Topic 6
©R. Schwartz
Equity Markets: Trading and Structure
Slide 1
How Buyers & Sellers
Meet Each Other
©R. Schwartz
Equity Markets: Trading and Structure
Slide 2
ECONOMICS 101
The closest thing to it is a Call Auction
PRICE
SELL
The perfectly liquid,
frictionless market
solution
P*
BUY
0
©R. Schwartz
Q*
QUANTITY
Equity Markets: Trading and Structure
Slide 3
The Big Problem
Enabling Buyers and Sellers, Large and
Small, to Find Each Other
Two Dimensions
• Place
• Time
©R. Schwartz
Equity Markets: Trading and Structure
Slide 4
Order Driven Market
Public
Seller
10:50
Public
Buyer
©R. Schwartz
10:55
Places
a Buy
Limit
Order
Limit
Order
Executes
11:00
The limit order
book brings
buyer& seller
together
Equity Markets: Trading and Structure
Slide 5
Dealer Intermediation
Dealer
Sells
Public
Seller
10:50
10:55
Public
Buyer
©R. Schwartz
Dealer
Buys
11:00
Dealer provision
of immediacy
brings buyer
& seller together
Equity Markets: Trading and Structure
Slide 6
A Call Auction
Public
Seller
10:50
Public
Buyer
©R. Schwartz
10:55
11:00
A meeting point
in time can bring
multiple buyers &
sellers together
Equity Markets: Trading and Structure
Slide 7
How a Call Auction Works
©R. Schwartz
Equity Markets: Trading and Structure
Slide 8
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
©R. Schwartz
Equity Markets: Trading and Structure
Slide 9
The Batching of Customer Orders
Price
52
O
51
O
50
49
48
47
•
••
•O
•O
•
1
©R. Schwartz
2
O Offer
Bid
•
O
Question
How should these limit orders
be integrated to produce a good
price?
3 4 5 6
No. Orders
Equity Markets: Trading and Structure
Slide 10
Cumulate The Buy Orders
• Individual buy order
Price
52
51
•• (1)
•
50
49
•
48
•
47
•
1
©R. Schwartz
 Cumulated buy orders
at the price or better
•
• (1+2=3)
• (3+1=4)
• (4+1+5)
• (5+1=6)
2
3
4
5
6
No. Orders
Equity Markets: Trading and Structure
Slide 11
Cumulate The Sell Orders
Price
52
•
51
•
50
49
•
48
• (1)
O
O (5)
O (4)
O (3)
• O (2)
• Individual sell order
O Cumulative sell orders
47
at the price or better
1
©R. Schwartz
2
3
4
5
6
Orders
Equity Markets: Trading and Structure
Slide 12
Match Cumulated Buy & Sell Orders
Price
52
51
P* =
CUMULATED
O
SELL ORDERS
•
•
O
50
49
48
O
O
•
O
•
47
1
©R. Schwartz
2
3 4
5
•
CUMULATED
BUY ORDERS
6
Orders
Equity Markets: Trading and Structure
Slide 13
Call Auction Limit Order Books
Thicker
Book
Sparser
Book
©R. Schwartz
Equity Markets: Trading and Structure
Slide 14
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
©R. Schwartz
Equity Markets: Trading and Structure
Slide 15
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
©R. Schwartz
Equity Markets: Trading and Structure
Slide 16
Benefits
• Focused liquidity – especially small & mid caps
• Control price volatility
• Fair
• Harder to manipulate
• Lower order handling costs
• A price discovery mechanism
©R. Schwartz
Equity Markets: Trading and Structure
Slide 17
Problems
• Does not offer immediacy
• Bookbuilding
©R. Schwartz
Equity Markets: Trading and Structure
Slide 18
Order Handling Differences
Call 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?
©R. Schwartz
Equity Markets: Trading and Structure
Slide 19
Types of Calls
• Price Scan Auction
• Sealed Bid Auction
• Crossing Network
• Open Limit Order Book Auction
– TraderEx
©R. Schwartz
Equity Markets: Trading and Structure
Slide 20
Optimal Order Placement
©R. Schwartz
Equity Markets: Trading and Structure
Slide 21
How to Submit a Buy Order:
Calls are the only game in town
Your Reservation Price = $12
Limit Price
$11.10
$11.10
$11.10
Clearing Price
$11.20
$11.10
$11.00
Surplus
$0.00
$0.90
$1.00
Limit Price
$11.20
$11.20
$11.20
Clearing Price
$11.30
$11.20
$11.10
Surplus
$0.00
$0.80
$0.90
Why not $11.30 or higher?
©R. Schwartz
Equity Markets: Trading and Structure
Slide 22
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)
©R. Schwartz
Equity Markets: Trading and Structure
Slide 23
How To Submit A Buy Order To A
Call 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?
©R. Schwartz
Equity Markets: Trading and Structure
Slide 24
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 = $0.10 x 0.99
$11.90
= $0.099
Q3
Surplus at $11.90 =
$0.100
<
Expected Surplus at = $0.20 x 0.90
$11.80
= $0.180
Q4
Surplus at $11.90 =
$0.100
>
Expected Surplus at = $0.20 x 0.10
$11.80
= $0.020
Q5
Surplus at $11.90 =
$0.100
=
Expected Surplus at = $0.20 x 0.50
$11.80
= $0.100
©R. Schwartz
Equity Markets: Trading and Structure
Slide 25
How to Submit a Buy Order:
Call Followed by Continuous
Finding the Optimal Price
Price
Surplus in
Call
Breakeven
Probability
Surplus in
of Executing
Continuous
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
©R. Schwartz
Equity Markets: Trading and Structure
Slide 26
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)
©R. Schwartz
Equity Markets: Trading and Structure
Slide 27
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
©R. Schwartz
Equity Markets: Trading and Structure
Slide 28
A Call’s Contribution to
Market Quality
©R. Schwartz
Equity Markets: Trading and Structure
Slide 29
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
©R. Schwartz
Equity Markets: Trading and Structure
Slide 30
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
©R. Schwartz
Equity Markets: Trading and Structure
Slide 31
Nasdaq Volatility Differences Between
Feb 2004 and Feb 2005
One-minute Volatility
Feb 2004 (Pre-Calls)
w
60 bps
r ange
60
Feb 2005 (Post-Calls)
60 bps
r ange
60
40
40
20
20
0
0
0
30
60
90
120
150
180
210
240
270
300
330
360
390
0
30
60
90
120
150
i nt er val
©R. Schwartz
180
210
240
270
300
330
360
390
i nt er val
Equity Markets: Trading and Structure
Slide 32
Nasdaq Volatility Differences Between
Feb 2004 And Feb 2005
10-Second Volatility
Feb 2004 (Pre-Calls)
40 bps
r ange
40
5 Min After
Opening
40 bps
r ange
40
5 Min Before
Close
30
20
20
10
10
0
0
6
12
18
24
30
36
42
48
54
60
0
6
12
18
24
30
36
42
48
54
i nt er val
i nt er val
©R. Schwartz
5 Min Before
Close
5 Min After
Opening
30
0
Feb 2005 (Post-Calls)
Equity Markets: Trading and Structure
Slide 33
60