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Topic 6

Topic 6. Call Auction Vs. Continuous Trading. How Buyers & Sellers Meet Each Other. PRICE. SELL. P*. BUY. 0. Q*. QUANTITY. The closest thing to it is a Call Auction. ECONOMICS 101. The perfectly liquid, frictionless market solution. The Big Problem.

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Topic 6

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  1. Topic 6 Call Auction Vs. Continuous Trading

  2. How Buyers & SellersMeet Each Other

  3. PRICE SELL P* BUY 0 Q* QUANTITY The closest thing to it is a Call Auction ECONOMICS 101 The perfectly liquid, frictionless market solution

  4. The Big Problem Enabling Buyers and Sellers, Large and Small, to Find Each Other • Two Dimensions • Place • Time

  5. Order Driven Market Public Seller 10:50 10:55 11:00 The limit order book brings buyer& seller together Places a Buy Limit Order Limit Order Executes Public Buyer

  6. Dealer Intermediation Public Seller Dealer Sells 10:50 10:55 11:00 Dealer provision of immediacy brings buyer & seller together Public Buyer Dealer Buys

  7. A Call Auction Public Seller 10:50 10:55 11:00 A meeting point in time can bring multiple buyers & sellers together Public Buyer

  8. How a Call Auction Works

  9. The Electronic Call Auction • Orders that could otherwise be matched and executed are held for a big, multilateral clearing • Clearings are held at pre-determined points in time (i.e., once an hour) • All crossing orders are executed at a single price • Buy orders at that price and higher execute • Sell orders at that price and lower execute

  10. The Batching of Customer Orders O Offer • Bid Price 52 O • O 51 • • O 50 • 49 O Question How should these limit orders be integrated to produce a good price? • 48 O • 47 1 2 3 4 5 6 No. Orders

  11. • • (1) • (1+2=3) • • • (3+1=4) • • (4+1+5) • • (5+1=6) • Cumulate The Buy Orders • Individual buy order  Cumulated buy orders at the price or better Price 52 51 50 49 48 47 1 2 3 4 5 6 No. Orders

  12. O (5) • (4) O (3) • O • O (2) (1) O • • Cumulate The Sell Orders Price 52 51 50 49 • Individual sell order O Cumulative sell orders at the price or better 48 47 1 2 3 4 5 6 Orders

  13. CUMULATED SELL ORDERS O • O • O 50 • O • O CUMULATED BUY ORDERS • 3 Match Cumulated Buy & Sell Orders Price 52 51 P* = 50 49 48 47 1 2 3 4 5 6 Orders

  14. Call Auction Limit Order Books Thicker Book Sparser Book

  15. When Calls Are Used • Market Openings • Market Closings (MOC & LOC orders) • Nasdaq’s Crosses (open and close) • Intra-day • At a predetermined time • To reopen the market after a trading halt

  16. Calls Auctions And… • Electronic technology • The time clock – • Jim Ross’s piece in the text • Who gets price improvement – • Al Berkeley’s piece in the text

  17. Benefits • Focused liquidity – especially small & mid caps • Control price volatility • Fair • Harder to manipulate • Lower order handling costs • A price discovery mechanism

  18. Problems • Does not offer immediacy • Bookbuilding

  19. Order Handling DifferencesCall vs Continuous Trading • Market orders • – infinitely aggressively priced limit orders • Limit orders • – can expect to be price improved Who provides liquidity to whom in a call?

  20. Types of Calls • Price Scan Auction • Sealed Bid Auction • Crossing Network • Open Limit Order Book Auction • – TraderEx

  21. Optimal Order Placement

  22. How to Submit a Buy Order:Calls are the only game in town Your Reservation Price = $12 Limit PriceClearing PriceSurplus $11.10 $11.20 $0.00 $11.10 $11.10 $0.90 $11.10 $11.00 $1.00 Limit PriceClearing PriceSurplus $11.20 $11.30 $0.00 $11.20 $11.20 $0.80 $11.20 $11.10 $0.90 Why not $11.30 or higher?

  23. How to Submit a Buy Order:Calls are the only game in town Your Reservation Price = $12 Conclusion Limit Order Price = Reservation Price = $12 (Or one tick below)

  24. How To Submit A Buy Order To ACall That Is Followed By Continuous Trading Your Reservation Price = $12 Question: Would You Prefer To 1.Execute at $12.00 or not at all? 2 Execute at $11.90 in call or at $11.90 in continuous with 0.99 prob? 3. Execute at $11.90 in call or at $11.80 in continuous with 0.90 prob? 4. Execute at $11.90 in call or at $11.80 in continuous with 0.10 prob? 5. Execute at $11.90 in call or at $11.80 in continuous with 0.50 prob?

  25. How to Submit a Buy Order:Call Followed by Continuous (Answers to Questions 2 – 4) Call Auction Continuous Auction Q2 Surplus at $11.90 = $0.100 > Expected Surplus at $11.90 = $0.10 x 0.99 = $0.099 Q3 Surplus at $11.90 = $0.100 < Expected Surplus at $11.80 = $0.20 x 0.90 = $0.180 Q4 Surplus at $11.90 = $0.100 > Expected Surplus at $11.80 = $0.20 x 0.10 = $0.020 Q5 Surplus at $11.90 = $0.100 = Expected Surplus at $11.80 = $0.20 x 0.50 = $0.100

  26. Price Surplus in Call Surplus in Continuous Breakeven Probability of Executing in Continuous Call Continuous $12.00 $11.90 $0.00 $0.10 NA $11.90 $11.80 $0.10 $0.20 0.50 $11.80 $11.70 $0.20 $0.30 0.67 $11.70 $11.60 $0.30 $0.40 0.75 $11.60 $11.50 $0.40 $0.50 0.80 How to Submit a Buy Order:Call Followed by Continuous Finding the Optimal Price

  27. How to Submit a Buy Order:Continuous Followed by Call Your Reservation Price = $12 • Your time frame is the trading day • You place a day order that must be filled by 4:00 pm • As the day progresses, all else equal, you are more apt to place a market order than a limit order • There is a closing call • Your limit order in the closing call would be one tick below your reservation price ($12)

  28. Continuous Followed by Call S = your surplus from trading Pr = prob your limit order executes in cont. market • E(S) = [Pr x SCont] + [(1-Pr) x E(SCall)] • SCont = surplus if order executes in cont. market • E(SCall) = expected surplus from the call • SCall = max(0, PR – PCall) • Because (1-Pr) x E(SCall) >0, you are more apt to place a limit order in the continuous market when it is followed by a closing call • Remember the gravitation pull effect

  29. A Call’s Contribution to Market Quality

  30. Let’s Focus on Volatility The opening spike: Price discovery The closing spike: End of day impatience to Get the job done What does this imply about market structure? A natural experiment: Nasdaq’s closing/opening crosses (call auctions) introduced in March/October of 2004

  31. The Nasdaq Study* • 52 large cap Nasdaq firms • Time period: Feb 04 and Feb 05 • We examined per day: • 390 1-minute intervals (9:30-16:00) • 30 10-second opening intervals (9:30-9:35) • 30 10-second closing intervals (15:55-16:00) • Volatility measured by high-low range for the interval *“Market Structure and Intra-day Price Volatility: An Event Study on Nasdaq’s Crosses” Michael Pagano, Lin Peng, and Robert Schwartz

  32. 60 bps Feb 2005 (Post-Calls) Nasdaq Volatility Differences BetweenFeb 2004 and Feb 2005One-minute Volatility 60 bps Feb 2004 (Pre-Calls) w

  33. Nasdaq Volatility Differences Between Feb 2004 And Feb 200510-Second Volatility 40 bps Feb 2005 (Post-Calls) 40 bps Feb 2004 (Pre-Calls) 5 Min After Opening 5 Min Before Close 5 Min Before Close 5 Min After Opening

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