Introduction to Trading

1. Introduction to Trading

2. INTRODUCTION TO TRADING AGENDA MARKET JARGON MARKET STRUCTURE MARKET PARTICIPANTS ORDER TYPES PRICE QUOTATION ORGANIZATION OF MARKETS

3. INTRODUCTION TO TRADING – Market Jargon • BULL MARKETS VS BEAR MARKETS • Bull Market • When prices move up • Characterized by optimism, investor confidence and expectations that strong results will continue • Bear Market • When price move down • A downturn of 20% or more in multiple broad market indexes, such as the Dow Jones Industrial Average (DJIA) or Standard & Poor's 500 Index (S&P 500), over at least a two-month period • Widespread pessimism causes the negative sentiment to be self-sustaining.

4. INTRODUCTION TO TRADING – Market Jargon • BIGGEST INDICATORS: • The Dow Jones, the NASDAQ Composite, the S&P 500 Index, and the Russell 2000 Index are the most closely watched benchmark indices tracking targeted stock market activity. • Dow Jones: • Most widely used indicator of the overall condition of the stock market, a price-weighted average of 30 actively traded blue chip stocks, primarily industrials • The 30 stocks are chosen by the editors of the Wall Street Journal • Officially started by Charles Dow in 1896 • NASDAQ Composite: • Used mainly to track technology stocks, and thus it is not a good indicator of the market as a whole. • market value-weighted, so it takes into account the total market capitalization of the companies it tracks and not just their share prices. • S&P 500: • A basket of 500 stocks that are considered to be widely held. • Weighted by market value • Provides a broad snapshot of the overall U.S. equity market • Over 70% of all U.S. equity is tracked by the S&P 500 • Most of the companies in the index are solid mid cap or large cap corporations. • Russell 2000: • Small-cap stock market index of the bottom 2,000 stocks in the Russell 3000 Index. • Most widely quoted measure of the overall performance of the small-cap to mid-cap company shares.

5. INTRODUCTION TO TRADING – Market Jargon Nasdaq Dow Jones S&P Russell

6. INTRODUCTION TO TRADING – Market Structure MARKET MICROSTRUCTURE Microstructure deals with the following issues = Market structure and design This factor focuses on the relationship between price determination and trading rules. Price formation and discovery This factor focuses on the process by which the price for an asset is determined. Transaction cost and timing cost This factor focuses on transaction cost and timing cost and the impact of transaction cost on investment returns and execution methods. Transaction costs include order processing costs, adverse selection costs, inventory holding costs, and monopoly power. Information and disclosure This factor focuses on the market information and transparency and the impact of the information on the behavior of the market participants.

7. INTRODUCTION TO TRADING – Market Structure • MARKET MICROSTRUCTURE • Traditional asset pricing attempts to determine the fundamental value of a security. The actual exchange of the security is simply a black box. This does not address how prices adjust to reflect news nor does it explain how investors’ subjective assessment of a security “gets into” the price. • The exchange of the securities is governed by a unique set of rules and processes. • Trading rules and trading methodologies will affect how asset prices change in response to new information.

8. INTRODUCTION TO TRADING – Market Structure • MARKET STRUCTURE • Trading takes place in trading sessions • Continuous trading • Call market • Trading Forums: • 1. Physically convened markets – Trading pits • 2. Distributed access markets – Telephones or screen-based systems • Market participants use various execution systems to arrange trades • 1. Quote-driven systems • 2. Order-driven systems • 3. Brokered trading system

9. INTRODUCTION TO TRADING – Market Structure • MARKET STRUCTURE • Systems can use the following to arrange trades: • Screen-based • Open-outcry • Hand-signaling technologies • Information routing systems: • Order-routing systems • Order-presentation systems

10. INTRODUCTION TO TRADING – Market Structure • OPEN OUTCRY TO ELECTRONIC SYSTEM… • In 1989 the Paris Bourse introduced an automated electronic trading • + French stocks trading in London migrated to Paris • The progression to electronic trading is based on two concepts: • + Traders want their markets to operate fairly • + Traders want fair access to markets • Liquidity always will dictate

11. INTRODUCTION TO TRADING – Market Structure • FORCES AFFECTING THE STRUCTURE OF MARKETS • Demand for trading • + Liquidity trading • + Information trading • + Noise trading • Order processing costs • + Information system • + Order routing systems • + Order execution system • + Clearing and Settlement costs

12. INTRODUCTION TO TRADING – Market Structure • MORE FORCES AFFECTING THE STRUCTURE OF MARKETS • Technology and automated trading • + Resistance/vested interests (e.g., CBOT floor community) • + Block traders • Risk bearing • + Inventory risk • + Payments risk • Free options • + Stale limit orders • + Stale quotes • Information trading • + Liquidity traders lose • + Informed traders need to be compensated for research • Anonymity, Reputation, Transparency • + Disclosure of trades and quotes • + Upstairs facilitated trade • + Reputation through repeated trading

13. INTRODUCTION TO TRADING – Market Participants • TWO SIDES OF THE TRADING INDUSTRY: • People and institutions who use market services are on the buy-side. These people pay the spread. • Those who provide market services are on the sell-side. These people earn the spread. • These sides have nothing to do with whether you are a buyer or seller of a specific security

14. INTRODUCTION TO TRADING – Market Participants • PARTICIPANTS: • People will trade to invest, borrow, exchange assets, hedge risks, distribute risk and to speculate. • Market Makers: provide liquidity. Their stay in the market is not long. • Speculators: profit motivated traders. Will try to predict futures price movement. • Informed Traders: Trades based on fundamental information. • Arbitrageurs: Simultaneously buy and sell. No risk. • Anticipatory Traders: Trade based on information. Will try to trade ahead of other traders. • Noise Traders: traders that add vibrations to prices. Non-informed traders.

15. INTRODUCTION TO TRADING – Market Participants • PLAYERS: • Institutional Sales and Trading • Sales people provide clients for the traders • Sales people discuss markets and prices with clients • Wants to sell high and buy low • Need excellent communication skills and be likeable • Traders provide products for the clients • Once quoted a trader wants the deal to be closed immediately before the price move • Makes money on the spread between bid and offer • Wants to buy low sell high • Traders need quant skills and mental sharpness

16. INTRODUCTION TO TRADING – Order Types • DEFINITION OF ORDERS: • Orders are instructions that traders give to the brokers and exchanges which arrange their trades. • The Order will Include = • Instrument (or instruments) to trade • How much to trade • Whether to buy or sell • Conditions: • + Limit price • + Duration • + Partial or fill-or-kill • + Where to present the order

17. INTRODUCTION TO TRADING – Order Types • Market Orders: best price currently available, look for immediacy paying the spread between bid and ask prices • Limit Orders: best price available, but only if it is not worse than the limit price specified • Stop Orders: a cut-off of order execution • Market-If-Touched Orders: activation of order if level is reached • Tick-Sensitive Orders: conditioning orders • Market-Not-Held Orders: not needed to fill immediately

18. INTRODUCTION TO TRADING – Market Impact • Large market orders tend to move prices due to asymmetric information • Liquidity might not be sufficient at the inside quotes for large orders to fill at the best price. The order may then push through standing limit orders until completely filled • Prices might move further following the trade • Dealers are uncertain what information the aggressor has and may expand their quotes to reduce the potential losses

19. INTRODUCTION TO TRADING – Limit Order • EXPLAINED: • A limit order is an instruction to trade at the best price available, but only if it is not worse than the limit price specified by the trader: • + OK to trade at or above the limit sell price • + OK to trade at or below limit buy price • If the limit order is executable, then 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

20. INTRODUCTION TO TRADING – Other Types • A stop instruction stops an order from executing until price reaches a stop price specified by a trade • + Buy only after price rises to the stop price • + Sell only after price falls to the stop price • + Can be either stop market or stop limit orders • Market-if-touched orders become a market order when price reaches some preset touch price • + Buy when market falls to the touch price • + Sell when market rises to the touch price

21. INTRODUCTION TO TRADING – Additional Orders • Day orders (DAY) • Good-til-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 • All-or-none (AON) orders • Minimum-or-none (MON) orders • All-or-nothing, and minimum acceptable quantity instructions • Spread orders • Display instructions • Hidden/Ice-berg orders/reserve • Substitution orders • Special settlement instructions • Regular-way settlement • Cash settlement • How do these affect the cost of trading?

22. INTRODUCTION TO TRADING – Trade Matching Rules • What order precedence does the exchange use? • Price priority • + Market orders always rank above limit orders • Time priority • + Strict time precedence or • + Floor time precedence to first order at price. • - All subsequent orders at that price have parity • Size priority • + Some markets give precedence to small orders, other markets favor large orders

23. INTRODUCTION TO TRADING – Liquidity • Liquidity is the ability to participate in trades when you want. Easily convertible into cash. • Market Depth is the size of an order needed to move the market a given amount. Is closely related to the notion of liquidity, a deep market is also a liquid market. • Market Breadth is the price at which you can trade a given size

24. 90.60 - 65 The “Big Figure” The “Quote” INTRODUCTION TO TRADING – Price Quotation • The quotation: • To save time, market makers sometimes just quote the two way price as: • “60 – 65”

25. Bid Offer 60 - 65 spread INTRODUCTION TO TRADING – Price Quotation TWO WAY PRICE: At the BID price: • Market Maker BUYS • Price Taker SELLS At the OFFER price: • Market Maker SELLS • Price Taker BUYS

26. INTRODUCTION TO TRADING – Price Quotation • TWO SIDES OF THE SAME COIN: • Price takers are typically hedgers • + Hedgers usually trade for purposes related to an underlying portfolio • + Their reason for trading futures is ancillary to their overall goal • Market makers are usually trading for profit in that financial instrument • + Their reason for trading futures is primary to their overall goal • Market makers do not always buy at the bid nor do price takers always buy at the ask (offer) • Every time someone sells someone is buying and vice versa

27. INTRODUCTION TO TRADING – Price Quotation • RELATIONSHIP BETWEEN BID AND ASK: • There is a trade off between price and time for everyone • + Of course it is better to buy at the cheaper price and sell at the higher price • + Then why does someone pay the higher price to buy (from someone selling at the higher price)? • Immediacy of trading is the reason • + Hedgers prefer certainty in their futures trading since it is only a means to an end and not part of their goal • + They are willing to pay a slightly higher price in order to trade immediately • Remember: Market makers do not always buy at the bid nor do price takers always buy at the ask (offer)

28. Bid Offer 60 - 65 spread INTRODUCTION TO TRADING – Price Quotation “Buy Low / Sell High” The MARKET MAKER: • buys low (at the bid) • sells high (at the offer) • earns the spread The PRICE TAKER: • buys high (at the offer) • sells low (at the bid) • pays the spread

29. INTRODUCTION TO TRADING – Price Quotation • ORDER DRIVEN VS QUOTE DRIVEN: • For any transaction to take place, two parties must agree to trade. • Parties can be distinguished by: • + Buyer vs. Seller • + Price Taker vs. Market Maker • … but who starts the ball rolling? • Order-Driven Markets • + Instructions to buy or sell are the prime mover • + Orders , typically from customers , are brought to the market place • + Market-makers fill the orders • Quote Driven Markets • + Quotes , typically from market-makers, are the prime mover • + Quotes are displayed and disseminated for all market participants to see • + Customers and other market-makers trade at the prices quoted

30. INTRODUCTION TO TRADING – Price Quotation The PRICE TAKER: • Initiates the call • Receives the quote • Makes the decision whetherto buy, sell, or decline • Pays the spread The MARKET MAKER: • Receives the call • Makes the price quotation • Must handle the consequencesof the price taker’s decision • Earns the spread

31. INTRODUCTION TO TRADING – Price Quotation • MARKET MAKERS: • A market maker is often an institution which makes the price quotation • Institutions assume the role of market maker to two types of counterparties • + their own customers • + other market participants (either by direct quotation or through a broking system) • Market making to customers is done for the following reasons • + customer facilitation for relationship purposes • + profit by standing between the customer and the market and taking a small “turn” • + market intelligence to see what deal flows are in the market • Market making to other financial institutions is done for the following reasons • + to add liquidity to the market and to facilitate reciprocity • + to profit by making a large number of trades for small turns • + because an institution may be a specialist in a particular market • Market makers in futures put capital at risk in competition with other market makers to earn profits • + They do not have customers per se

32. INTRODUCTION TO TRADING – Price Quotation • PRICE TAKERS: • A price taker is an institution which requests or takes the price quotation • The key advantage of being a price taker is having control over the alternatives when asking for a quote: • + the price taker can buy • + the price taker can sell • + the price taker can decline • The disadvantage of being a price taker is: • + paying the bid-ask spread when entering into or closing out positions

33. INTRODUCTION TO TRADING – Price Quotation Volumes vs. Profitability W I D E spread BIGGER profitability smaller volume NARROW spread smaller profitability BIGGER volume

34. INTRODUCTION TO TRADING – Organization of Markets • ORGANIZATON OF SECONDARY MARKETS: • (1) Organized exchanges • (2) OTC market • (3) Third market • (4) Fourth market

35. INTRODUCTION TO TRADING – Organization of Markets • (1) ORGANIZED EXCHANGES: • Auction markets with centralized order flow versus fragmented markets • Dealership function: can be competitive or assigned by the exchange (Specialists) • Securities: stock, futures contracts, options, and to a lesser extent, bonds • Examples: NYSE, AMEX, Regionals, CBOE

36. INTRODUCTION TO TRADING – Organization of Markets • (2) OTC MARKET: • Dealer market without centralized order flow • NASDAQ: largest organized stock market for OTC trading; information system for individuals, brokers and dealers • Securities: stocks, bonds and some derivatives • + Most secondary bonds transactions

37. INTRODUCTION TO TRADING – Organization of Markets • (3) THIRD MARKET: • Trading of listed securities away from the exchange • Institutional market: to facilitate trades of larger blocks of securities • Involves services of dealers and brokers

38. INTRODUCTION TO TRADING – Organization of Markets • (4) FOURTH MARKET: • Institutions trading directly with institutions • No middleman involved in the transaction • Organized information and trading systems • ECN Development

39. Thank You