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Money, Banking & Finance Lecture 4

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 & Finance Lecture 4

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  1. Money, Banking & FinanceLecture 4 The Theory and Practice of Equity Trading

  2. 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.

  3. 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

  4. 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

  5. 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.

  6. 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.

  7. 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.

  8. Ask Bid Sells Buys Price Discovery P*

  9. 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.

  10. P* and Best Bid and Offer Quotes

  11. 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.

  12. 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.

  13. 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

  14. 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

  15. 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)

  16. Teaching Trading and Markets with TraderEx simulations(I) e.g., cardiff2 cardiff

  17. Teaching Trading and Markets with TraderEx simulations(II)

  18. Buy orders Market orders Limit orders Sell orders

  19. Order book market Ask: 213 offered at 20.60 20.40 Bid for 59

  20. Entering a limit order User has entered 2 limit orders to sell

  21. 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

  22. Sold! Mark-to-market P&L = -2.00

  23. 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

  24. Can enter Chat messages

  25. Performance measures1) Average prices

  26. Performance measures2) P&L

  27. Performance measures3) VWAP

  28. 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

  29. 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

  30. 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

  31. 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

  32. 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.

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