Money, Banking & Finance
Lecture 4
The Theory and Practice of Equity
Trading
Aims
• Examine the process by which investment
decisions are translated into the action of buying
or selling shares.
• Understand how a trading environment operates
and how the players interact.
• Appreciate how the actions of traders influence
the market.
• Examine the Trader-Ex software for training of
stock-market traders.
Trading and Investing
• Important distinction between Investing and
Trading.
• Trading is about converting an investment
decision at the least cost point.
• Trading is also about price discovery. The
investment manager will have an idea of the
equilibrium price but this could change in a
dynamic and fast moving situation.
• Trading is also about finding price discrepancies
and exploiting these for profit
Investment Decisions
Time Taken by Fund Managers to make buy/sell decision
5
4
3
2
1
Mean
frequency
< 1 hr
3.1
6.2
13.8
46.1
30.8
2.05
1 hr – 1
day
7.7
9.2
41.6
24.6
17.0
2.66
1 day – 1
wk
10.7
32.3
27.7
20.0
9.2
3.15
1 wk – 1
m
7.5
40.9
21.2
18.2
12.1
3.14
1m
15.2
22.7
19.7
24.2
18.2
2.92
%
Score 5 = very frequently (75 – 100% of the time); 1 = never
Source: Schwartz R and Steil B (2002), “Controlling Institutional Trading Costs:
We have met the enemy and it is us”, Journal of Portfolio Management, 23, 3, 3949
Trading and Time
• Investment decisions are made in discrete time.
• Trading decisions are made in continuous time.
• Once a decision to invest has been activated to a
trade, time takes on a different meaning.
• The trader wants to satisfy the instruction before
the end of the trading day and show a good
performance.
• Performance can be measured in terms of
opportunity cost and/or actual cash surplus.
Bid-Ask Spread
• A bid order is an offer made by a trader to BUY a
security.
• An ask order is the price a trader is willing to
SELL a security. Sometimes called the OFFER
price.
• A bid or an ask can stipulate the amount the trader
will buy or sell and this is called a LIMIT
ORDER.
• A market sell is a willingness to accept a bid order
and a market buy is a willingness to accept an ask.
Order Arrival
• Orders to buy and sell will arrive during the market day.
• The Trader may be a short-term trader with orders to work
for a client or working for a pension fund or hedge fund.
• Traders don’t have the luxury of time. Their decision is to
buy sell or wait
• To gauge the market – the balance of buy and sell orders
• At above equilibrium prices the arrival rate of sell orders
are faster than the arrival rate of buy orders.
• Similarly at prices below some notional equilibrium, the
arrival rate of buys are greater than sells.
Price Discovery
P*
Ask
Bid
Sells
Buys
Informed Traders
• Informed Traders – agents who trade knowing that the
current price level has diverged from the fundamental.
• Buy orders are sent to market if P* > P
• Sell orders are made when P* < P. When P* > P(offer) or P*
< P(bid).
• In the theoretical world of costless trading, complete
markets, instantaneous information dissemination, price
adjustments are instantaneous.
• In reality prices adjust rapidly with ‘new’ news, but news
could be changes in fundamentals, uncertainty, rumour or
noise.
• The informed Trader will exploit information and act with
a short lag to news about fundamentals.
P* and Best Bid and Offer
Quotes
$28.00
$27.00
$26.00
$25.00
$24.00
$23.00
$22.00
$21.00
Liquidity Traders
• Idiosyncratic reasons for trade.
• Orders are two-sided. They can be market orders
or limit orders and arrive randomly.
• Sometimes called ‘noise traders’.
• Liquidity traders differ in that they issue both
market and limit orders but informed traders
submit market orders only.
• Liquidity traders will not drive a price back to
some previous level or reinforce a trend because
informed traders drive the price to equilibrium.
Technical (Momentum)
Traders
•
•
•
•
•
These Traders are prevalent in the market.
Market technician – using chartist analysis
Algo trader – using a black-box device
Arbitrageur – exploit price inefficiencies to profit.
Market maker or Day Trader – profiting from the
bid-ask spread or profiting from changing market
conditions to buy low and sell high.
What Drives a Market?
Informed
P*
Is p*>offer
or p*<bid?
Liquidity
Order Flow
Momentum
Quotes,
Prices,
Volume
Is there a
trend/
pattern?
Trading Mechanism
Order Book, Market Makers, Call Auction
TraderEX Purpose
1)
Make trading decisions
2)
Understand price discovery
3)
Evaluate trading rules for:
–
market participants
–
market quality
–
intermediaries and dealer roles
4) Compare alternative market systems
5) Have Fun
Computer’s Role
Establish “market background”
– Generate order flow
– Update display and bid-ask quotes
2) Give participants orders to execute
3) Maintain transactions records for
subsequent analysis on
– Participants’ order placement decisions
– Market quality (e.g., bid-ask spread)
Teaching Trading and Markets
with TraderEx simulations (I)
e.g., cardiff2
cardiff
Teaching Trading and Markets
with TraderEx simulations (II)
Buy
orders
Market orders
Limit orders
Sell
orders
Order book market
Ask: 213
offered at
20.60
20.40 Bid
for 59
User has
entered 2
limit orders
to sell
Entering a
limit order
User is
entering a
market order
to sell
(44) units
ahead of your
10
Click to cancel
your limit order to
sell 10 at 19.90
Sold!
Mark-to-market P&L = -2.00
Day’s High Price
The Order Driven
Market in
TraderEx
Your lim
orders to se
Ask: 46
offered
at 20.00
40 units
ahead of
your 10
Ticker of trades
Can enter
Chat
messages
Performance
measures
1) Average prices
Performance
measures
2) P&L
Performance
measures
3) VWAP
Market Structures
1. Order-driven: Buy-side trader with large
order
2. Quote-driven: Market maker/ liquidity
provider
3. Order book w/ Periodic call auction (3x
day)
4. Order book w/ Dark liquidity pool
Order driven market
Investment
Managers’
Decision
Add 250,000
shares to
portfolio’s
holding of CAB
Buy-Side
Trader
“Tak
(YOU) Mark
Buy
5,000
share
CAB
Trade
Occurs
Order to sell
5,000 shares of
CAB executes at
$48.10
Order Book
Market
Performance
• Average Cost
• You purchased
140,000 shares at 3.5
cents below VWAP
• But 23.6 cents above
the last price of the
day.
• Your P&L position is
• -33
Buy side performance
• P&L per share
• = Mark-to-Market Price – Average
Purchase Cost
• Good trading:*
• VWAP – Average Purchase Cost > 0
• Good stock selection:
• Last Price – Price at time
Summary
• We have seen that investing is not the same as
trading
• Investing is a strategic decision made by the
portfolio manager.
• Trading involves meeting the instructions of the
portfolio manager at the least cost or best price.
• The TraderEx software is a computer package that
simulates trading in different market structures
• It also allows for interactive trading in real time.