Market Structure, Trading, and Liquidity
FIN 2340
Dr. Michael Pagano, CFA
Adapted from Slides by:
Dr. Robert Schwartz © 2004
Baruch College
and
Wayne Wagner
President, Plexus Group
Market Structure, Trading, and Liquidity
Slide 1
Overview of Key Market Structure
Topics
(1)
(2)
(3)
(4)
(5)
(6)
(7)
(8)
(9)
(10)
Why Study Financial Market Structure?
Overview of Market Structures & Trading Simulation
From Information to Prices
Liquidity Provision in Perfect & Imperfect Markets
Strategic Use of Limit and Market Orders
Market Intermediaries & the Evolution of Securities Markets
Institutional Order Flow
Algorithmic Trading and Technical Analysis
Trading Performance Measurement
Regulation
Market Structure, Trading, and Liquidity
Slide 2
Topics 1 & 2
Getting a Grip on Trading
(1) Customers (Investors & Issuers)
(2) Brokers / Dealers
(3) Market Centers (Listings / Order Flow / Data)
(4) Benefits vs. Costs (Net Returns vs. Transaction
Costs)
Market Structure, Trading, and Liquidity
Slide 3
Fundamental Financing Channels
Firm
Firm
Investor
IB / CB
Buyer
Investor
Seller
Agent
Agent
Exchange
or Market
Maker
Market Structure, Trading, and Liquidity
Slide 4
The Equity Markets
U.S. Equity Market Centers
 National Markets: NYSE, Nasdaq, Amex
 Regional Exchanges: Boston, Chicago, National, Pacific,
and Philadelphia
 Over-the-Counter Market (OTC)
 Alternative Markets (ATSs, ECNs), e.g.:
– INET (part of Nasdaq now)
– Archipelago (part of NYSE Group now)
– POSIT (Investment Technology Group)
– Liquidnet
– Pipeline
Market Structure, Trading, and Liquidity
Slide 5
Trading Players
•
•
•
•
•
•
•
•
Investors
Asset Exchangers
Bluffers
Uninformed traders
Speculators
Dealers
Brokers
Exchanges
Market Structure, Trading, and Liquidity
Slide 6
Some Main Points to keep in mind
• Traders who seek profit create liquidity and price
efficiency.
• Keep your eye on who has the information.
• All profits ultimately must come from uninformed
traders.
• Comparative advantages and trading rules
determine trader profits in the long run.
Market Structure, Trading, and Liquidity
Slide 7
Major Trading Issues
• Liquidity
• Informative Prices
• Volatility
• Transaction Costs
• Trading Profits
• Net Investment Returns
Market Structure, Trading, and Liquidity
Slide 8
The Iceberg of Transaction Costs
Commission
5 ¢ (17 bp)
Impact
10 ¢ (34 bp)
Delay
23 ¢ (77 bp)
Missed Trades
9 ¢ (29 bp)
Source: Plexus Group, 2003
Market Structure, Trading, and Liquidity
Slide 9
Cost Components
• Total Cost = Commission
+ Impact (intra-day)
+ Delay (inter-day)
approx. 157 bps (one-way)
 314 bps (round-trip!)
• What is the cumulative impact on a 10%
annual return over: 1, 5, and 10-year
horizons?
Market Structure, Trading, and Liquidity
Slide 10
Total Cost
Total Cost of Trading
Basis Points
250
200
150
NASDAQ
100
NYSE
50
0
Giant
Cap
Large
Cap
Mid
Cap
Small
Cap
Micro
Cap
NASDAQ
43
71
85
134
230
NYSE
43
56
81
94
138
Market Structure, Trading, and Liquidity
Slide 11
Commissions
Commission Cost
Basis Points
150
125
100
NASDAQ
75
NYSE
50
25
0
Giant Cap Large Cap Mid Cap
Small
Cap
Micro Cap
NASDAQ
16
15
22
29
50
NYSE
12
15
20
26
39
Market Structure, Trading, and Liquidity
Slide 12
Impact
Basis Points
Impact Cost
150
125
100
75
50
25
0
NASDAQ
NYSE
Giant Cap Large Cap Mid Cap Small Cap MicroCap
NASDAQ
16
28
33
37
42
NYSE
18
19
25
23
20
Market Structure, Trading, and Liquidity
Slide 13
Inter-day Delay
Delay Cost
Basis Points
150
125
100
NASDAQ
75
50
25
0
NYSE
Giant
Cap
Large
Cap
Mid Cap
Small
Cap
MicroCa
p
NASDAQ
10
27
30
67
137
NYSE
13
22
37
46
79
Market Structure, Trading, and Liquidity
Slide 14
Getting a Grip on Trading (cont.)
• Order Flow & Order Arrival Rates
• Trading vs. Investing
• Trader Types: Informed / Liquidity / Technical
• Trading Simulation: Limit Order Books & Trading
“Ecology”
• Bid-Ask Spread & Limit vs. Market Orders
• Liquidity (Time & Space) & Trading Performance
Market Structure, Trading, and Liquidity
Slide 15
The Two Sides of the
Trading Industry
• People and institutions who use market services are
on the buy-side.
• Those who provide market services are on the sellside.
• Both are customers of exchanges / markets.
• These sides have nothing to do with whether you are
a buyer or seller of a specific security.
Market Structure, Trading, and Liquidity
Slide 16
Buy-Side Players
• Individuals
• Corporate pension fund
sponsors
• Charitable trusts
• Legal trusts
• Endowments
Market Structure, Trading, and Liquidity
• Investment managers
• Corporate investment
funds
• Insurance reserve funds
• Governmental funds
Slide 17
Sell-Side Players
• Dealers trade for their own accounts.
– Day Traders
– Scalpers
– “Locals”
• Brokers trade for other people’s accounts.
– Retail and institutional
– Full-service and discount
• Broker-dealers do both.
– Specialists
– Wire houses
Market Structure, Trading, and Liquidity
Slide 18
Sell-Side Trade Facilitators
• Market Centers provide systems that help traders
arrange their trades.
– Note that market centers and brokers often compete with
each other.
• Clearing houses help settle trades and guarantee that
traders will perform (NSCC).
• Depositories and custodians hold securities (DTC).
Market Structure, Trading, and Liquidity
Slide 19
Goal of a Trading System
Bring customer orders together to make trades:
 At reasonable cost
 In a timely fashion
 At reasonable prices
Success depends on quality of a market’s structure:
 The systems, rules and protocols that determine
how orders are handled and transformed into trades
Market Structure, Trading, and Liquidity
Slide 20
What Drives a Market?
3 Sources of Orders
Liquidity
Order Flow
Informed
P*
Quotes,
Prices,
Volume
Is p*>offer
or p*<bid?
Technical
Trading
Is there a
trend/
pattern?
Trading Mechanism
Market Structure, Trading, and Liquidity
Slide 21
The Big Problem
Enabling Buyers and Sellers, Large and
Small, to Find Each Other
Two Dimensions
 Place
 Time
Market Structure, Trading, and Liquidity
Slide 22
Order Driven Market
Public
Seller
10:50
Public
Buyer
10:55
Places
a Buy
Limit
Order
Market Structure, Trading, and Liquidity
Limit
Order
Executes
11:00
The limit order
book brings
buyer& seller
together
Slide 23
The Limit Order Book
BIDS
Bid – Ask Spread
(10.95 - 11.10)
PRICE
OFFERS
11.30
91
11.25
0
11.20
52
11.15
24
11.10
7
Air Pocket
11.05
11.00
35
10.95
70
10.90
0
10.85
20
10.80
67
10.75
39
10.70
46
10.65
Air Pocket
Market Structure, Trading, and Liquidity
Slide 24
P* and Best Bid and Offer Quotes
$28.00
$27.00
$26.00
$25.00
$24.00
$23.00
P*
Ask
$22.00
$21.00
Bid
Day 1
Market Structure, Trading, and Liquidity
Day 2
Slide 25
Topics 3 & 4
All About Liquidity
• Gross vs. Net Investment Returns ($1100 vs. $1067)
• Frictionless CAPM vs. Real-world Frictions
• Info Types:
– Market vs. Fundamental
– Public vs. Private vs. Insider
• Divergent Expectations and Adaptive Valuations
• Liquidity: Depth / Breadth / Resiliency / Speed
Market Structure, Trading, and Liquidity
Slide 26
All About Liquidity (cont.)
• Transaction Costs: Explicit vs. Implicit
• Explicit: Commissions / Exchange Fees / Taxes
• Implicit:
– Bid-Ask Spread
– Total Trading Cost = Delay + Impact + Opportunity Cost
• Illiquidity & Transaction Costs affect:
–
–
–
–
Price Volatility (via bid-ask “bounce”)
Price Discovery
Quantity Discovery
Reduced portfolio net returns
Market Structure, Trading, and Liquidity
Slide 27
All About Liquidity (cont.)
• Market Structure Types:
–
–
–
–
–
Continuous Order-Driven
Periodic Order-Driven Call Auctions
Continuous Quote-Driven (aka “Dealer markets”)
Negotiated Markets (e.g., ECN / ATS / block trader)
Hybrid Markets
• Random Walk vs. Illiquid Market “Symptoms”:
– Serial Return Correlation (Positive vs. Negative)
– Time Scaling of Variance (e.g., Variance Ratio analysis)
– Serial Cross-Return Correlation
Market Structure, Trading, and Liquidity
Slide 28
What Do the Following Have in
Common?
Without Gas, Neither Will Run
Market Structure, Trading, and Liquidity
Slide 29
Order Flow is Gas For a Market
Order Flow = Liquidity
An excellent system will not operate
if it does not receive
Critical Mass Order Flow
“Order flow attracts order flow”
Market Structure, Trading, and Liquidity
Slide 30
Liquidity
Attributes of a liquid asset
 Breadth: orders on the book exist at an array of
prices in the close neighborhood above and below the
price at which shares are currently trading.
 Depth: orders are of large size.
 Resiliency: price changes due to temporary order
imbalances quickly attract new orders to the market,
thereby restoring reasonable share values.
 Frequent trading (at high speed).
Market Structure, Trading, and Liquidity
Slide 31
Price & Quantity Discovery
 The most important objective of any market
is to foster accurate price and quantity
discovery
 Much demand is latent – participants do not
readily reveal their desires to buy or to sell
 Traders instinctively know the price discovery
problem. That is why technical analysis is
widely used
Market Structure, Trading, and Liquidity
Slide 32
Price Discovery is Difficult
Because
Investors
 Cannot assess share values with
precision
 Have divergent expectations
 Have adaptive valuations
Do analysts ever agree?
Market Structure, Trading, and Liquidity
Slide 33
Difficulty of Assessing Share
Valuations With Precision
Can a stock analyst say with
precision that the expected growth
rate for XYZ is:
 7.00%, not
 7.55%?
Market Structure, Trading, and Liquidity
Slide 34
Analyst Evaluation of XYZ
Dividend one year from now
= $1.35
Appropriate cost of eq. cap.
= 10%
(1) Growth rate (g)
= 7.00%
(2) Growth rate (g)
Share price if g =7.00%
Share price if g =7.55%
= 7.55%
= $45
= $55
Market Structure, Trading, and Liquidity
Slide 35
Price Determination
V(H) = $55: The Bulls
k percent
What price(s) will
prevail on the market?
V (L) = $45: The Bears
Market Structure, Trading, and Liquidity
1-k percent
Slide 36
Order Driven Market
Public
Seller
10:50
Public
Buyer
10:55
Places
a Buy
Limit
Order
Market Structure, Trading, and Liquidity
Limit
Order
Executes
11:00
The limit order
book brings
buyer& seller
together
Slide 37
The Limit Order Book
BIDS
Bid – Ask Spread
(10.95 - 11.10)
PRICE
OFFERS
11.30
91
11.25
0
11.20
52
11.15
24
11.10
7
Air Pocket
11.05
11.00
35
10.95
70
10.90
0
10.85
20
10.80
67
10.75
39
10.70
46
10.65
Air Pocket
Market Structure, Trading, and Liquidity
Slide 38
Dealer Intermediation
Dealer
Sells
Public
Seller
10:50
10:55
Public
Buyer
Market Structure, Trading, and Liquidity
Dealer
Buys
11:00
Dealer provision
of immediacy
brings buyer
& seller together
Slide 39
View From a Market Maker’s Desk
Dealer
Bid
Dealer
Ask
COD
26.00
CAT
26.20
DOG
26.00
COD
26.30
TUNA
25.90
DOG
26.30
CAT
24.80
TUNA
26.30
Market Structure, Trading, and Liquidity
Slide 40
Order Driven Market
Best Ask 100 shs @ $20.00
<Last sale $15
Best Bid 200 shs @ $10.00
Market Structure, Trading, and Liquidity
Slide 41
Thin Order Book
Best Public Ask 100 shs @ $20.00
<Last sale $15
< Mkt order: Sell 100
< Sold @ $10
< # @$%
*
**
Best Public Bid 200 shs @ $10.00
Market Structure, Trading, and Liquidity
Slide 42
Dealer/Specialist
“Makes” the Market
Best Public Ask 100 shs @ $20.00
Specialist Ask 100 shs @ $15.05
<Last sale $15
Specialist Bid 100 shs @ $14.95
Best Public Bid 200 shs @ $10.00
Market Structure, Trading, and Liquidity
Slide 43
Public Trades with Dealer
Best Public Ask 100 shs @ $20.00
Specialist Ask 100 shs @ $15.05
< Mkt order: Sell 100
<Last sale $15
Specialist Bid 100 shs @ $14.95
< Sold @ $14.95
< 
Best Public Bid 200 shs @ $10.00
Market Structure, Trading, and Liquidity
Slide 44
Dealer Is Long
100 Shares
Best Public Ask 100 shs @ $20.00
Specialist Ask 100 shs @ $15.05
Specialist Bid 100 shs @ $14.95 $14.90
Best Public Bid 200 shs @ $10.00
Market Structure, Trading, and Liquidity
Slide 45
A Call Auction
Public
Seller
10:50
Public
Buyer
Market Structure, Trading, and Liquidity
10:55
11:00
A meeting point
in time can bring
multiple buyers &
sellers together
Slide 46
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
Market Structure, Trading, and Liquidity
Slide 47
The Batching of Customer Orders
Price
52
O
51
O
50
49
48
47
•
••
•O
•O
•
1
2
Market Structure, Trading, and Liquidity
O Offer
Bid
•
O
Question
How should these limit orders
be integrated to produce a good
price?
3 4 5 6
No. Orders
Slide 48
Cumulate The Buy Orders
• Individual buy order
Price
52
51
•• (1)
•
50
49
•
48
•
47
•
1
 Cumulated buy orders
at the price or better
•
• (1+2=3)
• (3+1=4)
• (4+1+5)
• (5+1=6)
2
3
Market Structure, Trading, and Liquidity
4
5
6
No. Orders
Slide 49
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
2
Market Structure, Trading, and Liquidity
3
4
5
6
Orders
Slide 50
Match Cumulated Buy & Sell Orders
Price
52
51
P* =
CUMULATED
O
SELL ORDERS
•
•
O
50
49
48
O
O
•
O
•
47
1
2
Market Structure, Trading, and Liquidity
3 4
5
•
CUMULATED
BUY ORDERS
6
Orders
Slide 51
Trading Costs
1.
Explicit costs
 commissions
 taxes
 etc.
2. Execution Costs (the implicit costs of trading)
 Bid-ask spread
 Market impact
 Delay/Opportunity cost
Market Structure, Trading, and Liquidity
Slide 52
Trading Costs and Volatility
1.
2.
3.
4.
The bid-ask spread
Market impact
Momentum trading
Imperfect price discovery
Trading costs
cause prices to bounce between
higher and lower values
Market Structure, Trading, and Liquidity
Slide 53
Trading Costs & Volatility
C = Implicit transaction cost of buy or sell
= Transaction price (triggered by buy order)
= Transaction price (triggered by sell order)
= Magnitude of C
P* = Unobserved, costless trading price
Price
P*
Time
Market Structure, Trading, and Liquidity
Slide 54
Trading Costs & Volatility
C = Implicit transaction cost of buy or sell
= Observed price of buy-triggered trade
= Observed price of sell-triggered trade
=C
P* = Unobserved, costless trading price
Price
P*
Time
Market Structure, Trading, and Liquidity
Slide 55
Trading Costs & Returns
Price
P
T
Time
Market Structure, Trading, and Liquidity
Slide 56
Trading Costs & Volatility
Which is more volatile:
P* or the transaction price we
observe?
Price
P*
Observed
Transaction
Price
Time
Market Structure, Trading, and Liquidity
Slide 57
The Efficient Market Hypothesis
(EMH)
Existing information cannot be exploited to realize above normal (risk
adjusted) trading profits
• Weak form
•
•
information
= historical market information
Semi-strong form
information
= weak form + publicly available info
Strong form
Information
Market Structure, Trading, and Liquidity
= semi-strong form + private info
= the complete information set
Slide 58
Random Walk
If the EMH holds
Security price changes (returns)
are not serially correlated
Ri,t ≠ f(ri,t-1)
Market Structure, Trading, and Liquidity
Slide 59
Liquidity
CAPM, the frictionless environment
2 dimensions: risk and return
Liquidity is perfect and a stock can be traded
immediately at its equilibrium value (P*)
Actual markets
3 dimensions: risk, return, and liquidity
Market Structure, Trading, and Liquidity
Slide 60
Liquidity & Random Walk
Positive Intertemporal Correlation
 Sequential information arrival
 The limit order book
 Market maker intervention
 Inaccurate price discovery
Negative Intertemporal Correlation
 Bid-ask spread
 Market impact effects
 Inaccurate price discovery
Serial Cross-Correlation
Market Structure, Trading, and Liquidity
Slide 61
Market Structure, Trading, and Liquidity
30
00
30
00
30
00
3:
30
-4
:0
0
3:
00
-3
:3
0
2:
30
-3
:0
0
2:
00
-2
:3
0
1:
30
-2
:0
0
1:
00
-1
:3
0
12
:3
01:
00
12
:0
012
:
11
:3
012
:
11
:0
011
:
10
:3
011
:
10
:0
010
:
9:
30
-1
0:
Half-Hour Volatility
INTRADAY VOLATILITY
NYSE
October - December 1999
1.60%
The First 1/2 Hour
1.20%
0.80%
0.40%
0.00%
Slide 62
8:
00
-8
:3
0
8:
30
-9
:0
0
9:
00
-9
:3
9:
0
30
-1
0:
00
10
:0
010
:3
10
0
:3
011
:0
11
0
:0
011
:3
11
0
:3
012
:0
12
0
:0
012
:3
12
0
:3
01:
00
1:
00
-1
:3
0
1:
30
-2
:0
0
2:
00
-2
:3
0
20
:3
03:
00
3:
00
-3
:3
0
3:
30
-4
:0
0
4:
00
-4
:3
0
Half-Hour Volatility
INTRADAY VOLATILITY
LONDON STOCK EXCHANGE
January - May 2000
3
Market Structure, Trading, and Liquidity
The First 1/2 Hour
2.5
2
1.5
1
0.5
0
Slide 63
Prices (P)
P0 , P1 , P2 , … , PT
Time
P0
P1
Market Structure, Trading, and Liquidity
P2
PT
Slide 64
Arithmetic Returns (P)
P0,1 = P1 – P0
P1,2 = P2 – P1
PT-1,T = PT – PT-1
Market Structure, Trading, and Liquidity
Slide 65
Percentage Returns (r)
r0,1 = ( P1 – P0 ) / P0
= P0,1 / P0
r1,2 = ( P2 – P1 ) / P1
= P1,2 / P1
rT-1,T = ( PT – PT-1 ) / PT-1 = PT-1,T / PT-1
Market Structure, Trading, and Liquidity
Slide 66
Price Relatives (PR)
PR0,1 = P1 / P0
= ( P0 + P0,1 ) / P0
= 1 + r0,1
PR1,2 = P2 / P1
= ( P1 + P1,2 ) / P1
= 1 + r1,2
PRT-1,T = PT / PT-1 = ( PT-1 + PT-1,T ) / PT-1 = 1 + rT-1,T
PR0,T = PT / P0
= (P1 / P0) * (P2 / P1) *…* (PT / PT-1)
Market Structure, Trading, and Liquidity
Slide 67
Log Returns (R)
R = ln(1+r) = ln(price relative)
R0,1 = ln(P1/P0) = ln(P1) – ln(P0) = ln(1+r0,1)
R1,2 = ln(P2/P1) = ln(P2) – ln(P1) = ln(1+r1,2)
RT-1,T = ln(PT) – ln(PT-1) = ln(1+rT-1,T)
PR0,T = PT / P0 = (P1 / P0) * (P2 / P1) *…* (PT / PT-1)
R0,T = R0,1 + R1,2 +…+ RT-1,T =
Ri-1,i = ln(PT) – ln(P0)
Market Structure, Trading, and Liquidity
Slide 68
Question:
Which of the following
may be normally
distributed?
P
r
PR
R
Market Structure, Trading, and Liquidity
Slide 69
Two Period Log Returns
P2 = P0 ( 1 + r0,2 )
P2 = P0 ( 1 + r0,1 ) ( 1 + r1,2 )
1 + r0,2 = P2 / P0 = ( P1 / P0 ) * ( P2 / P1 ) =
= ( 1 + r0,1 ) ( 1 + r1,2 )
R0,2 = R0,1 + R1,2
Market Structure, Trading, and Liquidity
Slide 70
Log Returns: Two Period Mean
Assume constant Mean:
E(R0,1) = E(R1,2)
E(R0,2) = E(R0,1) + E(R1,2)
E(R0,2) = 2E(R0,1)
Market Structure, Trading, and Liquidity
Slide 71
Log Returns: Two Period Variance
Var(R0,2)=Var(R0,1)+Var(R1,2)+2Cov(R0,1,R1,2)
Assume constant Variance:
Var(R0,1) = Var(R1,2)
For Cov(R0,1,R1,2) = 0
Var (R0,2) = 2 Var(R0,1)
What if Cov(R0,1,R1,2) < 0 ?
Market Structure, Trading, and Liquidity
Slide 72
Key Statistical Measures
 Mean Return (via ln of Price Relative)
 Variance and S.D. of Returns
 Market Model Beta, R2, and Residual Variance.
 Variance Ratio = Var (R0,2) / [2 * Var (R0,1)]
 Volume-Weighted Average Price =
VWAP0,T = t=1,T wt * Pt
where, wt = Sharest / t=1,T Sharest
Market Structure, Trading, and Liquidity
Slide 73
Additional Measures
•
•
•
•
Quoted Spread = (Ask – Bid)
Effective Spread = 2 * (B/S) * (Pt – Quote Midpointt)
Quote Midpoint = (Ask + Bid) / 2
Realized Spread = 2 * (B/S) * (Pt – QMPt+n)
• Tot. Trans. Cost = Delay + Impact + Missed Trades
• Implementation Shortfall =
Beginning Portfolio Value – Ending Portfolio Value
Market Structure, Trading, and Liquidity
Slide 74
Topic 5
How to use Limit and Market Orders
• Limit Order Books / Market Makers / Hybrids
• Key Order Types:
– Limit orders: “make” liquidity / “patient”
– Market orders: “take” liquidity / “impatient”
– Stop Loss & Stop Limits: manage risk
• Limit Orders: ↓ Impact vs. ↑ Delay
• Limit Order Risks: Execution Risk and “Bagging”
• Price & Time Priority Rules reduce risk somewhat
Market Structure, Trading, and Liquidity
Slide 75
How to use Limit and Market Orders
(cont.)
• Break-even Probability of Limit vs. Market Orders
ProbB-E = (Preserve - Pmarket) / (Preserve - Plimit)
• Expected Gain = Probactual * (Preserve - Plimit)
• Equilibrium B-A spread size is determined by
“Gravitational Pull” concept of limit vs. market
• Option Value of a Limit Order:
– Bid Limit order = “short Put” (must buy from a seller)
– Ask Limit order = “short Call” (must sell to a buyer)
– The “Premium” received from these sales = B-A spread
Market Structure, Trading, and Liquidity
Slide 76
Ecology of a Pure Order
Driven Market
Participants meet to establish
prices and trade. This requires:
 Limit orders be posted
 Market orders be submitted
Market Structure, Trading, and Liquidity
Slide 77
Informational Change
Assume I have an open, unexecuted buy limit
order on the book. If a news event occurs, it’s …
"Heads You Win, Tails I Lose”
 Heads You Win: Bearish news has caused the
price of the stock to fall and my limit order
executes
 Tails I Lose: Bullish news has caused the price
ofSo
theWhy
stockDid
to rise
and my
limit
order
doesn’t
I Place
That
Limit
Order?
execute
Market Structure, Trading, and Liquidity
Slide 78
Compensation From a Liquidity Event
•
•
•
•
A liquidity event that results in a price decline could
cause my buy limit order to execute.
After being driven down, price would revert back up.
I profit as price mean reverts after my order has
executed.
Sufficient mean reversion can offset the costs that result
from
informational
change.
Mean
Reversion
= Accentuated Volatility
They are the same thing!
Market Structure, Trading, and Liquidity
Slide 79
Bid-Ask Spread
Compensation for
 Risk of adverse informational change
 Risk of limit order not executing
Gravitational Pull Effect
Market Structure, Trading, and Liquidity
Slide 80
Gravitational Pull
Market Ask
Potential Buy Order 2
Potential Buy Order 1
Market Bid
Market Structure, Trading, and Liquidity
Slide 81
Making the Trade
(based on Navarro chapters)
Market Structure, Trading, and Liquidity
Slide 82
The Stock Market and Business Cycles
 Stock Market is a leading economic indicator
 Different Sectors shine at various points
during the business cycle.
 Early / Middle / Late Bull Markets:
Transportation / Capital Goods / Commodities
 Early / Middle / Late Bear Markets:
Consumer Staples / Utilities / Cons. Cyclicals
Market Structure, Trading, and Liquidity
Slide 83
The Interest Rate Cycle & Yield Curve
 Yield Curve can be a Leading indicator of
both the Stock Market and Economy.
 Federal Reserve sets short-term rates but…
 Long-term rates set by investor expectations
of economic growth and inflation.
 Bonds and Money Market instruments can
be competitors to Stocks.
Normal / Steep / Inverted / Flat Yield Curves:
Middle Bull / New Bull / Bearish / Mixed
Market Structure, Trading, and Liquidity
Slide 84
Managing Risk
 3 Key Risks: Market, Sector, Company.
 Compute Reward-to-Risk Ratio for your
trades / stocks:
Ad hoc Rule of Thumb (3:1), Sharpe Ratio,
Alpha, Beta.
 Diversification is very important (e.g., “no
more than 20% in one sector”).
 “Never bet the farm!”
 “When in doubt, go flat.”
Market Structure, Trading, and Liquidity
Slide 85
Managing Trade Execution
 Market vs. Limit Orders
 Trading Range vs. Trending Markets
 Intelligent Stop Loss orders:
 Set “loose stops”
 Avoid round numbers & technical nodes
 Use “trailing stops” to lock in gains
 “Never turn a winner into a loser”
 “Never average down a loss”
 “Never churn your own portfolio”
Market Structure, Trading, and Liquidity
Slide 86
Topics 6 & 7
Market Intermediaries: Nuts & Bolts
• Broker vs. Dealer vs. Specialist
• Blurring of Lines between:
– Sell-side vs. Buy-side
– Securities Exchanges vs. ECNs vs. ATSs
• NYSE Specialist vs. Nasdaq Mkt Maker vs. ECN / ATS
• NYSE Specialist: Positive & Negative Obligations
• Nasdaq MM: Proprietary dealers change quotes
depending on their inventory position: ↑ B-A if INV < 0
Market Structure, Trading, and Liquidity
Slide 87
Market Intermediaries: Nuts & Bolts (cont.)
• Institutional Order Flow (Large Peg vs. Small Hole)
and Institutional Investors’ responses:
– “Slicing and Dicing”
– Greater control over order-routing (incl. “preferencing”)
– Increased use of ECN and ATS services
• Market Maker (MM) Services: Immediacy / Liquidity /
Animation / Price Discovery / P & Q Improvement
• MM Revenues: B-A spread / Trading Order Flow /
Commissions
• MM Costs: Inventory Mgmt / Asymmetric Info / Order
Processing = f (INV, AI, KL) / Q
Market Structure, Trading, and Liquidity
Slide 88
The Eye of the Storm
 The institutions are huge
 Markets are structured for retail order flow
 How can the big guys get the liquidity they need?
Big Pegs and Tiny Holes
 Dealer capital
 Place limit orders
 Trade negotiation
 Not held (NH) orders
 Slice, dice and shred
Market Structure, Trading, and Liquidity
Slide 89
Remarks from John Phinney*
• To a retail investor, the stock exchanges look
like a vending machine!
• This is not the case for the institutional
trader. As we know, the “peg” of institutional
trading interest is much larger than the “hole”
size of the exchange process.
* Remarks made at Baruch Conference, Coping With
Institutional Order Flow, NYC, April 29, 2003
Market Structure, Trading, and Liquidity
Slide 90
Remarks from John Phinney (cont.)
• The “meat grinder” appears clearly in all of
our data sampling.
• Trading costs seem to be much more related to
endogenous market factors, structure, and
process, than to exogenous factors derived from
investor behavior.
Market Structure, Trading, and Liquidity
Slide 91
Phinney’s Meat Grinder Example
1.8 Million Buy Order for Oracle,
August 15, 2002
Executions
Number:
Average size:
Largest :
Smallest:
1000 shares or less
100 shares or less:
Time to complete:
Market Structure, Trading, and Liquidity
1,000+
1,700 shares
64,000 shares
13 shares
61% of execs
17% of execs
51 minutes
Slide 92
Phinney’s Conclusion
It was a DFT
It required a 1,000-to-1 reduction of the
manager’s intent (and a significant amount
of technology) to get trade pieces small
enough to be digestible by the market.
Market Structure, Trading, and Liquidity
Slide 93
Market Maker Services
 Immediacy
 Supplemental liquidity
 Price discovery
 Animation
Market Structure, Trading, and Liquidity
Slide 94
Immediacy
 Market maker practices are designed to
facilitate the rapid execution of customer orders
 However, orders are commonly traded
patiently (i.e., without immediacy)
 Upstairs negotiation of large block trades
 Breaking up large orders for submission over
time
 Limit orders
Market Structure, Trading, and Liquidity
Slide 95
Market Maker Costs
 Inventory cost: Cost of carrying unbalanced
inventory
 Processing cost: Cost of labor, physical capital
required to execute trades
 Information cost: Cost of trading with better
informed participant
 Spread = f (INV, KL, AI) / Q
Market Structure, Trading, and Liquidity
Slide 96
What Makes a Market
Maker Successful?
 Inventory control
 Trading the order flow carefully
 Ability to hide/disguise large positions
 Knowledge of customers (source of the order
flow) is also important in practice
Market Structure, Trading, and Liquidity
Slide 97
Inventory Control in TraderEx
 If P* jumps above your offer, your customers will, on
net, be buyers and your inventory will fall
 As your inventory falls, you raise your bid and offer
 The higher bid attracts sellers and the higher offer
discourages buyers
 What happens to your inventory if your bid is raised
above P*?
Your inventory is controlled by adjusting your bid
and offer relative to the unobserved P*
Market Structure, Trading, and Liquidity
Slide 98
Transparency
As a Market Maker,
How Transparent Do You Want the Market To Be?
After you acquire a large inventory in the
process of servicing a customer, you must work
off that position
"Shares sold to a market maker are still
for sale”
You do not want your inventory revealed by a
trade publication
Market Structure, Trading, and Liquidity
Slide 99
So, How Do Market Makers Compete?
 Knowing their customers
 Offering an array of services
 Developing customer relationships; this results in
Preferencing
Quote matching
A market spread that is greater than it would be in an
order-driven environment
Market Structure, Trading, and Liquidity
Slide 100
Topic 8
The Road to Tech. Analysis & Algo Trading
• Dynamic Price Discovery due to:
– Large, complex information set
– Divergent expectations and Adaptive valuations
• Quantity Discovery problems due to:
– Institutional Order Flow and Bifurcation of P & Q discovery
– Bookbuilding problem and Trade Clustering
• Technical Analysis to increase trading profits: S-T
timing / “Trade the OF” / B-A Bounce vs. Momentum
• Algo Trading to reduce trading costs: automates
“slicing & dicing”, “VWAP trades”, etc.
Market Structure, Trading, and Liquidity
Slide 101
Some Observations
 Trading occurs in bursts (trade clustering).
 The bursts are commonly 2-sided.
 But the large orders are not meeting each other
efficiently.
 There is a large latent demand to trade.
Market Structure, Trading, and Liquidity
Slide 102
Some Conclusions
1.
Big Trades Cluster in Time
2.
Two-Sided Clusters Are Common for Big Orders
This implies that
3. Institutional Orders are Portable in Time
4. Much Institutional Demand is LATENT
Market Structure Objective:
Bring Hidden Liquidity
“In From The Cold”
Market Structure, Trading, and Liquidity
Slide 103
Some Technical Analysis Techniques
• Moving Averages
• MACD and Cross-overs
• Trendlines and Break-outs
• Relative Strength (RSI)
• Stochastics / Oscillators
• Pattern Recognition (e.g., “head &
shoulders”, “pennants”, etc.)
• Point and Figure charts
• Candlestick charts
• Volume and Market Breadth
• Money Flow statistics
Market Structure, Trading, and Liquidity
Slide 104
Algorithmic Trading
 Background
 Market Maker Operations
 Floor Broker Intermediation
 Algorithmic Trading
An electronic intermediary
Market Structure, Trading, and Liquidity
Slide 105
Which is Smarter?
 Floor based trading and NH orders
Or…
 Electronic systems and algorithmic
trading
Kasparov vs. Deep Blue
Market Structure, Trading, and Liquidity
Slide 106
The Raison d’être of
Algorithmic Trading
o Dynamic price discovery
o The speed with which events can occur
o Exploit Market inefficiencies to ↓ costs
Market Structure, Trading, and Liquidity
Slide 107
Topics 9 & 10
Trading Performance Measurement
• Key Measures: P&L / Trading Surplus /
Benchmarks (VWAP & Implementation Shortfall)
P&L = Cash Position + (Open Position * Bid Price)
Trading Surplus = (Preserve - Ptransaction) * Quantity
VWAP0,T = t=1,T wt * Pt
where, wt = Sharest / t=1,T Sharest
IS = (B/S) * [(QMP0 - QMPt) + (Avg. QMPt,T – Avg. Pt,T)
+ (% Unfilled * (QMP0 - PT))]
where, 0 = time of initial request / t = first trade / T =
last trade
Market Structure,
Trading, and Liquidity
Slide 108
Trading Performance Measurement
(cont.)
• Transaction Cost Analysis (TCA) typically focuses on
Implementation Shortfall (IS) plus trading
commissions to measure Total Trading Costs (TTC).
• Risk Management vs. Transaction Costs (e.g., limit
orders might lower cost but increase market risk).
• Best Execution:
– Analyze processes vs. individual trades
– Soft Dollars and Agency conflicts
– New Regulatory Environment: MiFID in Europe and Reg NMS
in the U.S.
– Market Centers’ responsibilities in this new environment
Market Structure, Trading, and Liquidity
Slide 109
Best Execution
 1975 Security Acts Amendments
 Retail vs. institutional order flow
 Execution price vs
 Speed
 Certainty
 Anonymity
 Control
 Etc.
 An order is multi-dimensional.
Market Structure, Trading, and Liquidity
Slide 110
What is Best Execution?
•
A snapshot assessment for a single, no brainer order?
– What about orders that are sliced & diced?
– Order that are market timed?
• Beating a performance benchmark?
• Quality of procedures followed?
• None of the above?
• Best Execution is better thought of as a process.
Market Structure, Trading, and Liquidity
Slide 111
Impediments to Best Execution
•
•
•
•
Soft dollar commitments
Use of an erroneous benchmark
Excessive pressure to trade quickly
Imperfect market structure
Market Structure, Trading, and Liquidity
Slide 112
Heart of the Problem
Soft Dollars
Outsourcing research, computer
systems, and other support services
to sell-side with client assets used
as payments => Agency Problem!
(The costs are hidden)
Commission Bundling
Market Structure, Trading, and Liquidity
Slide 113
Key Regulatory Topics
 Soft Dollar Commissions and Preferencing
 Best Execution procedures
 Reg NMS and the nature of competition
 Level Playing Field: NYSE, Nasdaq, ECNs
 Transparency and Market Access
 Fairness for Retail vs. Institutional Investors
 Rate of Technological Innovation
Market Structure, Trading, and Liquidity
Slide 114