Presentation Transcript

1. Market MicrostructureLecture 02Daniel Sungyeon Kim

2. Investments vs. This class Selection Fund A manager Fund A manager Fund A manager Request Request Request Implementation Order desk Order Order Exchange 1 Exchange 2 Exchange 3 Investments covers selection and ignores implementation This class covers implementation and ignores selection Analogy to how large institutional traders divide up the overall trading task:
3. What is market microstructure? Market microstructure studies the process by which investors' latent demands are ultimately translated into prices and volumes. - Madhavan (2000) The Market Microstructure Working Group is devoted to theoretical, empirical, and experimental research on the economics of securities markets, including: the role of information in the price discovery process; the definition, measurement, control, and determinants of liquidity and transactions costs; and their implications for the efficiency, welfare, and regulation of alternative trading mechanisms and market structures. - NBER Market Mircostructure working group
4. Harris, Chapter 2 Trading StoriesA Retail Trade in a NYSE-listed Stock Q: What trade does Jennifer want to do?
5. Harris, Chapter 2 Trading StoriesA Retail Trade in a NYSE-listed Stock Q: What does she do first?
6. Cincinnati Stock Exchange Q: Why?
7. More on Consolidated Quotation System Q: How are the bids sorted?
8. More on Retail Trade in NYSE-listed Stk. Q: What instructions does Jennifer give to the broker?
9. More on Retail Trade in NYSE-listed Stk. Broker enters the order, verifies Jennifer’s authorization to do this trade, verifies order, and submits it Q: Why must the broker confirm that Jennifer is authorized to trade?
10. More on Retail Trade in NYSE-listed Stk. Broker’s order system decides where to route order considering prices and payments If sent to NYSE  goes via SuperDOT to specialist on trading floor who handles AT&T Specialist tries to fill the limit order immediately or else places it on the Limit Order book
11. More on Retail Trade in NYSE-listed Stk. Q: What happens next?
12. More on Retail Trade in NYSE-listed Stk. Specialist enters price and volume in order reporting system, which notifies Consolidated Trade Reporting System – trades are reported worldwide Q: What does the broker do next?
13. More on Retail Trade in NYSE-listed Stk. Jennifer pays purchase price and broker’s commission Q: Is that it? Or is there another step?
14. NBBO Example
15. A Retail Trade in a NASDAQ Stock Q: What trade does Jennifer want to do on NASDAQ?
16. A Retail Trade in a NASDAQ Stock Microsoft is traded by about 40 independent dealers on the NASDAQ Jennifer calls a broker. Broker reads a screen like Figure 2-2
17. More on a Retail Trade in a NASDAQ St. (Looks very similar to Figure 2-1, except the quotes come from NASD market makers and ECNs, not separate exchanges)
18. More on a Retail Trade in a NASDAQ St. Q:What instructions does Jennifer give to the broker?
19. More on a Retail Trade in a NASDAQ St. Broker asks if she own shares to sell or wants to short-sell – in later case, the broker arranges to borrow shares Broker submits order and order system routes the order to the NASDAQ Small Order Execution System (SuperSOES) Broker may send it to a particular dealer who has agreed to provide a payment = “payment for order flow” Dealer executes the trade at $55.97or better – must match the best bideven if not current quoting it Broker confirms trade
20. An Institutional Trade in a NYSE Stock Q: What is Bob’s position and company and who is the client he’s working for?
21. An Institutional Trade in a NYSE Stock Example: 12:30 pm: Bob is asked to buy 400,000 shares of Exxon (current price = $40 / share) = 5% of average daily volume = not too difficult If trading on short-term info  trade fast In this case “fundamentally undervalued”  trade patiently
22. More on Institutional Trade in NYSE Stk. Check info display for recent trades: Falling prices may be selling pressure  good price for buy Rising prices may be buying pressure  poor price for buy Checks electronic exchanges (Bridge, Liquidnet, Autex, and Instinet) for buying interest vs. selling interest Morgan Stanley indicates interest Call NYSE floor trader and asks for current market conditions in Exxon  floor trader reports no large trader interest currently, but Morgan Stanley was selling earlier
23. More on Institutional Trade in NYSE Stk. 12:50 pm: sends confidential buy order for 400,000 shares of Exxon to POSIT (POrtfolio System for Institutional Trading = an electronic exchange) POSIT trades 8 times daily (9:40, 10, 10:30, 11, 12, 1, 2, 3) and tries to match buyers and sellers price = (bid + ask) / 2 at random time in next 7 min 1:10 pm: 48,000 shares of 400,000 filled at $39.84
24. More on Institutional Trade in NYSE Stk. Calls sales trader at Morgan Stanley client may want to sell more, Bob expresses interest trade for 200,000 shares is negotiated at $39.87 call Morgan Stanley floor broker to “print the trade” floor broker tells Exxon specialist he wants to cross a block of 200,000 at $39.87 specialist approves and trade is executed on the floor other floor traders ask if there is additional trading interest
25. More on Institutional Trade in NYSE Stk. Bob gives Merrill Lynch floor broker (market-not-held) 80,000 buy order to work at his discretion Merrill floor broker stands in the crowd Over next hour: buys 20,000 at $39.88, 32,000 at $39.90, 28,000 at $39.95 Gives Merrill floor broker remaining (market-not-held) 36,000 buy order Merrill trades remaining 72,000 against specialist at $40.00
26. More on Institutional Trade in NYSE Stk. Settlement is three days later
27. The Trading Industry Players Q: What are these two “sides” of the market?
28. Players Q: What are some examples of buy side investors?
29. Players Q: What are some examples of sell side traders?
30. Properties of buy side vs. sell side
31. What is the distinction between real vs. financial assets?
32. Instrument Class
33. More on Instrument Classes (Capital wealth is interesting = approximate market value of each class Stocks are 20% vs. real estate is 50% Q: Which gets more media attention? Clearly stocks, but real estate is much bigger Q: Why? Far more trading in stocks This class has disproportionate coverage of the equity markets more data, rules, and information is publicly available real estate, bonds, currencies, etc. are much more private concepts in equities apply in other markets will cover these other markets as possible
34. More on Instrument Classes (Real estate is the opposite extreme – a huge amount of capital wealth, but super low trading frequency Q: Why isn’t human capital on this list? Its bigger than everything on the list. Is this a mistake?
35. Markets
36. More on Markets Q: Anything interesting in the Markets table?
37. International Stocks Nearly every country has a stock market – you must have: flag, currency, and a stock market! Q: Do you see any difference between stock markets in developed countries vs. emerging countries?
38. Futures Markets
39. More on Futures Markets
40. Regulators Q: How many federal government regulators are there in the US?
41. Orders and Order Properties Q: What is an order?
42. Orders and Order Properties Q: What does an order always specify? What may an order specify?
43. Market Orders Q: What are the key properties of a market order?
44. Market Orders Suppose Bid = 30.00, Ask = 30.10 Consider a “round trip” trade: Buy at 30.10 and then immediately sell at 30.00  Cost = 30.10 – 30.00 = 0.10 = Bid-Ask Spread = Dollar Quoted Spread
45. More on Market Orders Then we asked what if you trade at some other price? Suppose you Buy at 30.08 and sell at 30.02  Cost = 30.08 – 30.02 = 0.06 ≠ Dollar Quoted Spread
46. More on Market Orders Now consider: One-way trade = Buy at 30.08 now and plan to sell a year or two in the future How can we think about the Cost of Trading? – we said Quoted Spread was not good enough, so we introduced Effective Spread – now let me give you a slightly different formula for effective spread: Dollar Effective Spread = (Trade Price – Midpoint) * 2 for buys (Midpoint – Trade Price) * 2 for sells = (30.08 – 30.05) * 2 = .06
47. More on Market Orders Dollar Effective spread = (Trade Price – Midpoint) * 2 for buys (Midpoint – Trade Price) * 2 for sells = (30.08 – 30.05) * 2 = .06 Q: What was the reason for times 2?
48. More on Market Orders Intuitively, Effective Spread is the Cost of Trading based on actual Trade Prices For the TAQ Project: approximated Effective Spread = | Trade Price – BBO Midpoint | * 2 Q: On the TAQ Project, why didn’t we use more exact formula for Effective Spread?
49. More on Market Orders Can benefit from price improvement(i.e., trade inside the spread – example: ask = $30.10 & bid = $30.00, trade = $30.08 – more likely with small orders) Can be hurt by walking the book(i.e., exercise the full quantity at the best price, then trade at 2nd best price, then at 3rd best price, etc.) much of the original trade executes outside the spread Happens when: market buy > ask depth or market sell > bid depth – more likely with large orders
50. More on Market Orders Summary of Market Order Properties: Execution is certain Price is uncertain
51. Limit orders Now lets turn to limit orders Suppose best ask = 32.10 and best bid = 32.00 Terms used to describe limit price placement
52. Limit orders Q: Why called ”marketable”?
53. More on Limit Orders “At the market” limit buys add liquidity at the current price “In the market” limit buys create a new bid price with a tighter spread “Behind the market” limit buys add liquidity for large orders “At,” “In,” and “Behind” = Non-marketable limit orders For limit buys, higher price is more Aggressivemore likely to execute, but at a worse price For limit sells, lower price is more Aggressivemore likely to execute, but at a worse price
54. More on Limit Orders Q: What are the key properties of a non-marketable limit order?
55. More on Limit Orders Other properties of limit orders: Limit orders may not execute (execution uncertainty) – happens when price move up on a LB and down on a LS – if price is “chased,” ultimate execution price may be poor LOs may execute and loose money (ex post regret) – happens when price move down on a LB and up on a LS – need to monitor the market and cancel LOs to avoid trading at a “stale” price LOs may execute and loose money to privately informed traders (adverse selection risk)
56. More on Limit Orders Summary of Limit Order Properties: Price is certain Execution is uncertain
57. More on Limit Orders Q: What is meant by validity and expiration instructions?