Types of Orders

1

• Part - IV
• Types of Orders
• Market Structures

2
Introduction to Orders

• What is an order?
• It is a trade instruction given to a broker or to
  an exchange.
• Whenever a trader wishes to buy or sell a
  security he needs to place an order
• It should indicate
• What he wishes to accomplish
• The terms and conditions subject to which he
  wants his instructions to be carried out.

3
Introduction (Cont)

• In order to convey meaningful information to the
  person who is executing the trade, an order must
  contain certain basic information.

4
Required Information

• Firstly the trader needs to indicate as to
  whether he wishes to place a long or a short
  position.
• For a long position a buy order needs to be
  placed.
• For a short position a sell order needs to be
  placed.

5
Required Information (Cont)

• The security that is sought to be bought or sold
  must be clearly identified.
• For instance if we assume that the investor
  wishes to go long in IBM stock, he should
• Place a buy order for IBM shares

6
Required Information (Cont)

• The number of shares that are sought to be bought
  or sold must be specified.
• This is called the Order Size.
• To continue with our example let us assume that
  the investor places a buy order for 200 shares of
  IBM.

7
Required Information (Cont)

• The next critical issue is the price.
• Is the trader prepared to accept the best price
  that is currently available in the market?
• If not, if he wishes to buy
• What is the maximum price that he is willing to
  pay
• Else if he is seeking to sell
• What is the minimum price that he is prepared to
  accept

8
Required Information (Cont)

• Traders who are prepared to accept the best terms
  available in the market
• Place Market Orders
• Others who wish to place a ceiling or a floor
• Place Limit Orders
• The corresponding price ceiling or floor is
  called the Limit Price.
• Let us assume that the investor places a limit
  buy order with a limit price of 595.

9
Required Information (Cont)

• Finally the trader needs to specify how long he
  would like the order to remain valid for in the
  event of a delay in execution due to the
  unavailability of a suitable matching order on
  the other side of the market.
• For instance a trader may specify that his order
  should be either executed on submission or
  canceled.

10
Required Information (Cont)

• Or he may be prepared to specify a period of time
  for which he is prepared to wait if a suitable
  match is not available.
• Exchanges will not obviously permit orders to
  stay alive forever.
• They will specify a maximum validity period.
• Orders which fail to get executed within this
  period will automatically stand canceled.

11
Required Information (Cont)

• Continuing with our example assume that our
  investor places a Day Order.
• It means that if a suitable match is not found by
  the end of the day on which the order is entered,
  it should be canceled.
• The next issue is
• Is it acceptable to partially fill the order

12
Required Information (Cont)

• Take the case of the buy order for 200 shares
• What if a counterparty is found for only 100
  shares?
• Should the order be partially executed and the
  remaining order for 100 shares be kept in
  abeyance until another suitable match is found.
• If the investor does not wish this to happen he
  will place an All or None (AON) order.

13
Introduction (Cont)

• Orders are the fundamental building blocks of
  trading strategies.
• A proper order issued at the right time can
• Make the difference between a profitable trade
  and a costly trade.
• It can at times even make a difference between a
  trade and no trade.

14
Why Orders?

• Orders become essential because most investors do
  not personally arrange their trades.
• Thus, in order to ensure that others execute
  their trades as per their intent, they must
  specify all relevant information.
• Thus it is desirable that they envisage all
  possible contingencies and prescribe suitable
  courses of action.

15
Revocation

• In the event that an investor wishes to modify
  the terms on which he wishes to trade, he has no
  option but to cancel his existing order and
  resubmit a fresh order.
• The problem in practice is that by the time a
  fresh order is issued, market conditions may have
  changed adversely.

16
Revocation (Cont)

• At times, to make matters worse, an existing
  order may get executed before the trader is able
  to have it canceled.
• Thus correct specification is critical.
• Speed is the essence in order placement,
  execution, and cancellation.
• Obviously computer based trading systems are
  superior to manual systems.

17
Terminology

• When a trader wants to indicate that he wishes to
  buy a security, he will make a bid.
• When he wishes to convey that he is seeking to
  sell he will make an offer.
• When a dealer wishes to trade on his own account
  he will quote either a bid or an offer.

18
Terminology (Cont)

• Whereas if the dealer is trading on behalf of a
  client, he will convey the buy or sell order
  placed by the client to a broker or to an
  automated trading system.
• Bids and offers include information not just
  about the price, but also about the quantity
  sought to be transacted.
• This is known as the order size.

19
Terminology (Cont)

• The price specified in a buy order is called the
  bid or the bidding price.
• The price specified in a sell order is called
  the offer, offering, ask, or asking price.
• The highest bid price in the market is called the
  best bid.
• The lowest offer price in the market is called
  the best offer.

20
Terminology (Cont)

• The best bid and offer are also known as the
  Market Bid and Market Offer respectively.
• A Market Quotation, often called a Best Bid and
  Offer (BBO) reports the best bid and offer in the
  market at a point in time.
• The best bid and offer available anywhere in the
  U.S. at a point in time is known as the National
  Best Bid and Offer (NBBO).

21
Terminology (Cont)

• The difference between the best ask and the best
  bid is the bid-ask spread.
• It is also known as the inside spread, since it
  is observed within the market.
• In England the spread is often referred to as the
  touch.
• Once an order is accepted the price at which the
  trade is executed is known as the Trade Price.

22
Terminology (Cont)

• An order may not be released for trading as soon
  as it is submitted.
• In practice a broker may need to check whether a
  particular account is authorized to trade.
• Once an order is accepted, but before it is
  executed, it is known as a Working Order.

23
Order Driven Markets

• Markets may be classified based on the execution
  system
• An execution system is a set of procedures for
  matching buyers and sellers.
• We will first focus on what are called order
  driven markets.

24
Order Driven Markets (Cont)

• What is an order driven market?
• It is a market in which buyers and sellers can
  trade with each other without the intermediation
  of a dealer.
• These markets have specified trading rules which
  stipulate as to how trades should be executed.

25
Order Driven Markets (Cont)

• There are two sets of rules.
• The Order Precedence Rules state as to how buy
  and sell orders should be arranged and matched.
• The Trade Pricing Rules are used to determine the
  price at which a trade is to be executed.

26
Order Driven Markets (Cont)

• Most of these markets are Auction Markets.
• In these markets the trading rules define the
  process by which buyers seek the lowest available
  prices and sellers seek the highest available
  prices.
• This is called the Price Discovery Process.

27
Order Driven Markets (Cont)

• Public traders are not the only traders on such
  markets.
• Dealers can also trade.
• There are in fact markets where they provide most
  of the liquidity.
• In a pure order driven market however, a dealer
  is on par with any other public trader.

28
Order Driven Markets (Cont)

• Many order driven markets conduct continuous
  two-sided auctions in which buyers and sellers
  can continuously attempt to arrange their trades
  at prices that vary through time.
• Such auction markets can be of two types
• Open outcry systems
• Electronic rule based systems

29
Order Driven Markets (Cont)

• In an open outcry system also known as an Oral
  Auction traders negotiate face to face on the
  floor of an exchange.
• The trading rules determine as to who can
  negotiate and when.

30
Order Driven Markets (Cont)

• In an electronic rule based system the trading
  rules are coded into the order-processing
  software.
• There are still some outdated systems where
  incoming orders are matched manually by clerks.

31
Order Driven Markets (Cont)

• Since these markets employ clearly specified
  trading rules traders cannot choose with whom
  they will trade.
• In practice, a trader may end up trading with
  someone with whom he does not have a credit
  relationship.
• To prevent settlement failure, such exchanges
  employ elaborate procedures to ensure that all
  traders are creditworthy and trustworthy.

32
Market Orders

• In the case of a market order there is no
  specified price limit.
• The execution price for such orders is determined
  as follows.

33
Market Orders (Cont)

• A market buy order will be executed at the best
  available price from the standpoint of the
  trader.
• What is the best available price for him?
• It is obviously the lowest of the limit prices
  specified by all those traders who have placed
  unexecuted limit sell orders prior to the
  placement of the market order.

34
Market Orders (Cont)

• Market sell orders too will get executed at the
  best available price from the standpoint of the
  trader.
• This will obviously be the highest of the limit
  prices specified by the traders who have placed
  unexecuted limit buy orders prior to the incoming
  market sell order.

35
Priority Rules

• In order to ensure that market orders get
  executed at the best available prices, the
  unexecuted but valid limit orders at any point in
  time must be sorted according to Priority Rules.
• There are two major rules
• The price priority rule and
• The time priority rule

36
Priority Rules (Cont)

• The primary priority rule is the Price Priority
  Rule.
• According to this
• A limit buy order with a higher limit price ranks
  higher than all other limit buy orders with lower
  limit prices.
• A limit sell order with a lower limit price ranks
  higher than all other limit sell orders with
  higher limit prices.

37
Priority Rules (Cont)

• Thus an incoming market buy order is guaranteed
  to get executed at the lowest available price on
  the sell side of the market.
• An incoming market sell orders is assured of
  getting executed at the highest available price
  on the buy side of the market.

38
Priority Rules (Cont)

• The secondary priority rule is the Time Priority
  Rule.
• How should two or more limit buy orders or limit
  sell orders with the same limit price be
  prioritized?
• Obviously the order which comes in first is
  automatically accorded priority.

39
Limit Order Books

• A Limit Order Book (LOB) at any point in time
  contains the details of those limit orders which
  are currently valid, but which have not been
  executed thus far due to the unavailability of a
  suitable match.
• In the earlier days this record was physically
  maintained in the form of a book of orders.
• These days everything is in electronic form.

40
Illustration

• We will now give a detailed example to
  illustrate
• How orders are arranged on the basis of the
  priority rules
• How matching between orders on the opposite sides
  of the market takes place

41
Illustration (Cont)

• Assume that today is 2 January and that shares of
  a company have just been listed for trading.
• Also assume that in the first 30 minutes the
  following orders are placed.

42
Table-1Chronological Sequence of Orders
Time Trader Order Side Order Size Limit Price
1001 Arvind Buy 100 600.00
1003 Beena Buy 200 600.20
1007 Charu Sell 200 600.10
1010 Dhiraj Sell 500 600.25
1015 Ejaz Buy 200 600.00
1018 Francis Buy 400 Market
1020 Gauri Sell 500 600.00
1025 Harish Sell 200 599.90
1030 Leena Buy 500 599.75
43
Illustration (Cont)

• At 1001 Arvinds order will enter the system.
• It is the very first order so it cannot be
  matched with an order on the other side.
• Since it is a buy order it will go to the top of
  the buy side of the LOB.

44
Table-2Snapshot of the LOB at 1001

• Buyers Sellers

Trader Order Size Limit Price Limit Price Order Size Trader
Arvind 100 600.00
45
Illustration (Cont)

• At 1003 Beenas order will enter the system.
• It too cannot be matched because there are no
  sell orders in the book at that point in time.
• So the order will queue up on the buy side.
• The limit price specified by her which is 600.20
  is higher than the price of 600.00 specified by
  Arvind. So she will get priority.

46
Table-3Snapshot of the LOB at 1003

• Buyers Sellers

Trader Order Size Limit Price Limit Price Order Size Trader
Beena 200 600.20
Arvind 100 600.00
47
Illustration (Cont)

• At 1007 Charus sell order will enter the
  system.
• It has a limit price of 600.10
• It indicates that she is prepared to sell at this
  price or more.
• The system will try and match it with the best
  buy order in the LOB
• This is Beenas order with a limit price of
  600.20.

48
Illustration (Cont)

• Obviously a trade is feasible.
• Charu has sought to sell 200 shares
• Beena has sought to buy 200 shares
• So in the process of execution, both the orders
  will be completely filled.
• One question remains
• At what price will the trade be executed?

49
Illustration (Cont)

• On the National Stock Exchange (NSE) an incoming
  or Active order will get executed at the price of
  the existing or Passive order with which it is
  matched.
• So in this case the trade will get executed at
  600.20.

50
Table-4Snapshot of the LOB following the trade

• Buyers Sellers

Trader Order Size Limit Price Limit Price Order Size Trader
Arvind 100 600.00
51
Illustration (Cont)

• At 1010 Dhirajs sell order will enter the
  system with a limit price of 600.25.
• The system will try and match it with the best
  order on the buy side which has a limit price of
  600.00.
• Obviously a trade is infeasible.
• So Dhirajs order will take its place at the top
  of the sell side of the LOB.

52
Table-5Snapshot of the LOB at 1010

• Buyers Sellers

Trader Order Size Limit Price Limit Price Order Size Trader
Arvind 100 600.00 600.25 500 Dhiraj
53
Illustration (Cont)

• At 1015 Ejazs buy order for 200 shares with a
  limit price of 600.00 will come in.
• It cannot be matched with the best sell order.
• In terms of the limit price it will have equal
  priority with Arvinds order.
• However since it came in later it will be
  accorded lower priority based on the time
  priority rule.
• Hence it will be placed below Arvinds order.

54
Table-6Snapshot of the LOB at 1015

• Buyers Sellers

Trader Order Size Limit Price Limit Price Order Size Trader
Arvind 100 600.00 600.25 500 Dhiraj
Ejaz 200 600.00
55
Illustration (Cont)

• At 1018 Francis market buy order for 400 shares
  will come in.
• This order is assured of execution if there
  happen to be one or more orders on the opposite
  side with a cumulative order size greater than or
  equal to the size of the incoming order.
• In this case there is a sell order for 500 shares.

56
Illustration (Cont)

• Thus the incoming order will be fully filled.
• The trade price will be the price of the passive
  order which 600.25.

57
Table-7Snapshot of the LOB following the trade

• Buyers Sellers

Trader Order Size Limit Price Limit Price Order Size Trader
Arvind 100 600.00 600.25 100 Dhiraj
Ejaz 200 600.00
58
Illustration (Cont)

• At 1020 Gauris sell order for 500 shares with a
  limit price of 600.00 will enter.
• The system will try and match it with Arvinds
  order.
• A trade will result for 100 shares.
• However 400 shares will remain to be filled on
  Gauris order.

59
Illustration (Cont)

• The system will try and match the remainder of
  the order with Ejazs order
• A trade will result for 200 shares.
• However Gauris order will still not be fully
  filled.
• For the balance 200 shares there is no
  possibility of a match.
• So the unfilled portion will stay in the LOB.
• It will go to the top of the sell side since
  Gauris limit price of 600.00 is less than the
  price of 600.25 specified by Dhiraj.

60
Table-8Snapshot of the LOB following the trade

• Buyers Sellers

Trader Order Size Limit Price Limit Price Order Size Trader
600.00 200 Gauri
600.25 100 Dhiraj
61
Illustration (Cont)

• At 1025 Harishs sell order with a limit price
  of 599.90 will enter.
• Based on the price priority rule it will go to
  the top of the sell side of the LOB.

62
Table-9Snapshot of the LOB at 1025

• Buyers Sellers

Trader Order Size Limit Price Limit Price Order Size Trader
599.90 200 Harish
600.00 200 Gauri
600.25 100 Dhiraj
63
Illustration (Cont)

• At 1030 Leenas buy order with a limit price of
  599.75 will enter.
• The system will try and match it with the best
  sell order which has a limit price of 599.90.
• Obviously a trade is infeasible.
• The incoming order will therefore go to the top
  of the buy side of the LOB.

64
Table-10Snapshot of the LOB at 1030

• Buyers Sellers

Trader Order Size Limit Price Limit Price Order Size Trader
Leena 500 599.75 599.90 200 Harish
600.00 200 Gauri
600.25 100 Dhiraj
65
Question

• What would happen if a market order were to enter
  the system and there were to be no limit orders
  on the opposite side.
• Every exchange will specify a solution for this
  eventuality.
• On the NSE if this kind of a situation were to
  occur during the course of a business day then
• The incoming order will become a limit order with
  a limit price equal to the last recorded trade
  price.

66
Table-11The LOB at a Particular Instant

• Buyers Sellers

Trader Order Size Limit Price Limit Price Order Size Trader
599.90 200 Harish
600.00 200 Gauri
600.25 100 Dhiraj
67
Question (Cont)

• Assume that the last recorded trade took place at
  a price of 599.80.
• Assume that a market sell order for 500 shares
  placed by Raghu enters the system.
• Obviously a suitable match cannot be found.
• The incoming order will therefore be converted to
  a limit sell order with a limit price of 599.80.

68
Table-12Post Submission Snapshot of the LOB

• Buyers Sellers

Trader Order Size Limit Price Limit Price Order Size Trader
599.80 500 Raghu
599.90 200 Harish
600.00 200 Gauri
600.25 100 Dhiraj
69
Question (Cont)

• A related question would be
• What if a market order were to enter the system
  at the start of a trading day and there were to
  be no limit orders on the other side.
• The incoming order in such cases will be
  converted to a limit order with a limit price
  equal to the previous days closing price.

70
Market Orders versus Limit Orders

• Isnt a limit order a more sensible alternative
  to placing a market order?
• After all it gives the investor more control over
  the trade.
• The answer is that while it is true that traders
  can control the execution price using limit
  orders, there is no guarantee that a suitable
  match for such orders can be found within a
  reasonable period of time.

71
Market(Cont)

• For instance assume that the last trade price was
  600.20 and the order book at a point in time
  looks as follows.

72
Table-13

• Buyers Sellers

Trader Order Size Limit Price Limit Price Order Size Trader
Arvind 100 600.00 600.25 500 Dhiraj
600.30 300 Solomon
600.30 1,700 Suniti
600.40 1,500 Sunil
600.50 1,000 Kumar
600.50 1,000 Swamy
73
Market(Cont)

• Assume that Ejaz places a buy order for 200
  contracts with a limit price of 600.00.
• It cannot be matched with an existing order.
• So it will take its place in the queue behind
  Arvinds order.

74
Table-14Snapshot of the LOB after Ejazs Order

• Buyers Sellers

Trader Order Size Limit Price Limit Price Order Size Trader
Arvind 100 600.00 600.25 500 Dhiraj
Ejaz 200 600.00 600.30 300 Solomon
600.30 1,700 Suniti
600.40 1,500 Sunil
600.50 1,000 Kumar
600.50 1,000 Swamy
75
Market(Cont)

• Now assume that Simeran places a market buy order
  for 1,500 shares.
• It will obviously get executed immediately.
• 500 shares will be bought at 600.25
• 1000 shares will be bought at 600.30
• So the last reported trade price will be 600.30.

76
Table-15Snapshot of the LOB following the trade

• Buyers Sellers

Trader Order Size Limit Price Limit Price Order Size Trader
Arvind 100 600.00 600.30 1,000 Suniti
Ejaz 200 600.00 600.40 1,500 Sunil
600.50 1,000 Kumar
600.50 1,000 Swamy
77
Market(Cont)

• Now assume that another market order is placed
  for 1500 shares by Rahul.
• It too will get executed.
• 1000 shares will get traded at 600.30
• And 100 shares at 600.40.

78
Table-16Snapshot of the LOB following the second
trade

• Buyers Sellers

Trader Order Size Limit Price Limit Price Order Size Trader
Arvind 100 600.00 600.40 1,000 Sunil
Ejaz 200 600.00 600.50 1,000 Kumar
600.50 1,000 Swamy
79
Market(Cont)

• Seeing the market price jump from 600.20 to
  600.40 in a short span, other traders wishing to
  place buy orders may be induced to place limit
  orders with prices higher than that of the best
  order on the buy side.
• Assume that Pooja places a buy order for 500
  shares at 600.10
• Followed by Ajay who places a buy order for 1,500
  shares at 600.15.

80
Table-17The LOB at the End

• Buyers Sellers

Trader Order Size Limit Price Limit Price Order Size Trader
Ajay 1,500 600.15 600.40 1,000 Sunil
Pooja 500 600.10 600.50 1,000 Kumar
Arvind 100 600.00 600.50 1,000 Swamy
Ejaz 200 600.00
81
Market(Cont)

• As can be seen Ejazs order has been pushed back
  in the queue.
• There is no way of telling when it will get
  executed
• There is no guarantee that it will get executed
  at all.
• Had Ejaz placed a market order instead at the
  outset it would have been immediately executed at
  600.25.

82
Market(Cont)

• Thus market orders are guaranteed to be executed
  if there are sufficient limit orders on the other
  side
• But the trader has no control over the execution
  price.
• This is because the trade price will depend on
  the limit price of the matching limit order.

83
Marketable Limit Orders

• The odds of a limit order being executed on
  submission would depend on its limit price.
• For buy orders, the higher the limit price the
  greater is the chance of early execution.
• For sell orders, the lower the limit price the
  greater is the chance of early execution.
• Limit buy orders with high prices and sell orders
  with low prices are said to be Aggressively
  Priced.

84
Marketable(Cont)

• In most cases
• Limit buy orders will be placed at a price lower
  than the best available price in the market
• Which is the price of the best sell order in the
  LOB
• Limit sell orders will be placed at a price
  higher than the best available price in the
  market
• Which is the price of the best buy order in the
  LOB

85
Marketable(Cont)

• Sometimes however a trader could price his limit
  order very aggressively.
• A limit order is said to be marketable if it can
  be executed on submission.
• We will illustrate it using an example.
• Consider the following LOB.

86
Table-18Snapshot of an LOB

• Buyers Sellers

Trader Order Size Limit Price Limit Price Order Size Trader
Anil 500 600.00 600.25 1300 Prasad
Ashraf 1000 599.90 600.40 1200 Ahmed
Mohan 1500 599.75 600.50 1500 Kumar
87
Marketable(Cont)

• A limit buy order with a limit price of 600.25 or
  more will get executed as soon as it enters the
  system.
• A limit sell order with a limit price of 600.00
  or less will be executed as soon as its enters
  the system.

88
Marketable(Cont)

• So the limit price for a marketable buy order
• Must be greater than or equal to the best
  available offer
• The limit price for a marketable sell order must
  be less than or equal to the best bid.

89
Marketable(Cont)

• A marketable limit order seems fairly similar to
  a market order
• The question is
• Why would anyone wish to place a marketable limit
  order instead of a market order?

90
Rationale

• Both market orders as well as marketable limit
  orders embody a desire for quick execution on the
  part of the trader.
• But in the case of a market order he has no
  control over the execution price
• In the case of a marketable limit order he can
  specify a floor or a ceiling.

91
Rationale (Cont)

• When is this freedom to specify a floor or a
  ceiling likely to prove valuable?
• It will be significant if circumstances were to
  preclude a marketable limit order from getting
  executed as planned.
• Let us go back to Table-18.

92
Table-18Snapshot of an LOB

• Buyers Sellers

Trader Order Size Limit Price Limit Price Order Size Trader
Anil 500 600.00 600.25 1300 Prasad
Ashraf 1000 599.90 600.40 1200 Ahmed
Mohan 1500 599.75 600.50 1500 Kumar
93
Rationale (Cont)

• Assume that a trader named Ravi issues a limit
  buy order with a limit price of 600.30 for 300
  shares.
• His expectation at the time of placing the order
  is that
• It will get matched with the best offer which is
  at 600.25

94
Rationale (Cont)

• But it may so happen that another market order
  may enter the system before Ravis order.
• Traders throughout the country (world) are
  monitoring the situation
• A split seconds delay in order entry can lead to
  another order (s) acquiring time priority.

95
Rationale (Cont)

• Let us assume that a large market buy order for
  3000 shares enters prior to Ravis order.
• It will push the trade price up to 600.50.
• Since Ravi has specified a limit of 600.30
• His order will not be executed
• Instead it will go to the top of the LOB on the
  buy side

96
Rationale (Cont)

• If Ravi believes that the execution price is
  important although the speed of execution is a
  major factor
• He may prefer a marketable limit order to a
  market order
• In this case had he placed a market order it
  would have got executed at 600.50, an outcome
  that may not be satisfactory.

97
Rationale (Cont)

• Thus marketable limit orders give the trader
  control over the execution price
• But there is execution uncertainty.

98
Limit Orders as Options

• A standing limit order is an offer of liquidity
  to other traders.
• It gives them an option to trade at the limit
  price.
• A limit sell order is a call option that gives
  other traders the right to buy.
• A limit buy order is a put option that gives
  other traders the right to sell.

99
Options (Cont)

• The specified limit prices are the exercise
  prices of the corresponding options.
• However although a limit order represents an
  option, it is not an options contract in the
  conventional sense.
• An options contract is an option to trade that is
  sold by a writer to a buyer in return for a price
  or premium.

100
Options (Cont)

• Limit orders however are options given away for
  free.
• In the sense that the traders who place such
  orders do not receive a premium.
• Besides there is no exclusive owner of the option
  on the other side.
• For any trader can exercise the option by placing
  a market order or a marketable limit order.

101
Compensation for Traders Placing Limit Orders

• A trader who places a limit order does not get an
  option premium even though the order represents
  an option.
• So why should the trader offer an option for
  free?
• The answer is that the trader hopes to trade at a
  better price.

102
Compensation(Cont)

• A buyer who has submitted a standing limit order
• Expects to buy at the bid price represented by
  his order
• Had he submitted a market order instead
• He would have to buy at the ask price
• Consider the following LOB

103
Table-19Snapshot of the Petronet LOB

• Buyers Sellers

Trader Order Size Limit Price Limit Price Order Size Trader
Vivek 500 20.85 20.95 1300 Usha
Vikas 1000 20.80 21.05 1200 Uma
Vinod 1500 20.75 21.15 1500 Urmila
Vijay 1000 20.70 21.20 2000 Urvi
Vinay 1500 20.65 21.15 1000 Uttara
104
Compensation(Cont)

• The trader who has placed the best bid expects to
  trade at 20.85.
• Had he placed a market order instead
• He would have ended up buying at 20.95

105
Problems with Limit Orders

• A trader placing a limit order will not always
  get what he is seeking.
• Sometimes the market could move away from him
• The consequence will be that his order never gets
  traded

106
Problems(Cont)

• If he still wants to trade he will have to chase
  the market
• Bidders will have too increase their bids
• Sellers will have to lower their offers
• Thus the price at which he ultimately trades may
  be worse than the price that he would have traded
  at had he used a market order at the outset.

107
Illustration

• Take the case of the trader who has placed the
  best bid for Petronet at 20.85.
• Assume that a market order for 3000 shares comes
  in and get executed.
• The best ask will become 21.15.
• Also assume that new limit buy orders come in at
  20.90 and 21.00.

108
Illustration(Cont)

• If after observing this our trader were to cancel
  his limit order and either place a fresh limit
  order at 21.00 or else place a market order which
  will then get executed at 21.15
• The eventual price will be worse than 20.95
• Which is the price he would have got had he used
  a market order at the outset.

109
Risks

• Traders who use limit orders face two kinds of
  risks.
• The first pertains to execution uncertainty.
• When prices move away from their orders limit
  order traders will fail to trade
• For instance in the case of Petronet, if market
  buy orders keep entering
• The best offer will move up from 20.85
• From the point of view of a trader who has placed
  a buy order at 20.65
• The odds of execution will be reduced.

110
Risks (Cont)

• The second risk is that a trader may end up
  trading and may subsequently regret it.
• This will be the case if the price moves towards
  and through his limit price.
• His order will obviously get executed.
• But if the market continues to move sharply
  against him he could make significant losses.

111
Risks (Cont)

• For instance, in the case of Petronet, assume
  that a market sell order for 4000 shares comes in
• It will cause a buy order for 1000 shares at
  20.70 to get executed.
• If the price were to keep declining
• The buyer may have to offload the shares
  subsequently at an even lower price

112
Risks (Cont)

• This is called ex-post regret.
• This kind of regret is an occupational hazard for
  all traders and not just those who place limit
  orders.

113
Stop-Loss Orders

• What is a Stop-Loss order?
• A stop or a stop loss order is an order placed by
  a trader who has a position in the market and
  would like to cut his losses and quit immediately
  if the conditions were to turn adverse.
• Such a person may have no desire to close out his
  position at the time of placing his order.

114
Stop-Loss Orders (Cont)

• Take the case of an investor who is long in a
  stock and expects the price to rise.
• However if there were to be a sudden
  unanticipated decline in the market he may like
  to ensure that his loss does not exceed an
  acceptable level.
• Let us assume that his threshold loss corresponds
  to a price of P.

115
Stop-Loss Orders (Cont)

• In this case he can place a stop order with a
  trigger price of P
• The stop instruction will prevent the order from
  getting activated until and unless the trigger is
  hit or breached.
• Once the trigger is hit or breached the order
  will get triggered off and will become a market
  order.

116
Table-20LOB prior to the placement of a
stop-sell order

• Buyers Seller

Trader Order Size Limit Price Limit Price Order Size Trader
Aarti 1200 600.00 600.20 500 Arvind
Anita 1000 599.85 600.30 1000 Anurag
Aakanksha 500 599.75 600.35 500 Amitabh
Anamika 800 599.55 600.40 700 Arjun
Anushua 500 599.25 600.50 300 Ajay
Anjali 1000 598.00 602.00 1000 Avinash
117
Illustration (Cont)

• Assume that Vijay is currently long in 800
  shares.
• He has no intention of selling.
• However if the market were to trade at 599.60 or
  below then he would like to exit the market
  immediately.
• He can therefore place a stop sell order with a
  trigger price of 599.60.

118
Illustration (Cont)

• Assume that a market sell order for 4000 shares
  comes in.
• It will ensure that Aartis, Anitas,
  Aakankshas, Anamikas, and Anushuas orders are
  fully filled.
• The last trade price will be 599.25
• This is less than Vijays trigger.
• So his order will get activated and will get
  executed at 598.00.

119
Illustration (Cont)

• The trigger price in the case of a stop sell
  order will always be less than the best price
  that is available at the time of placing the
  order
• Which in Vijays case is 600.00

120
Stop Orders (Cont)

• Such orders can also be used by those who wish to
  buy in the event of adverse market conditions.
• Assume that Rajiv has a short position in 800
  shares.
• He expects the market to fall.
• However if the price were to rise and hit or
  cross 600.50, then he would like to offset his
  short position and exit the market.

121
Stop Orders (Cont)

• Assume that Rajiv places a stop buy order with a
  trigger of 600.50.
• Assume that a market order for 3000 shares
  enters.
• Arvinds. Anurags, Amitabhs, Arjuns, and
  Ajays orders will be completely filled.
• The last trade price will be 600.50 which
  corresponds to Rajivs trigger.

122
Stop Orders (Cont)

• The stop buy order will get activated and will
  get executed at 602.00.
• In the case of stop buy orders the trigger price
  will always be greater than the best price
  available in the market which is 600.20.

123
Stop-Limit Orders

• Such an order also is an instruction to hold the
  order in abeyance until a specified trigger is
  hit or breached.
• The difference is that in this case if the order
  is triggered off it will become a limit order.
• Thus two threshold prices have to specified.
• The first corresponds to the activation level for
  the limit order
• The second is the limit price for the limit order.

124
Stop-Limit Orders (Cont)

• Why do we need such orders?
• Take Vijays case first.
• His sell order got executed at 598.00 even though
  he had specified a trigger of 599.60.
• He obviously had no control over the execution
  price
• Because the order became a market order on
  activation.

125
Stop-Limit Orders (Cont)

• If Vijay wanted to protect himself against such
  an eventuality he could have placed a stop limit
  order with a trigger price of 599.60 and a limit
  price of say 599.25.
• In this case if the stop order is activated it
  will become a limit order at 599.25.
• So Vijay is assured of a price of 599.25.

126
Stop-Limit Orders (Cont)

• Similarly when Rajiv placed a stop buy order it
  eventually got executed at 602.00 even though the
  specified trigger was 600.50.
• To protect himself he could have specified a
  stop-limit order with a trigger of 600.50 and a
  limit price of say 601.
• In this case he will have to pay a maximum price
  of 601.

127
Market Impact

• Large market orders are more difficult to fill
  than small ones and often result in large price
  moves.
• If there is a large buy order prices may move up
  substantially.
• If there is a large sell order prices may move
  down substantially.

128
Market Impact (Cont)

• The movement in price due to a large order is
  called the Market Impact or the Price Impact of
  the order.
• Take the case of the following LOB.

129
Table-20

• Buyers Seller

Trader Order Size Limit Price Limit Price Order Size Trader
Aarti 1200 600.00 600.20 500 Arvind
Anita 1000 599.85 600.30 1000 Anurag
Aakanksha 500 599.75 600.35 500 Amitabh
Anamika 800 599.55 600.40 700 Arjun
Anushua 500 599.25 600.50 300 Ajay
Anjali 1000 598.00 602.00 1000 Avinash
130
Illustration (Cont)

• A large market buy order for 4000 shares would
  get executed at prices ranging from 600.20 to
  602.00.
• A large market sell order for 5000 shares would
  get executed at prices ranging from 600.00 to
  598.00

131
Lot Size

• The usual unit of trading is referred to as a
  Round Lot.
• Normally traders trade in multiples of a round
  lot.
• Anything less than a round lot is an odd lot.
• The definition of a round lot depends on the
  instrument being traded and the market on which
  it trades.

132
Lot Size (Cont)

• On the American Stock Exchange, there is no no
  standard lot size, and a trade can be for any
  number of shares.
• Most stock exchanges in the U.S. specify a round
  lot as constituting 100 shares.
• In Japan a round lot is equivalent to 1000 shares.

133
Time Conditions

• Traders specify validity instructions to indicate
  the period of validity of their orders.
• They also specify expiration instructions to
  indicate as to when and how their orders become
  void.
• In principle such instructions can be specified
  for any kind of an order.

134
Time Conditions (Cont)

• But these conditions are particularly important
  for standing limit orders and stop orders.
• This is because such orders rarely trade on
  submission, and some may never trade.
• Consequently there is a need to specify what is
  to be done with unfilled orders.

135
Open Good Orders

• An order that that has not yet been executed or
  canceled is an open order.
• An order that is eligible for execution is a good
  order.
• All good orders by definition are open orders.
• But every open order need not be a good order.

136
Open Good Orders (Cont)

• Consider an order placed on 1 July to buy a stock
  on or after 3 July.
• On 1 July the order is an open order.
• But is not a good order.

137
Day Orders

• A day order is valid only for the duration of the
  day on which it is entered.
• If it is not executed during the course of the
  day, then the system will automatically cancel it
  at the end of the day.
• As of 1999 the Stock Exchange of Singapore has
  been permitting only good today limit orders.

138
Day Orders (Cont)

• Every morning the Exchange opens with no
  outstanding orders carried over from the previous
  day.

139
Good Till Canceled Orders

• Such orders will remain in the system until they
  are executed or canceled, whichever happens
  first.
• So if they are not executed on the day on which
  they are entered, they will be carried over to
  the next day and so forth.
• But obviously they cannot remain in the system
  indefinitely.

140
GTC Orders (Cont)

• The exchange will notify a maximum time period
  after which such orders will be automatically
  canceled.
• In order to ensure that traders do not forget
  such orders, many brokers provide their clients
  with a list of unfilled GTC orders at the end of
  every month.

141
GTC Orders (Cont)

• Some brokers cancel GTC orders after
  pre-specified time periods to avoid the cost of
  keeping track of stale orders.
• In the U.S GTC orders expire semi-annually unless
  canceled earlier.
• That is, they have a maximum validity of six
  months.

142
Good Till Days Order

• In the case of such orders, the investor has to
  specify the number of days for which the order
  can stay in the system unless it is executed.
• The number of days that can be specified
  obviously cannot exceed the time limit set for
  Good Till Canceled orders.

143
GTD Orders (Cont)

• Special cases of such orders are Good-this-week
  (GTW) orders and Good-this-month (GTM) orders.
• Not all brokers will accept such orders because
  it requires then to keep track of expiration
  dates.

144
Immediate or Cancel Orders

• Such orders have to be executed as soon as they
  are released into the system or else they have to
  be canceled.
• Sometimes only a partial match may be found.
• If so, a part of the order will be executed and
  the unmatched portion will be immediately
  canceled.
• They are also known as Fill or Kill (FOK) orders
  or as Good-on-sight orders.

145
Other Types of Orders

• Good-after-orders are activated or become valid
  only after a pre-specified date.
• Market-on-open orders can be filled only at the
  beginning of the trading session.
• Market-on-close orders can be filled only at the
  close of the trading session.

146
Quantity Instructions

• All-or-nothing or all-or-none (AON) orders must
  be either filled all at once or else remain
  unexecuted.
• There are also trades with a minimum or none
  instruction.
• In such cases multiple trades can be used to fill
  an order.

147
Quantity (Cont)

• But each trade must be for a quantity that is
  greater than or equal to a specified minimum
  size.
• Such orders are also known as Minimum Acceptable
  Quantity (MAQ) orders.

148
Tick Size

• What is a tick?
• It is the minimum price increment or variation
  observable in the market.
• In other words, it is the smallest amount by
  which two prices can differ.
• It is usually set by exchange regulations.

149
Tick Size (Cont)

• In the U.S. until 2000 the tick size was
  one-sixteenth of a dollar or 6.25 cents.
• Subsequently the system has been decimalized and
  tick size is now 0.01 dollars or one cent.
• The tick size on the Tokyo Stock Exchange is a
  function of the price.

150
Tick Size (Cont)
Price Tick Size
P ? 2000 Yen 1 Yen
2000 lt P ? 3000 5 Yen
3000 lt P ? 30000 10 Yen
30000 lt P ? 50000 50 Yen
50000 lt P ? 100000 100 Yen
100000 lt P ? 1000000 1000 Yen
P ? 1000000 10000 Yen
151
Tick Size (Cont)

• Traders classify prices by their relation to
  previous prices.
• A price is said to be on an uptick if it is
  higher than the last observed price.
• A price is said to be on a downtick if it is
  lower than the last observed price.
• If a price is equal to the last observed price it
  is said to be on a zero tick.

152
Tick Size (Cont)

• Zero tick prices are further classified depending
  on the last different price observed.
• A price is said to be on a zero downtick if the
  last different price observed was higher.
• A price is said to be on a zero uptick if the
  last different price observed was lower.

153
Illustration
Previous to Last Price Last Price Current Price Term
72.00 72.00 72.10 Uptick
72.00 72.00 71.90 Downtick
72.10 72.00 72.00 Zero Downtick
71.90 72.00 72.00 Zero Uptick
154
Oral Auctions

• Many futures, options, and stock exchanges use
  continuous bilateral oral auctions to trade their
  contracts and securities.
• The largest such market is the market for T-bond
  futures on the CBOT which attracts 500 floor
  traders.
• In an oral auction traders meet face to face on
  the floor of the exchange.

155
Oral Auctions (Cont)

• Some will cry out their bids while others will
  call out offers.
• Still others will listen for bids and offers that
  meet their requirements.
• Most traders will do both shout as well as
  listen.

156
Oral Auctions (Cont)

• Trades occur when a buyer accepts a sellers
  offer or when a seller accepts a buyers bid.
• In the first case the buyer will shout take it
  to accept the offer.
• In the second case the seller will call out
  sold to accept the bid.

157
Oral Auctions (Cont)

• Buyers and sellers often take turns bidding and
  offering until they agree on a price and quantity
  to trade.
• A trader who makes a bid or an offer to trade is
  a supplier of liquidity.
• A trader who accepts a bid or an offer is an
  acceptor of liquidity.

158
Oral Auctions (Cont)

• The first rule of an oral auction is the
  open-outcry rule.
• That is, a trader must publicly express his bid
  or offer to enable others to react.
• Any trader can accept a bid or ask called out by
  another trader, even though they may not be
  actively negotiating at that point of time.

159
Oral Auctions (Cont)

• The first person to accept a bid or an offer
  generally gets to trade.
• The order precedence rules determine who can bid
  or offer, as well as whose bids or offers other
  traders can accept.
• The primary order precedence rule is always price
  priority.

160
Oral Auctions (Cont)

• The secondary order precedence rule would depend
  on the market concerned.
• Futures markets go by time preference.
• Stock markets use public order preference
  followed by time preference.

161
Price Priority

• The rule gives precedence to traders who offer
  the best prices.
• Buyers can only accept the lowest offers and
  sellers can only accept the highest bid.
• This rule is self-enforcing.
• Because an honest trader will search for the best
  prices.

162
Price Priority (Cont)

• Most oral auctions will not allow a trader to bid
  below the best bid or offer above the best offer.
• Such bids and offers only add to the noise and
  create confusion.
• However a trader can improve the best bid by
  bidding higher.
• A trader can similarly improve the best offer by
  offering at a lower price.

163
Time Priority

• The time precedence rule gives precedence to the
  trader whose bid or offer improves the current
  best bid or offer.
• When a trader is having time preference no trader
  can bid or offer at the best bid or offer that is
  currently available.

164
Time Priority (Cont)

• A trader will retain his time preference until
  another trader improves his quote or until
  another trader accepts his quote.
• Once a bid or offer is accepted, anyone may bid
  or offer at the new price and all orders at that
  price have equal standing.

165
Priority

• In an oral auction bids or offers are valid only
  for an instant.
• In practice traders maintain their precedence by
  repeating their bids/offers as often as is
  necessary to show that they remain interested.
• In a large active market, a trader may
  continuously repeat his bid/offer.

166
Time Priority (Cont)

• The time precedence rule encourages competition
  among traders.
• Because if a trader is aggressive the only way
  that he can get ahead of someone who has time
  precedence is by improving the price.
• And if he improves the price he automatically
  gets the right to trade first.

167
Time Priority (Cont)

• Unlike price priority time priority is not self
  enforcing.
• Most traders do not care whose bid or ask they
  are accepting as long as they get the best price.
• Thus a person with time preference must defend it
  when someone improperly tries to quote at the
  same price.

168
Time Priority (Cont)

• In practice a trader whose priority is being
  challenged will yell out
• Thats my bid or
• Thats my offer or
• Thats my market

169
Public Traders

• Some equity exchanges prohibit members from
  trading ahead of a public trader who is willing
  to trade at the same price.
• Why is this rule required?
• An exchange member can easily acquire time
  preference at a new price before a public trader,
  because he sees price changes first and can quote
  faster than a public trader can submit orders.

170
Public Traders (Cont)

• Thus this priority rule permits a public trader
  to take precedence over a member even when the
  member has time preference.
• The objective is to give public traders greater
  access to the market and weaken the information
  advantage possessed by the floor trader.

171
Trade Pricing Rule

• This is used to determine the price at which a
  trade is accepted.
• In an oral auction every trade takes place at the
  price proposed by the trader whose bid or offer
  is accepted.