4370, 1st Semester 2015 - 2016
C
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Fundamentals of Derivatives Trading
Applying Options Theory in the Marketplace
Tobias Hekster
-Co-CIO and Senior Strategist, True Partner Fund
-Adjunct Professor, National Taiwan University
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4370: Fundamentals of Derivatives Trading Strategies
Lecture 1
Introduction to the Course
Introduction to Trading
Markets in Practice
Logistics of Markets (market microstructure)
Futures and Futures strategies
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Fundamentals of Derivatives Trading Strategies
Course Introduction
• Introduction of the Lecturers
• Course Structure and Objectives
• Group Projects
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Fundamentals of Derivatives Trading Strategies
Introduction of the Lecturers: Tobias Hekster
Personal Activities past 16 years:
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1996:
Master’s Degree in Economics, Rijksuniversiteit Groningen, The Netherlands
1997:
Finance Controller, Royal Dutch Shell, Rotterdam, The Netherlands
1998:
Options Trader, IMC Trading, Amsterdam, The Netherlands
2000:
Established Cash Arbitrage Desk, IMC Trading
2003:
Head-of-Trading, Holland Trading House, Chicago, USA
2008:
Head of Volatility Arbitrage, IMC Asia Pacific
2011:
Co-CIO and Senior Strategist, True Partner Fund
Adjunct Professor Chinese University of Hong Kong
Adjunct Professor National Taiwan University
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Fundamentals of Derivatives Trading Strategies
The aim of the course
• Understanding of both the theoretical foundation of Derivatives Trading as
implementing trading strategies in practice
• Lessons will be consist of a theoretical part where we will discuss Options Theory
and trading strategies
• The theory will be applied in practice, using various actual trading tools,
combined with real-time market data
• There will be an examination at the end of the course, which accounts for 65% of
the total score
• The remaining 35% will be based on group trading projects (30%) as well as class
participation in general (5%)
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Fundamentals of Derivatives Trading Strategies
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Group Projects
Group Project I: creating a structured product
• You will create a derivative structure on an underlying instrument of
your choice and write a ‘termsheet’ for retail investors.
•Price the option components and calculate profit profile for the
customer (and of course for the issuer)
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Fundamentals of Derivatives Trading Strategies
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Group and Individual Projects
Group Project II: Volatility Arbitrage Strategy
• select strategy and underlying product(s)
• calculate expected and realized results
• deliverable to be a ‘project proposal’ for the Head of Trading
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The evolution of Trading
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The evolution of Trading
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Introduction to Markets
•
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What are we looking at?
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What is a Market?
 A market is nothing more than a gathering of different opinions on the value
of the traded subject.
 A PRICE is a valuation attributed to an asset by any market participant, THE
PRICE is a valuation of the asset that all participants agree with.
 Central is the process of Price Discovery:
If market participants disagree on valuation, they will exchange the traded
object. The market clears if no participants are willing to trade with each
other anymore.
 The actual process how buyers and sellers are matched can differ per market
and per instrument traded. This is described as market (micro)structure and
is an important aspect of today’s trading
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Price Discovery in Practice
 Make an estimate for the number of McDonalds ‘restaurants’ in Hong Kong.
The different phases of the auction will show different processes of price discovery
 1st Phase: Open Auction
Each participant is able to submit a bid for the number of McDonalds’s.
- The highest bidder becomes the first buyer
- The ‘stand’ price for lower bidders remains in the book
This is the standard ‘winner takes all’ variety, most commonly known from the
world of art (or overpriced land for real estate development)
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Open auction
Trader
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Bid Price
Trader
Bid Price
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Price Discovery in Practice
• 2nd Phase: Book building process
The book on the buy side consists of the remaining ‘stand’ prices
- Bidders can join on the auction price
- Sellers can indicate they think the auction price is too high
If there is a surplus of sellers at the auction price, we look at the next ‘stand’
price and repeat the process. Auction matches:
- When there is an exact balance of buy and sell interests
- At the price where the most buys and sells are matched
This process is applied at most markets in the ‘pre-opening auction’. Instead of
direct matching, there is more room for price discovery prior to matching
trades (for example to digest overnight events and movement abroad)
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Book Building
Trader
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Bid Price
Trader
Ask Price
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Price Discovery in Practice
 3rd Phase: Continuous Trading
After the auction match, the book consists of:
- The bids that were below the auction match
- The offers that were above the auction match
All participants are allowed to change their mind and unwind their previous
trade. Participants who have not traded yet can decide to buy or sell on this
market.
At this point, you are allowed to activate your smartphone !!!
This trading phase mostly lasts for the remainder of the trading day. It is
noticeable how new information changes the market: changes in valuation
are immediately reflected and processed in the market
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Price Discovery in Practice
 Let’s replace the number of McDonalds’ with the value of one share in a
company.
 As opposed to a verifiable number (www.wikipedia.com) the value of a
share represents the stream of future cash flows, which are uncertain.
 Thus each one’s valuation is an expectation and an opinion of the
prospects of the company.
 If your valuation exceeds the best offer you should buy shares, if your
valuation is below the best bid you should sell shares
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Price Discovery in Practice
 While physically things have changed (electronic), the process does not
differ from the old town square markets of the middle ages, there are
differences between markets
 What makes a ‘good’ market:
 Number of orders in the market (more different opinions, for better
price discovery)
 Spread between the best bid and best ask price (it takes a smaller
difference of opinion to trade)
 Size of orders in the market (availability of volume to trade)
 Depth of the market (if I want to trade for size, how much more do I
need to pay)
 Transparency (are there hidden traders out there)
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Actual Order Books
 A ‘liquid’ stock: Royal Dutch Shell
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Actual Order Books (Cont.)
 A less liquid stock (the not so famous Dutch building firm Heijmans NV)
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Order Entry and ‘lingo’
 Suppose we disagree with the displayed market and think the price of the share
should be higher. (let’s look at the Heijmans example)
 What to do:
 Enter a bid to buy 1 share, whatever the price - ‘market order’
 Enter a bid to buy 1 share at EUR 15.635 - ‘lifting the offer’
 Enter a bid to buy 1 share at EUR 15.535 - ‘diming the bid’
 Enter a bid to buy 1 share at EUR 15.53 - ‘joining the bid’
 Enter a bid to buy 1 share at EUR 15.51 - ‘behind the market bid’
Each of these actions carries a different risk-reward pattern:
 The higher the bid price, the larger the certainty of execution (but at a cost)
 The lower the bid price, the more favorable the trading price will be (but only
if executed)
 This is called the cost of immediacy and is a key factor in all trading decisions
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Crossing the bid-ask: the cost of immediacy
Optimal trading strategies: factors that influence trading choice
Expected cost
Higher Risk Aversion
Decreasing order size
Shorter trade horizon
Increasing Liquidity
Increasing Volatility
Lower Risk Aversion
Increasing order size
Longer trade horizon
Decreasing Liquidity
Decreasing Volatility
Timing risk
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Crossing the bid-ask: the cost of immediacy
Optimal trading strategies: factors that influence trading choice
1) Risk Aversion: to what extent am I prepare to have uncertainty over my order
execution
2) Order Size: how many shares do I need to trade (for example, I need 5,000
shares of Heijmans)
3) Trade Horizon: how long do I have to execute my order
4) Liquidity: how much does historically trade in this stock.
5) Volatility: how much does this stock bounce around
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Structure of a Trading Day
 Opening Auction
• Overnight events drive greater need for Price Discovery
Order accumulation period
Continuous dissemination of indicated opening price (or the entire
book)
 1 matching moment, either random or fixed
 Continuous Trading
• Order book and Trade history suffices for Price Discovery
Immediate matching of trades
‘Time/price priority’ or ‘Allocation based’
 Circuit breakers
• The system should protect against deviations caused by sudden and large
imbalances in supply and demand
 Static Bandwidth
Dynamic Bandwidth
Volatility Interruptions
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Introduction to Markets
•
Why are markets important?
Aggregation of opinions results in optimal results
(i) Put your money where your mouth is
(ii) Efficient allocation of objects to the highest utility
(iii) More participants allow for potential counterparties
Sounds straightforward, but…
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Introduction to Markets
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• Put your money where your mouth is!
Where does this stock trade?
Firm Name
CA Cheuvreux
AlphaValue
ING Wholesale Banking
Oddo & Cie
Macquarie
Exane BNP Paribas
Standard & Poor's Equity Research
RBS
Deutsche Bank
Petercam
Rabobank International
Societe Generale
EVA Dimensions
Mediobanca SpA
Barclays Capital
Keefe, Bruyette & Woods
Kepler Capital Markets
ABN Amro Bank N.V.
Natixis
Bank Degroof(ESN)
Nomura
Citi
JPMorgan
Goldman Sachs
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Analyst
PLUIJGERS
NIJDAM
PLOEGH
SASSUS
STOEGNER
BOISSIN
SILVERMAN
NAGTEGAAL
BENHAKOUN
DE WIT
KLUIS
LEMAIRE
TEAM COVERAGE
ROVERE
SIGEE
LAMBERT
PETRARQUE
WEIDEMA
KOAGNE
LEEMANS
JOSHI
NEDIALKOV
FORMANKO
NEUEZ
Recommendation
underperform
buy
hold
neutral
neutral
neutral
hold
hold
hold
add
buy
hold
overweight
outperform
overwt/neutral
underperform
buy
buy
neutral
hold
buy
buy
overweight
not rated
M
M
M
M
M
M
M
M
M
U
M
M
M
M
M
M
M
M
M
M
M
M
M
M
Tgt Px
10
17
12.5
29.5
15
15
17
12.5
15.8
14.2
25
20
18
15
12.6
32
22
15.5
20
36
40
40
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Introduction to Markets
Put your money where your mouth is
- US elections: opinion polls vs online-betting
- Credit Ratings (remember AAA rated subprime CDO’s)
There is a difference between the value one disseminates, and the price
one is actually prepared to buy or sell an object at.
As opposed to talking, in trading the validity of one’s value and thus the
traded prices define profit. This course will define trading relating to the
perspective of Market Making, Liquidity Provision (which differs from the
end-user)
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The basics of Trading
As soon as one has a valuation of an object, one can trade
• Taking risk for a premium (or credit, buying the object below the
theoretical value or selling it above)
• Trying to dispose of that risk and lock in (part of) the premium
Credit: difference between our valuation and the current market price
Risk: possibility and magnitude of unfavorable outcomes
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The basics of Trading: Risk
The following formula roughly applies in general for measuring risk (using normal
distributions):
Risk = Value of Position * Volatility * SQRT (Time)
Please note:
• The longer the holding period, the increase of the risk is not linear
• Watch out for definitions of risk: forward looking standard deviation is reflective, but
backward looking it is not
• This model is applied by most banks (Value at Risk) and has some flaws
=> The willingness to take risk is Risk Tolerance
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The basics of Trading: Credit
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•
Premium = ‘credit’; difference between your valuation and the current market
price
•
A market price that is out of line according to your pricing model
•
No premium => no trade, only for gamblers
•
Yes! premium => trade if
Premium (‐ Cost) >= Risk Aversion * Risk
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The basics of Trading
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“Am I so clever or are they so stupid?”
•
Different traders have different goals. It's not smart people versus stupid people in
the marketplace.
•
You can have two traders each at the opposite side of a trade and both make money
because the scope of the trade may be different.
•
Beware of the ‘greater fool’ theory
•
There is no such thing as a free lunch (it’s all about risk / reward)
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The basics of Trading: A rigged coin flip
C U H K
• It is all about managing your risk and position
• Even with trading with credit al the time credit you can still go bankrupt!
• As an example: a rigged coin flip game:
– 60% chance of heads
– 40% chance of tails
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Trading Strategies: a rigged coin-flip gain
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Assume you can participate in the following game:
• Flip a coin that has a 60% to return Tails
• You can play the game an endless amount of times
• But you have to invest a fixed proportion of your capital each flip
• What percentage should I invest (or rather, bet)?
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Trading Strategies: a rigged coin-flip gain
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So even the best trade can kill you, when not properly managed…
(by the way, the answer is about 20% according to the Kelly Criterion)
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Market Micro Structure
•
Market structure and design
•
Trading Mechanism
•
Fees and Transaction Costs
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Markets Micro Structure
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Market Type
•
Quote Driven
•
•
•
•
Continuous display of bid- and ask prices
Take-it or leave it / Limited negotiation
Preference / Benefit of Quote provider
Order driven
•
•
•
All combined orders create the order book
Lack of orders hinders price discovery
All orders created equal (pure time-price or allocation)
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Markets Micro Structure
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Order Types (the more exotic ones)
•
•
•
•
•
•
•
Immediate or cancel
Fill or kill
Icebergs
Pegged orders
Flash orders
Routing orders (fragmented markets)
Intermarket Sweep orders (fragmented markets)
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Order Types
C U H K
Assume the orderbook is as follows:
Bid Size
Bid Price Ask Price Ask Size
500
251
252
300
100
250
253
600
1,000
249
254
300
The difference between IOC and FOK is as follows:
Buy 500 at 252 as type IOC will buy 300 and the remainder will be cancelled
Buy 500 at 252 as type FOK will not execute and be cancelled
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Order Types
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Assume the orderbook and trade list are as follows:
Bid Size
Bid Price Ask Price Ask Size
Time
Quantity Price
1,500
251
252
300
01:24:10
300
252
1,000
250
253
600
01:24:50
600
252
1,000
249
254
300
01:25:30
300
252
01:26:10
600
252
How to spot an Iceberg:
- Quite a lot seems to be trading at 252 in multiples of 300
- Does the 300 offer at 252 remain even after it traded
- If the offer at 252 would be for a far larger size, does that impact
your decision if you are offering at 253
=> Analysis of the order book is vital to trading (and automatable)
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Order Types
C U H K
Assume the orderbook is as follows:
Bid Size
Bid Price Ask Price Ask Size
500
251
252
300
200
250
253
600
1,000
249
254
300
A Pegged order intends to have a bid (ask) price that is related to the best bid
(ask) price in the book:
In this example, our order will always be:
- Our bid = Best Bid – 1 point
- Our ask = Best Ask + 1 point
Why do this: catch orders that are ‘walking the book’
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Order Types: fragmented markets
C U H K
Assume the orderbooks are as follows:
Market ABC
Market XYZ
Bid Size
Bid Price
Ask Price
Ask Size
Bid Size
Bid Price
Ask Price
Ask Size
500
250.50
251.50
300
1,000
250.00
251.00
1,000
200
250.00
252.00
600
700
249.50
251.50
500
1,000
249.50
252.50
300
300
249.00
252.00
400
When I send a buy order to market ABC, I could actually get better execution at
market XYZ. So I need to make a decision:
- What market to route my order to?
- Do I want to expose the order first in ABC and if no interest route to XYZ?
- If my order is larger than 1,000 shares, do I split the order?
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Order Types: fragmented markets
Market ABC
C U H K
Market XYZ
Bid Size
Bid Price
Ask Price
Ask Size
Bid Size
Bid Price
Ask Price
Ask Size
500
250.50
251.50
300
1,000
250.00
251.00
1,000
200
250.00
252.00
600
700
249.50
251.50
500
1,000
249.50
252.50
300
300
249.00
252.00
400
- If I expose the order briefly at market ABC, I cannot use an IOC order (as that
will immediately cancel)
- The concept of a ‘flash order’ was to briefly expose the order to a limited
number of participants on market ABC before routing away to XYZ
- This caused concerns of ‘frontrunning’ and has been discontinued
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Order Types: fragmented markets
Market ABC
C U H K
Market XYZ
Bid Size
Bid Price
Ask Price
Ask Size
Bid Size
Bid Price
Ask Price
Ask Size
500
250.50
251.50
300
1,000
250.00
251.50
1,000
200
250.00
252.00
600
2,000
249.50
252.00
2,500
1,000
249.50
252.50
300
300
249.00
252.50
1,400
- If I want to enter a large buy order at 251.00, how should I distribute over the
different exchanges?
• Based on current markets (XYZ shows more volume)
• Based on past statistics, either market could have more volume
• How to distribute between markets (‘one cancels the other’)
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Order Types: fragmented markets
Market ABC
C U H K
Market XYZ
Bid Size
Bid Price
Ask Price
Ask Size
Bid Size
Bid Price
Ask Price
Ask Size
5,000
250.50
251.50
5,000
18,000
250.50
251.00
50
200
250.00
252.00
600
2,000
250.00
251.50
500
1,000
249.50
252.50
300
3,600
249.50
252.00
1,400
- If I want to enter a large buy order (6,000) at 251.50:
• If I buy the 251.50 offer on market ABC, I have traded through the 251.00
offer on market XYZ (not allowed)
• If I buy the 251.00 offer first, I might scare away the offer at 251.50
=> The solution is an Intermarket Sweep order, which does exactly that.
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Order Types: fragmented markets
Market ABC
C U H K
Market KLM (dark pool)
Bid Size
Bid Price
Ask Price
Ask Size
Bid Size
Bid Price
Ask Price
Ask Size
5,000
250.50
251.50
5,000
18,000
Mid Mkt
Offer
24,000
200
250.00
252.00
600
1,000
249.50
252.50
300
- My buy order in the dark pool is just waiting for any selling interest. As soon as
a seller emerges at Mid Market, we would be matched at the Mid Market of
the primary market ABC
- If someone is interested in buying the offer at market ABC, they should also
check the dark pool, as an additional sell order is here at the offer (look at the
similarity with a pegged order)
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Order Types: in-house matching
Market ABC
C U H K
Client Orders
Bid Size
Bid Price
Ask Price
Ask Size
Bid Size
Bid Price
500
250.50
251.50
15,000
100
251.50
200
250.00
252.00
600
1,000
249.50
252.50
300
Ask Price
Ask Size
- The bank matches my order at 251.50 with their own trading desk
- I might get charged lower transaction fees, but the bank has a valuable
proposition, as they can trade at the bid and offer in the market, but take the
first pick
- Complaints that this drains liquidity from the primary market ABC are valid, as
well are concerns of best execution and paper trail
=> In house matching now only performed at price improvement as opposed to
just matching the market (SEC proposal)
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Fragmented markets
C U H K
Bid Size
Bid Price
Ask Price
Ask Size
Bid Size
Bid Price
Ask Price
Ask Size
500
250.50
251.50
5,000
1,500
250.50
251.50
1,000
200
250.00
252.00
600
200
250.00
252.00
600
1,000
249.50
252.50
300
1,000
249.50
252.50
300
Bid Size
Bid Price
Ask Price
Ask Size
Bid Size
Bid Price
Ask Price
Ask Size
500
250.50
251.00
1,000
500
250.50
251.50
600
200
250.00
252.00
600
200
250.00
252.00
600
1,000
249.50
252.50
300
1,000
249.50
252.50
300
Bid Size
Bid Price
Ask Price
Ask Size
Bid Size
Bid Price
Ask Price
Ask Size
15,000
Mid Mkt
Offer
5,000
500
251.00
251.50
3,000
4,000
Bid
200
250.00
252.00
600
1,000
249.50
252.50
300
Comparing and routing
becomes humanly
impossible…
The US has now over
50 different venues
Bid Size
Bid Price
Ask Price
Ask Size
Bid Size
Bid Price
Ask Price
Ask Size
500
250.50
251.50
900
500
250.50
251.50
700
200
250.00
252.00
600
200
250.00
252.00
600
1,000
249.50
252.50
300
1,000
249.50
252.50
300
© True Partner Education Ltd 2014
Markets Micro Structure
C U H K
Market Transparency
•
Lit Markets
•
•
•
•
•
Entire order book is displayed
Trades follow visible matching of trade intensions
Price discovery takes place
Primarily limit orders
Dark pools
•
•
•
•
Part or none of the order book is displayed
Trades occur if invisible intensions match
Depends on price discovery elsewhere
Primarily pegged orders
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Markets Micro Structure
C U H K
Trading Mechanism
•
•
•
Continuous trading (oddly named Continuous Auction)
Periodic auctions
Request for quotation
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Continuous Trading
-
C U H K
Orders can be entered into the order book
As soon as an entered order equals or crosses an opposite order, the trade
is matched
Residual orders remain in the order book
Bid Size
Bid Price Ask Price Ask Size
500
251
252
300
100
250
253
600
1,000
249
254
300
What happens if I enter an offer for 600 shares at 251?
What happens if I enter a bid for 500 shares at 250?
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Continuous Trading
C U H K
What happens if I enter an offer for 600 shares at 251?
What happens if I enter a bid for 500 shares at 250?
Bid Size
Bid Price Ask Price Ask Size
600
250
251
100
1,000
249
252
300
253
600
What happens if now an offer of 100 is entered at 250?
- Time price priority (‘first come, first serve’)
- Allocation algorithm (‘all is shared’)
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Continuous Trading
C U H K
What happens if now an offer of 100 is entered at 250?
Bid Size
Bid Price
Ask Price
Ask Size
100 (bid 1)
250
251
100
500 (bid 2)
250
252
300
1,000
249
253
600
- Time price priority (‘first come, first serve’)
Bid 1 executes all 100
- Pro-rata allocation algorithm (‘all is shared’)
Bid 1 executes 16, bid 2 executes 84
Due to these incentives, time/price markets tend to be tight for
smaller displayed volumes, whereas pro-rata markets tend to be wider
for large displayed volumes
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Auction
-
C U H K
Orders can be entered into the order book
As soon as an entered order equals or crosses an opposite order, an
indicative matching is disseminated
Matching orders remain in the order book
At one moment (the Auction Match), matching orders are matched
Unmatched orders remain in the order book
Bid Size
Bid Price Ask Price Ask Size
500
251
252
300
100
250
253
600
1,000
249
254
300
What happens if I enter an offer for 600 shares at 251?
What happens if I enter a bid for 500 shares at 250?
© True Partner Education Ltd 2014
Auction
C U H K
What happens if I enter an offer for 600 shares at 251?
What happens if I enter a bid for 500 shares at 250?
Bid Size
Bid Price Ask Price Ask Size
500
251
251
600
600
250
252
300
1,000
249
253
600
Indicative Match Price:
Indicative Match Quantity:
251
500
What happens if I enter another offer for 400 at 250?
© True Partner Education Ltd 2014
Auction
C U H K
What happens if I enter another offer for 400 at 250?
Bid Size
Bid Price Ask Price Ask Size
500
251
250
400
600
250
251
600
1,000
249
252
300
If the matching price would be 250, that means that not all the
bids above 250 will get execution at the lower price of 250. That
cannot be, thus:
Indicative Match Price:
Indicative Match Quantity:
251
500
Now another offer appears, at 250 for 200 shares
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Auction
C U H K
What happens another offer for 200 at 250? (so 600 offered in total)
Bid Size
Bid Price Ask Price Ask Size
500
251
250
600
600
250
251
600
1,000
249
252
300
If the matching price would be 251, that means that not all the
offers at 250 will get execution at 251.
Indicative Match Price:
Indicative Match Quantity:
250
600
Within the auction, equal orders again are to be allocated time/price or
pro-rata
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Markets Micro Structure
C U H K
Transaction costs
•
Direct transaction costs
•
•
•
•
•
Stamp duty
Brokerage fee
Exchange fee
Clearing fee
Indirect transaction costs
•
•
Bid / ask spread
Market impact
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C U H K
Futures
 “A standardized contract between two parties to exchange a specified asset for
a price agreed today with delivery taking place at a specified date in the future”
 Futures are the oldest financial instruments, dating back to ancient Greece (the
irony!) with descriptions by Aristotle of a futures contract on Olives for pressing
into olive oil. (developed by a philosopher turned trader)
 All types of underlyings (currencies, commodities, shares, energy-transfercapacity, etc)
 Index Future: the underlying asset of the future is the value of the index
 Hang Seng Future
 S & P 500 Future
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C U H K
Futures vs Forwards:
Both instruments are agreements to:
- Exchange a certain underlying instrument
- At an agreed price
- At an agreed point in the future
The difference is that Futures are listed and cleared through the facilities of an
exchange, whereas Forwards are OTC contracts between two parties
=> Forwards are subject to counterparty risk (Lehman Brothers)
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C U H K
Futures vs Forwards:
The process of Novation:
A trade between Buyer A and Seller B is split into two different positions:
- Buyer A buys from the Clearing House (‘central counterparty’)
- Seller B sells to the Clearing House
Buyer A
Clearing House
Seller B
After the Matching of the trade, there is no relation between A and B,
both only have counterparty risk towards the Clearing House
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C U H K
Futures: marking-to-market
As the Clearing House bears all the counterparty risk, it will ask the
traders to post a deposit at the clearing bank: Margin
On a daily basis, outstanding contracts will be settled to the closing
price of the day (‘marking to market’)
Based on the mark to market, a payment will accrue between
counterparties of a futures trade, reflecting the daily change in the
price of the future
For example, if the TAIEX future drops 10 points (contract size NT$ 200) this results in a
transfer of NT$ 2,000 from the buyer to the Clearing House and on to the seller
Buyer
Clearing House
- NT$ 2,000
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Last mark: 7,500
New mark:7,490
Seller
+ NT$ 2,000
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Futures: Contract specifications
C U H K
 Hang Seng Future
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Futures: Contract specifications (Cont.)
C U H K
 S&P 500 Future
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C U H K
How to price a Future:
 “Cash and Carry Arbitrage”
 If you are to deliver the value of an index, one year from now, how to hedge?
Buy the index right now!
 You make an investment today equal to the current index
 You will incur interest costs over this investment
 You will receive dividends over the holding period
Future = Spot + Interest – Dividends
 It works the same for receiving the value of the index:
 You will receive an amount today equal to the current index
 You will receive interest costs over this investment
 You will pay dividends over the holding period
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C U H K
How to price a Future: (Cont.)
 Theoretically, the future should always trade at this level!
 In practice, there are reasons for deviation:
 If you want to sell shares, you need to borrow them. This requires a
payment, thus your net received interest will be lower
 Not all dividends are already known, so other participants could have other
predictions
 Stamp duty and other costs (in Hong Kong, 10 bbp stamp duty corresponds
with 22 points in the Hang Seng!)
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C U H K
How to price a Future: (Cont.)
 Hang Seng Future: different maturities
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C U H K
How to price a Future: (Cont.)
 This formula applies for all different maturities:
Future (September) = Spot + Interest (now to Sept) – Dividend (now through Sept)
Future (December) = Spot + Interest (now to Dec) – Dividend (now through Dec)
 Note that the Spot value is a common factor, therefore the difference
between the futures - The Future Roll
Future Roll (Sept, Dec) = Interest (Sept to Dec) – Dividend (Sept through Dec)
 If you buy the future roll (that is buy December future, sell September
future), you will have the following risks:
 Change in the interest rate between Sept and Dec
 Change in dividends between Sept and Dec
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C U H K
Future roll: example
 In February 2008, the French bank Societe Generale had to announce a massive
loss of several billion Euros, as one of their traders had accumulated an
enormous rogue position
 Societe Generale is a large component of the French CAC40 index
 Societe Generale is the only CAC40 component to pay a dividend in early March
 If you hear the news hitting the tape, what would you do:
a) Buy the March – February Future Roll in the CAC40 (+ March, - February)
b) Sell the March – February Future Roll in the CAC40 (- March, + February)
c) Do nothing
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C U H K
The Future tail
 Is there no risk whatsoever to movements in the spot?
Let’s look at the formula for the future roll:
Future Roll (Sept, Dec) = Interest (Sept to Dec) – Dividend (Sept through Dec)
 The interest is calculated over the spot price
So the higher the Spot, the higher the interest amount!
The future can move more than the underlying, this is called the future tail.
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Future tail example: the infamous
Volkswagen saga
C U H K
 In the end of October 2008, Porsche announced their stake in competitor
Volkswagen was far larger than previously known. The result was the ‘mother of
all short squeezes’ with shares of Volkswagen briefly exceeding EUR 1,000
 A market making firm traded long term dividend expectations in Volkswagen by
spreading the following position:
- Long 100,000 shares of Volkswagen
- Short 100,000 stock futures in Volkswagen (1 year maturity)
 Assume the following:
- Interest rate 3% per annum
- Dividend of EUR 2.00 paid at the end of 2008
- Share price rises to EUR 1,000 from EUR 300 before the announcement
 When the local head of trading calls that “there appears to be some money
missing in the trading sheet”, was that true and if so, how much?
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Future tail example: the infamous
Volkswagen saga
C U H K
 A market making firm traded long term dividend expectations in Volkswagen
by spreading the following position:
- Long 100,000 shares of Volkswagen
- Short 100,000 stock futures in Volkswagen (1 year maturity)
 Assume the following:
- Interest rate 3% per annum
- Dividend of EUR 2.00 paid at the end of 2008
- Share price rises to EUR 1,000 from EUR 300 before the announcement
 Old futures price:
New futures price:
Loss on futures:
Gain on stock:
EUR 300 x 1.03 – 2.00 = EUR 307
EUR 1,000 x 1.03 – 2.00 = EUR 1,028
EUR -/- 72,100,000
EUR 70,000,000
Missing from the sheet: -/- EUR 2,100,000
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C U H K
Future trading strategy: examples
 Contract Specifications
SGX
Eurex
Tick Size
1 point tick
1 point tick
Contract Size
USD 10 x index pt
EUR 10 x index pt
They certainly look suitable for spread strategies:
• Translate liquidity by quoting SGX at an edge
• Quoting both sides for ‘order book benefit’
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C U H K
Future trading strategy: examples (Cont.)
 Quoting a dual listing
Eurex Market
SGX Market
Q bid
P bid
P ask
Q ask
Q bid
P bid
P ask
Q ask
300
2,801
2,802
150
100
2,800
2,804
150
1,400
2,800
2,803
200
200
2,798
2,805
100
200
2,799
2,804
650
150
2,796
2,806
300
We can ‘lean’ on the Eurex market and allow for 1 tick of credit quoting SGX;
When traded, immediately hedge on Eurex.
Eurex Market
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SGX Market
Q bid
P bid
P ask
Q ask
Q bid
P bid
P ask
Q ask
300
2,801
2,802
150
200
2,800
2,803
50
1,400
2,800
2,803
200
200
2,798
2,805
100
200
2,799
2,804
650
150
2,796
2,806
300
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C U H K
Quoting a dual listing
 The benefit of this strategy is the translation of liquidity from the main product
(Eurex) to the alternative listing (SGX). This in turn provides retail investors with
a better market and is thus crucial for the success of the alternative listing
One can place multiple quotes at all layers of the book (even reverse)
 As the pricing is so obvious, this strategy is highly competitive
 Quoting holds significant exposure:
 When the market in the liquid instrument changes, one needs to immediately
adjust prices in the market
 When the quoter trades, one needs to immediately hedge in the liquid future
It is all about being fast (“ultra-low latency”)
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C U H K
What is ‘Latency’
•
Latency: microsecond is 0.000001 seconds……blink of an eye 100 – 150 milliseconds
•
Latency represents the inherent delays in transmitting and processing data (for orders
or market data prices)
=> Minimize distances involved: Co-location
=> Optimize internal processing
=> Keep data messages as small as they can
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C U H K
Dual listings on the same underlying: hitting
 Quoting a dual listing
Eurex Market
SGX Market
Q bid
P bid
P ask
Q ask
Q bid
P bid
P ask
Q ask
300
2,801
2,802
150
100
2,800
2,804
150
1,400
2,800
2,803
200
200
2,798
2,805
100
200
2,799
2,804
650
150
2,796
2,806
300
 We can ‘lean’ on the Eurex market and pre-define a potential order(s),
we can shoot into the market at will:
Market
Volume
Side
Price
Type
SGX
50
Sell
2,803
IOC
SGX
50
Sell
2,800
IOC
• Order 1 waits for an 2,803 bid to appear on SGX
• Order 2 waits for an 2,799 offer to appear on Eurex
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C U H K
Dual listings on the same underlying: hitting
 The benefit of this strategy is to increase the likelihood of execution for orders
In the alternative instrument. But contrary to quoting, the price discovery in
The alternative instrument does not benefit
Multiple potential orders can be generated, based on all layers of both books.
But opposite to quoting, if bid/ask of market is taken, hitter does not participate
 Hitting can be a predatory strategy
 Injecting a new order into the market is mostly faster than modifying an
existing order (the quoter gets ‘picked off’)
 The hitter has no obligation or exposure, just lays in ambush
It is still all about ultra-low latency
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C U H K
Spreading 2: jumping the queue
 Quoting a dual listing
Eurex Market
SGX Market
Q bid
P bid
P ask
Q ask
Q bid
P bid
P ask
Q ask
1,400
2,800
2,801
150
100
2,799
2,802
150
200
2,799
2,802
200
200
2,798
2,803
100
350
2,798
2,803
650
150
2,796
2,804
300
 We can ‘lean’ on the bid-size on Eurex and match it on SGX:
Eurex Market
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SGX Market
Q bid
P bid
P ask
Q ask
Q bid
P bid
P ask
Q ask
1,400
2,800
2,801
150
100
2,800
2,802
200
200
2,799
2,802
200
100
2,799
2,803
150
350
2,798
2,803
650
200
2,798
2,804
100
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C U H K
Spreading 2: jumping the queue (Cont.)
 When buy 14 futures at 2,800 at SGX we can do the following:
• Offer 14 futures at 2,801 on SGX for a ‘scalp’
• Offer 10 futures at 2,801 on Eurex for a ‘scalp’
• ‘Scratch’ by selling 10 futures on Eurex at 2,800 if the market bid shrinks
Eurex Market
SGX Market
Q bid
P bid
P ask
Q ask
Q bid
P bid
P ask
Q ask
1,400
2,800
2,801
250
200
2,800
2,801
100
200
2,799
2,802
200
200
2,798
2,802
200
350
2,798
2,803
650
150
2,796
2,803
150
 The purchase at 2,800 has a positive expected value !
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Dual listings on the same underlying: queue
jumping
C U H K
 When we investigate the result of the 3 potential outcomes:
 Offer 2,801 on SGX for a ‘scalp’
- P&L is USD 140 minus transaction costs * = USD 112
 Offer 2,801 on Eurex for a ‘scalp’
- P&L is USD 140 minus transaction costs (applying EUR/USD at 1.40)
 Sell at 2,800 if the market bid shrinks (‘scratch’)
- P&L is -/- the transaction costs = -/- USD 28
* Assumes transaction costs are USD 1 per future (and EUR 1 on Eurex)
If this trade works out more than 1-in-4, it has a positive net expected value
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Dual listings on the same underlying: queue
jumping (Cont.)
C U H K
 This ‘second generation’ HFT strategy even further benefits the liquidity in the
alternative instrument, as prices could even match the liquid instrument.
 Requires more parameters to be successful:
 What size on Eurex is deemed sufficiently large
 How long should one hold the position before ‘scratching’
When parameters are identical, the fastest execution is the difference.
When the bid shrinks, it becomes a game of chicken: who dares to stick to his
position the longest…
It is even more about ultra-low latency
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C U H K
Appendix: twist to the previous dual-listing?
The SGX product is ‘quantoed’: the underlying index is calculated
in EUR, but the SGX listing trades in USD. Does that matter?
Just a headline in Reuters:
GLOBAL MARKETS-Stocks sink, dollar rallies
on risk aversion
Assume we have the following position:
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Position
Instrument
Price
Delta
Currency
Long 100
Future Eurex
2,800
1,000
EUR
Short 140
Future SGX
2,800
-/- 1,400
USD
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C U H K
Appendix: twist to the previous dual-listing?
Suppose the EuroStoxx drops 50 points, with the Euro/Dollar
rate unchanged at 1.40
Position
Instrument
Result (local)
Result (USD)
Long 100
Future Eurex
-/- EUR 50,000
-/- 70,000
Short 140
Future SGX
USD 70,000
70,000
Net Result
0
=> The position remains fully hedged
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C U H K
Appendix: twist to the previous dual-listing?
Suppose the EuroStoxx drops 50 points, but now the previous
headline materializes and the Euro/Dollar drops to 1.38
Position
Instrument
Result (local)
Result (USD)
Long 100
Future Eurex
-/- EUR 50,000
-/- 69,000
Short 140
Future SGX
USD 70,000
70,000
Net Result
1,000
=> We earn money as the loss is in the depreciating currency and the
profit is in the appreciating currency
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C U H K
Appendix: twist to the previous dual-listing?
But in the past, what was good for the US Dollar, was good for
the European exporters. Suppose in this regime, the EuroStoxx
rises 50 points combined with a drop in Euro/Dollar to 1.38
Position
Instrument
Result (local)
Result (USD)
Long 100
Future Eurex
EUR 50,000
69,000
Short 140
Future SGX
-/- USD 70,000
-/- 70,000
Net Result
-/- 1,000
=> We lose money as the loss is in the appreciating currency and the
profit is in the depreciating currency
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C U H K
Appendix: twist to the previous dual-listing?
In the below graph, all scenario’s are depicted: the result in
Index Points of different movement results
15
10
5
Change EUR/USD
0
-5
3.75%
2.25%
0.75%
-0.75%
-10
-15
-2.25%
-3.75%
Change in Stoxx 50
For example, if the index moves up 1.5% and the Euro moves up 0.75% the effect is a
gain equivalent to 0.5 index points
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C U H K
Appendix: twist to the previous dual-listing?
So these effects, while relatively small on a day-to-day basis,
could add up over the life of a future contract.
While symmetric, the results do become more pronounced in
times of volatility
 If a correlation (‘risk-on, risk-off’) is present there should be
a premium/discount between USD and EUR denominated
futures
 Imagine the earthquake in Japan last March and the effect on
dual-listed Nikkei futures (in JPY or USD): a 10% move in the
Nikkei and a 4% move in the USD/JPY exchange rate
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C U H K
The Concept of Pairs Trading
Every stock has its alpha
• The ‘classic’ Capital Asset Pricing Model has beta as ‘just’ the indexrelated performance and alpha as specific (out)performance
• While we see this terminology commonly in hedge-fund lingo, the key
underlying concept is that instruments have a tendency to move in a
correlated fashion
• This moving in tandem mostly has obvious reasons
- Similar type of companies (Bank of China vs ICBC)
- Non-fungible dual listings (Swire ‘A’ shares vs Swire ‘B’ shares)
- Company and their products (Exxon Mobile vs West Texas
Intermediate (crude))
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The Concept of Pairs Trading
C U H K
How to benefit
The ‘classic’ Pairs trade aims to benefit from the fact that instruments move in
tandem:
When instruments move purely in tandem, they are near perfect hedges
• Which one is cheaper to trade (bid/ask spread)
• We can provide liquidity in the wider instrument
When the individual instruments’ deviation can be assumed to be noise
• The relationship between their prices will be mean reverting
• We can trade the mean reversion and amplitude embedded in this noise
In both cases, our position will be spreading the two instruments
General market exposure (‘beta’) is minimized
The position will be driven by specific exposures (‘alpha’)
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The Concept of Pairs Trading
C U H K
The alpha slide revisited
While we see this terminology commonly in hedge-fund lingo, the key underlying
concept is that instruments usually have a tendency to move in a correlated fashion
This moving in tandem mostly has obvious reasons
Similar type of companies (Sun Hung Kai vs Cheung Kong)
Non-fungible dual listings (Volkswagen shares vs Volkswagen preferreds)
Company and their products (BP vs West Texas Intermediate (crude))
Single stocks are more susceptible to shock events than indices
Over the past years, correlations between equity indices were at elevated levels
(within the Euro zone economies above 90%)
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C U H K
Spreading two correlated instruments
We can apply the same logic to futures on different indices, as long as
the relation between them is tight
• Consider the two main European index futures:
DAX
EURO STOXX 50
Constituents
30 German
50 Eurozone
Cross Members
14
14
Cross Weight
78 %
34 %
• Of the main, liquid, European indices, this pair exhibits the
highest correlation (0.956 over the past year)
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Creating a Future Pairs strategy
C U H K
Once we have established which instruments to trade, how to build the strategy
from here:
1) Which leg shall we quote in, which leg will be our hedge
2) What is the (theoretical) relationship between the two legs
3) Define trading parameters:
• Credit
• Position adjustment
• Time-based adjustment
4) ‘Backtesting’ and Risk Tolerance
5) Practical considerations
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Creating a Future Pairs strategy
C U H K
Selecting the Underlying and the ‘Quotee’
If we observe the two contracts:
DAX
EURO STOXX 50
Contract Size
EUR 25 per point
EUR 10 per point
Tick Size
0.5 point
1.00 point
Last Traded
6,763
2,313
Contract Value
EUR 169,075
EUR 23,130
Spread (bps)
0.7 bps
4.3 bps
In order to benefit from quoting a wide market, we quote in the
EURO STOXX and hedge in the DAX
For a similar contract value on both legs, we will trade 1 DAX future
vs 7 EURO STOXX
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Spreading two correlated instruments
C U H K
Setting a (theoretical) relationship
The next step is to define a theoretical level, to base our initial quotes on:
Bid Price
Ask Price
DAX
6,800
6,800.50
Euro Stoxx 50
2,311
2,312
Applying a straight ratio, we could define the following relationship:
Euro Stoxx = 0.34 x DAX
What does the ratio indicate:
Ratio’s above 0.34: Euro Stoxx rises and/or DAX declines since our fixing
Ratio’s below 0.34: Euro Stoxx declines and/or DAX rises since our fixing
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Spreading two correlated instruments
C U H K
Setting a (theoretical) relationship
Assuming the following markets in the futures:
Bid Price
Ask Price
DAX
6,800
6,800.50
EURO STOXX 50
2,311
2,312
Applying the ratio of 0.34, we would get the following theoretical pricing:
Bid Price
Ask Price
EURO STOXX 50
(actual)
2,311
2,312
EURO STOXX 50
(theoretical)
2,312
2,312.17
=> So should we buy the Euro stoxx future at 2,312 (and sell the DAX future
at 6,800?)
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Spreading two correlated instruments
C U H K
Defining trading parameters
On the previous slide, our theoretical bid price matched the offer in the
market, but…
- The objective is to earn money, which trading at theoretical will not help
in
- There are transaction costs and other frictions involved
- Quoting (and trading in general!) carries risks, which we intend to be
rewarded for
 We should take a ‘credit’ every trade we do; let’s assume 2 index points
in the Euro Stoxx futures
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Spreading two correlated instruments
C U H K
Mechanics of a spread trading strategy: theoretical pricing
Looking again at the market in the futures:
Bid Price
Ask Price
FDAX
6,800
6,800.50
SX5E
2,311
2,312
Applying the ratio of 0.34, and our 2 points credit, we calculate *
SX5E
Theoretical Bid
Theoretical Ask
2,310
2,314.17
* Calculation: Theo Bid = Ratio x FDAX bid – credit: 0.34 x 6,800 – 2 = 2,312
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Spreading two correlated instruments
C U H K
Defining trading parameters
Assume the same market in the futures:
Bid Price
Ask Price
DAX
6,800
6,800.50
EURO STOXX 50
2,311
2,312
Applying the ratio of 0.34 as well as a credit of 2 points, we would get the following
theoretical pricing
Bid Price
Ask Price
EURO STOXX 50 (actual)
2,311
2,312
EURO STOXX 50
(theoretical)
2,310
2,315*
The calculation remains straightforward: Theo Bid = Ratio x DAX Bid – Credit (0.34 x
6,800 – 2 = 2,310)
* As the tick size is a full point in the EURO STOXX, we should round-up our theoretical price
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Spreading two correlated instruments
C U H K
Defining trading parameters
Assuming the same market in the DAX futures, our quote will be as follows:
Bid Price
Ask Price
FDAX
6,800 (Market)
6,800.50 (Market)
SX5E
2,310 (Our)
2,315 (Our)
In our dreams, assuming an unchanged market in the DAX future, we would
trade on both sides of our quotes (‘the noise happens in the Euro Stoxx future’)
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Buy 7
SX5E
2,310
Sell 1
FDAX
6,800
Sell 7
SX5E
2,315
Buy 1
FDAX
6,800.50
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Spreading two correlated instruments
C U H K
Defining trading parameters
In this fine scenario, we make one full ‘scalp’
In the Euro Stoxx, we scalp 5 points over 7 futures:
5 x 7 x EUR 10 = EUR 350
In the DAX, we have to give away the bid/ask spread over 1 future:
0.5 x 1 x EUR 25 = -/- EUR 12.50
 overall, one full scalp earns us EUR 337.50
 In terms of the ratio, we do two trades:
• Buy the ratio at 0.3397 (which is 2,310 / 6,800)
• Sell the ratio at 0.3404 (which is 2,315 / 6,800.50)
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Spreading two correlated instruments
C U H K
Defining trading parameters
As in the previous slide, we start with buying the ratio...
Buy 7
EURO STOXX 50
2,310
Sell 1
DAX
6,800
But after these two trades, the market remains as is:
Bid Price
Ask Price
DAX (market)
6,800
6,800.50
EURO STOXX 50 (us)
2,310
2,315
EURO STOXX 50 (market)
2,309
2,310
So what is next?
101
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Spreading two correlated instruments
C U H K
Defining trading parameters
We now have a position in the spread (as we did a ‘half scalp’)
The goal of our strategy is to capture the bid/ask spread and trade the ‘noise’
in the spread. Therefore, we do need to continue quoting in the market.
As the bid in the DAX is still 6,800, our theoretical bid would still be 2,310,
but with this bid we will trade another half scalp, do we want that?
With the offer in DAX at 6,800.50, our theoretical offer would still be 2,315
but would we be prepared to accept a lower price, to unwind our risk?
If the answer to both questions is “yes”, we have intuitively changed our
valuation of our position.
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Spreading two correlated instruments
C U H K
Defining trading parameters
As this strategy is not a pure arbitrage (the 0.34 ratio is not set in stone),
we do not have infinite risk appetite.
•We are only prepared to accumulate more position at a better price
•We are prepared to unwind our position at a lower credit
The position should be reflected in our theoretical pricing:
“for every 7 Stoxx futures in my portfolio, I reduce my theoretical value
with two index points”
This concept is the cornerstone of continuous trading strategies and referred
to as Inventory Based Pricing
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Spreading two correlated instruments
C U H K
Defining trading parameters
Applying Inventory Based Pricing results in the following new quote:
Bid Price
Ask Price
Position
DAX (market)
6,800
6,800.50
-1
EURO STOXX 50 (market)
2,309
2,310
7
EURO STOXX 50 (theo)
2,308
2,313
Our theoretical bid and ask price are calculated as follows:
Theo Bid = 0.34 x Bid (DAX) – Credit – 2x Position (SX5E) / 7
Theo Bid = 0.34 x 6,800 – 2 – 2 x 7/7 = 2,308
Theo Ask = 0.34 x 6,800.50 + 2 – 2 x 7/7 = 2,313 (rounded up)
104
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Spreading two correlated instruments
C U H K
Defining trading parameters
If we would make a full scalp afterwards, the revenue has changed:
Buy 7
EURO STOXX 50
2,310
Sell 1
DAX
6,800
Sell 7
EURO STOXX 50
2,313
Buy 1
DAX
6,800.50
We ‘scalp’ 3 points in the 7 Euro Stoxx futures (EUR 210), but we incur a cost of
0.5 points in the DAX future (-/- EUR 12.50) for an overall result of
EUR 197.50
105
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Spreading two correlated instruments
C U H K
Defining trading parameters
While the Inventory Based Pricing avoids immediate accumulation, it does
not eliminate position risk:
Suppose the Euro Stoxx slides lower, while DAX remains unchanged… (Spain
anyone?)
106
Trade
Price
Position
Av. Price
Profit
7
2,310
7
2,310
0
7
2,308
14
2,309
-/- 140
7
2,306
21
2,308
-/- 420
7
2,304
28
2,307
-/- 840
7
2,302
35
2,306
-/- 1,400
7
2,300
42
2,305
-/- 2,100
7
2,298
49
2,304
-/- 2,940
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Spreading two correlated instruments
C U H K
Defining trading parameters
With a revenue of one full scalp of EUR 197.50, the losses from
accumulated positions will start to dwarf the scalp revenue
1,000
2,310 2,308 2,306 2,304 2,302 2,300 2,298 2,296 2,294 2,292
(1,000)
(2,000)
(3,000)
position loss
one scalp
(4,000)
(5,000)
(6,000)
(7,000)
As the position accumulates, please note that 14 points (60 bps) already
generates a loss of almost USD 4,000, whereas the revenue of one scalp is
about 1/20 thereof…
107
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Spreading two correlated instruments
C U H K
Defining trading parameters
Left unchecked, our position continues to grow if the trend persists
with position losses accelerating
At one point our position is so large that revenue from one scalp is dwarfed
by the impact of one tick movement in the future
One could consider applying time-based position adjustment as well
“if the trend does not reverse within 2 minutes, my original assumption of
immediate mean-reversion is flawed, thus I need to lower the theoretical value of
the EURO STOXX 50 by 1 point”
108
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Spreading two correlated instruments
C U H K
Defining trading parameters
The parameters as defined in the previous slides are crucial to the success of a
pairs trading strategy:
• Credit: a wider credit will make for more profitable scalps, though less
frequent
• Position Adjustment: a more aggressive position adjustment will reduce the
severity of accumulation, but at the cost of reducing scalp revenue
• Time-based Adjustment: quicker reduction of position will further reduce
the severity of accumulation, but temporary losses will be locked-in more
quickly
=> Set the right parameters (and recognize the regimes for each set) !
109
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Spreading two correlated instruments
C U H K
Backtesting and Risk Tolerance
=> Set the right parameters (and recognize the regimes for each set) !
Easier said than done, but l’histoire se repete (and we have buckets of historical
data)
110
- What pair to select:
* correlation and also co-integration
* short-term volatility exceeds long-term volatility
- What settings to use:
* run all varieties though the historical data-set
- Regimes:
* higher volatility would call for larger credits
* Increased trendiness would call for more
aggressive adjustments
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Spreading two correlated instruments
C U H K
Mechanics of a spread trading strategy: Technical Dependencies
•Feed: we quote in Stoxx based on the DAX; if our pricefeed for the DAX
is delayed, we will quote incorrect prices
•Position : we base our adjustments on our position; if we receive incorrect
position data, we will quote incorrect prices
•Latency: the products are correlated; if we sell in the Stoxx, we need to
be fast in getting our hedge trade in the DAX
•Trading state: we assume both markets are trading simultaneously; what
happens if a circuit breaker triggers an auction (CAC vs DAX !)
111
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Spreading two correlated instruments
C U H K
And finally a word of warning: Mind the tail events!
112
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Creating a Future Pairs strategy
C U H K
The Hang Seng vs H-Shares futures
Hang Seng
H-Shares
Contract Size
HKD 50 per point
HKD 50 per point
Typical Spread Width
1.00 point
2.00 points
Last Traded
20,000
10,000
Contract Value
HKD 1,000,000
HKD 500,000
Spread (bps)
0.5 bps
2.0 bps
How would we trade this pair:
a) Quote in Hang Seng with 1 future, hedge in H-Shares with 2 futures
b) Quote in Hang Seng with 2 futures, hedge in H-Shares with 1 future
c) Quote in H-Shares with 2 futures, hedge in Hang Seng with 1 future
d) Quote in H-Shares with 1 future, hedge in Hang Seng with 2 futures
113
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Creating a Future Pairs strategy
C U H K
The Hang Seng vs H-Shares futures
Let’s we apply a ratio of 0.50 and require a credit of 2 points
If we observe the following markets:
Bid Price
Ask Price
Hang Seng
20,002
20,003
H-Shares (market)
10,002
10,004
a) We will join the offer at 10,004 points
b) We will improve the offer to 10,003 points
c) We will hit the bid at 10,002 points
114
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Creating a Future Pairs strategy
C U H K
The Hang Seng vs H-Shares futures
Let’s we apply a ratio of 0.50 and require a credit of 2 points
If we observe the following markets:
Bid Price
Ask Price
Hang Seng
20,002
20,003
H-Shares (market)
10,002
10,004
H-Shares (our)
9,999
10,004
So if you would look in terms of the ratio between Hang Seng and H-Shares,
we are quoting the following
Bid price: 0.4999 (9,999 vs 20,002)
Ask price: 0.5001 (10,004 vs 20,003)
115
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Creating a Future Pairs strategy
C U H K
The Hang Seng vs H-Shares futures
Let’s we apply a ratio of 0.50 and require a credit of 2 points
If we observe the following markets:
Bid Price
Ask Price
Hang Seng
20,002
20,003
H-Shares (market)
10,002
10,004
H-Shares (our)
9,999
10,004
Assume we would do a full ‘scalp’ (i.e. buying and selling H-Shares at our
prices and hedging in the Hang Seng, how much do we earn:
a)
b)
c)
d)
116
HKD 200
HKD 450
HKD 500
Cannot calculate
© True Partner Education Ltd 2014
Creating a Future Pairs strategy
C U H K
The Hang Seng vs H-Shares futures
Let’s we apply a ratio of 0.50 and require a credit of 2 points
If we observe the following markets:
Bid Price
Ask Price
Hang Seng
20,002
20,003
H-Shares (market)
10,004
10,006
H-Shares (our)
9,999
10,004
Most likely, we would start trading with one side: a ‘half scalp’
As we do not want to limitlessly increase our position, we need to make
an adjustment after having traded:
“for every 2 H-Shares futures I buy (sell), I will decrease (increase) my
theoretical value by 2 points”
117
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Creating a Future Pairs strategy
C U H K
The Hang Seng vs H-Shares futures
Our pricing formula now becomes:
- Apply a ratio of 0.50
- Apply a credit of 2 points per trade
- Apply a position adjustment of 2 points per 2 futures (trade size)
If we observe the following markets:
Bid Price
Ask Price
Hang Seng
20,002
20,003
H-Shares (market)
10,004
10,006
Assuming our position is short 2 futures, our new market will become:
a) 9,997 bid at 10,002
b) 9,999 bid at 10,004
c) 10,001 bid at 10,006
118
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Creating a Future Pairs strategy
C U H K
The Hang Seng vs H-Shares futures
Our pricing formula now becomes:
-
Apply a ratio of 0.50
Apply a credit of 2 points per trade
Apply a position adjustment of 2 points per 2 futures (trade size)
While I reduce the risk of accumulating positions, I have not
eliminated such risk: if the H-Shares keeps trending higher we will
still increase our position
Suppose we do the following sequence of trades in both products:
-
sell 2 HHI at 10,004
sell 2 HHI at 10,006
sell 2 HHI at 10,008
sell 2 HHI at 10,010
sell 2 HHI at 10,012
&
&
&
&
&
buy 1 Hang Seng at 20,003
buy 1 Hang Seng at 20,003
buy 1 Hang Seng at 20,003
buy 1 Hang Seng at 20,003
buy 1 Hang Seng at 20,003
Based on the last traded prices (10,012 and 20,003), what is my
result?
119
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Creating a Future Pairs strategy
The Hang Seng vs H-Shares futures
C U H K
Our pricing formula now becomes:
-
Apply a ratio of 0.50
Apply a credit of 2 points per trade
Apply a position adjustment of 2 points per 2 futures (trade size)
Apply a time-based adjustment of 1 point per minute
Right now, I have the following position:
Short 10 HHI futures (last sale at 10,012)
Long 5 Hang Seng futures (last purchase at 20,003)
Bid Price
Ask Price
H-shares (our)
20,002
20,003
H-Shares (market)
10,012
10,014
Applying the time-based adjustment, how long will it
take before we have unwound the entire position?
a)
b)
c)
d)
120
10 minutes
11 minutes
12 minutes
13 minutes
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