Money, Banking

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Money, Banking FinanceLecture 4

• The Theory and Practice of Equity Trading

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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.

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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

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Investment Decisions
Time Taken by Fund Managers to make buy/sell
decision
5 4 3 2 1 Mean frequency
lt 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
1 m 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, 39-49
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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.

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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.

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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 dont 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.

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Price Discovery
P
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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 gt P
• Sell orders are made when P lt P. When P gt
  P(offer) or P lt 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.
  

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P and Best Bid and Offer Quotes
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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.

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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.

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What Drives a Market?
Liquidity Order Flow
Momentum
Informed
Quotes, Prices, Volume
Trading Mechanism Order Book, Market Makers, Call
Auction
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TraderEX Purpose

• Make trading decisions
• Understand price discovery
• 3) Evaluate trading rules for
• market participants
• market quality
• intermediaries and dealer roles
• 4) Compare alternative market systems
• 5) Have Fun

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Computers 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)

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Teaching Trading and Markets with TraderEx
simulations (I)
e.g., cardiff2
cardiff
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Teaching Trading and Markets with TraderEx
simulations (II)
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(No Transcript)
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Buy orders
Market orders
Limit orders
Sell orders
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Order book market
Ask 213 offered at 20.60
20.40 Bid for 59
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Entering a limit order
User has entered 2 limit orders to sell
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User is entering a market order to sell
Click to cancel your limit order to sell 10 at
19.90
(44) units ahead of your 10
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Sold!
Mark-to-market PL -2.00
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The Order Driven Market in TraderEx
Days High Price
Your limit orders to sell
Ask 46 offered at 20.00
40 units ahead of your 10
Ticker of trades
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Can enter Chat messages
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Performance measures1) Average prices
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Performance measures2) PL
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Performance measures3) VWAP
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Market Structures

• Order-driven Buy-side trader with large order
• Quote-driven Market maker/ liquidity provider
• Order book w/ Periodic call auction (3x day)
• Order book w/ Dark liquidity pool

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Order driven market
Buy-Side Trader (YOU)
Investment Managers Decision
Order Book Market
Trade Occurs
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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 PL position is
• -33

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Buy side performance

• PL per share
• Mark-to-Market Price Average Purchase Cost
• Good trading
• VWAP Average Purchase Cost gt 0
• Good stock selection
• Last Price Price at time

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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.