads You Win:Bearish news has caused the price of the stock to fall and my limit order executes • Tails I Lose:Bullish news has caused the price of the stock to rise and my limit order doesn’t execute

  7. 2 Costs of Trading By Limit Order Cost of being Bagged • Heads You Win:Bearish news has caused the price of the stock to fall and my limit order executes Non-execution Cost • Tails I Lose:Bullish news has caused the price of the stock to rise and my limit order does not execute • Or no news, and still my limit order does not execute So Why Did I Place That Limit Order?

  8. A Liquidity Event Occurs • A liquidity event that results in a price decline could cause my buy limit order to execute • After being driven down, price would revert back up • I profit as price mean reverts after my order has executed • Sufficient mean reversion can offset the costs that result from informational change Mean Reversion Compensates The Limit Order Trader

  9. Mean Reversion and Accentuated Intra-Day Volatility • Accentuated intra-day volatility implies negative serial correlation • Negative serial correlation implies mean reversion Mean Reversion = Accentuated Volatility They are the same thing

  10. What Accentuates Volatility? What Accentuates Volatility? Of these three different types of events that can trigger executions and price changes, which does it? • Informational events • Liquidity events • Technical trading (momentum) No Yes Yes

  11. All Three Occur in TraderEx • Information events • Liquidity events • Momentum trading How sensitive to them were you?

  12. Conclusion: Accentuated Volatility Is a Natural Property of the Continuous Market Regardless of • Size of customer orders • Sophistication of computer technology • Speed with which orders can be submitted, withdrawn, or turned into trades

  13. P* Ask Bid • Liquidity trading creates volatility and momentum players reinforce it Intra-Day Volatility Is Accentuated in TraderEx

  14. Optimal Order Placement

  15. Should I: • Submit a market order? • A limit order? • If a limit order, how should I price it? • The decision is made with respect to: • Gains from trading • Probability of a limit order executing Order Placement in an Order Driven Market

  16. Reservation Price • For a buyer: the highest price you are willing to pay for shares • For a seller: the lowest price you are willing to sell shares at • Gains from trading • For a buyer: reservation price – purchase price • For a seller: Sale price – reservation price The Gains From Trading and the Concept of a Reservation Price

  17. Your Reservation Price = $12.00 Market Order Market ask = $11.10 Buy 1000 by Market Order @ $11.10 Gain ($12.00 – $11.10) x 1000 = $900 Limit Order Attempt to buy 1000 by Limit Order @ $10.80 Gain ($12.00 – $10.80) x 1000 = $1200 Gains From Buying 1000 Shares

  18. Market Order Gain ($12.00 – $11.10) x 1000 = $900 Limit Order Gain ($12.00 – $10.80) x 1000 = $1200 $900 = PBE x $1200 PBE = 75% If actual Prob of Exec > 75%, place Limit Order Breakeven Probability (PBE) Reservation Price = $12.00

  19. Pricing a 1000 Share Buy Limit: Reservation Price = $12.00 * Market order ** Best order to place

  20. Buyer’s Surplus

  21. Probability of Executing

  22. Buyer’s Expected Surplus

  23. Back to TraderEx • When you play TraderEx, can you quickly make decisions like this? • Of course not • But you might nevertheless feel your way instinctively • Our discussion has hopefully formalized your instincts • And, of course, you could always write an algo

  24. Existence of the Bid-Ask Spread

  25. In a quote driven market: the spread is the source of market maker profits In an order driven market? In a pure order driven market, there is no market maker intermediary Why isn’t the spread eliminated as the book fills in the neighborhood of equilibrium? Why Do Bid-Ask Spreads Exist in Order Driven Markets?

  26. Meaningful spread: economic forces explain its existence Trivial spread: minimum tick size explains its existence We can demonstrate existence of a meaningful spread by showing the existence of a non-infinitesimal spread when the tick size is infinitesimal (i.e., price is a continuous variable) Meaningful vs Trivial Spreads

  27. Market order for 1000 shares (ask = $11.10) Gain: ($12.00 – $11.10) x 1000 = $900 Limit order infinitesimally close to $11.10 Gain: infinitesimally close to = $900 PBE: infinitesimally close to 100% Should you ever place a limit order to buy this close to an already posted limit order to sell? Bid – Ask Spread Reservation Price = $12.00

  28. Should You Ever Place a Limit Buy Infinitesimally Close to an Already Posted Offer? PBE would be infinitesimally close to 100% With discrete order arrival, the probability of order execution at any price below the offer will never be infinitesimally close to 1 So, should you ever place a limit order so close to an already posted contra-side quote? N o !

  29. Compensation for Risk of adverse informational change Risk of limit order not executing Bid-Ask Spread If you are a limit order trader, the bid-ask spread must give you a positive expected return Gravitational Pull Effect

  30. Potential Buy Order 2 Potential Buy Order 1 Gravitational Pull Market Ask Market Bid

  31. 26.60 26.50 Limit sell orders Price (5¢ Tick Size) 26.40 26.30 26.20 Offer 26.10 Bid 26.00 25.90 Executable sell orders 25.80 0% 2% 4% 6% 8% 10% 12% 14% Probability Why Do Non-Trivial SpreadsExist in TraderEx? The probability distribution use to get liquidity driven sell orders

  32. Two Other Topics

  33. The option extended The option received An Option Trader’s View of Limit Orders

  34. More tools are needed Slicing and dicing Working a Large Order

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