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Research Methodology in Market Microstructure


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Title: Research Methodology in Market Microstructure

Research Methodology in Market Microstructure
  • Kee H. Chung
  • State University of New York
  • at Buffalo

What is market microstructure?
  • Traditional asset pricing aims to understand what
    should be the price of a security.
  • It does not, however, address how prices adjust
    to reflect news.
  • Nor does it explain how investors subjective
    assessment of a security get into the price.

  • In practice, news and investors valuations are
    incorporated into security prices through
  • This means that the specific trading rules, and
    the strategies traders develop in response to
    these rules, will affect how asset prices change
    over time in response to new information.

  • Market microstructure is the study of the
    process and outcomes of exchanging assets under
    explicit trading rules. (Maureen OHara, a
    former president of the American Finance
  • Market microstructure has a profound impact on
    the real world on traders, broker/dealers,
    exchanges, regulators, and policy makers alike.

Why do we care?
  • Data guided by theory, theory guided by data
  • Market design issues
  • Agency auction market
  • Dealer market
  • Electronic limit order books

  • Market performance issues
  • Transaction costs
  • Shock absorption/resiliency
  • Trading halts
  • Efficiency welfare issues
  • Is insider trading bad?

Topics to be covered
  • Part I Foundation and Protocols
  • Orders and order properties
  • Market structure
  • Order-driven markets
  • Dealer markets

  • Part II Analytics and Models
  • Informed trading and market efficiency
  • Bid-ask spreads
  • Measurement of trading (execution) cost
  • Adverse selection models
  • Spread component models

  • Part III Select Topics
  • Trade classification
  • Nasdaq controversy, stock price clustering, and
    SEC market reforms
  • Order preferencing
  • Market structure and execution costs
  • Minimum price variation (tick size) and

  • Part III Select Topics (Continued)
  • Competition in dealer market
  • Intraday patterns and test of alternative
  • Spread and depth Joint decision variables
  • Trades, information, and prices
  • Commonality in liquidity
  • Market microstructure and interactions with other

  • Chapter 4
  • Orders and Order Properties

  • Orders are instructions to trade that traders
    give to brokers and exchanges that arrange their
  • Orders always specify
  • The security to be traded
  • The quantity to be traded
  • The side of the order (buy or sell)

  • Orders may specify
  • Price specifications
  • How long the order is valid
  • When the order can be executed
  • Whether they can be partially filled or not

Who uses orders?
  • Traders that either do not have direct access to
    the markets, or do not have the time to monitor
    the markets use orders.
  • Have to anticipate what is going to happen.
  • Have to clearly delineate contingencies. Use
    standard orders to avoid mistakes.

  • Traders who use orders are at a disadvantage
    vis-à-vis professional traders.
  • Risk of misunderstandings
  • Conflicts of interest
  • Speed of reaction to changing market conditions
  • Cancellations can be time consuming
  • Access to order flow information

Some important terms 1
  • Bid buy order specifying a price (price is
    called the bid).
  • Offer sell order specifying a price (price is
    called offer or ask).
  • Best Bid standing buy order that bids the
    highest price bid.
  • Best offer standing sell order that has the
    lowest price offer.

Some important terms 2
  • Dealers have an obligation to continuously quote
    bids and offers, and the associated sizes (number
    of shares), when they are registered market
    markers for the stock.
  • Their quotes also have to be firm during regular
    market hours.

Some important terms 3
  • Public orders with a price limit can also become
    the market bid or offer if they are at a better
    price than those currently quoted by a registered
    market maker.
  • The markets best bid and offer constitute the
    inside market, the best bid/ask, or the BBO. The
    best bid and offer across all markets trading an
    instrument is called the NBBO.

Some important terms 4
  • The difference between the best offer and the
    best bid is the bid/ask spread, or the inside
    spread (touch).
  • Orders supply liquidity if they give other
    traders the opportunity to trade.
  • Orders demand liquidity (immediacy) if they take
    advantage of the liquidity supplied by other
    traders orders.

What are agency/proprietary orders?
  • Orders submitted by traders for their own account
    are proprietary orders.
  • Broker-dealers and dealers.
  • Since most traders are unable to directly access
    the markets, most order are instead agency
  • Presented by a broker to the market.

Market orders
  • Instruction to trade at the best price currently
    available in the market.
  • Immediacy
  • Buy at ask/sell at bid gt pay the bid/ask spread
  • Price uncertainty
  • Fills quickly but sometimes at inferior prices.

  • Used by impatient traders and traders who want to
    be sure that they will trade. It is usually
    thought that insiders use that type of order.
  • When submitting a market order execution is
    nearly certain but the execution price is
  • Takes liquidity from the market in terms of
    immediacy. They then pay a price for immediacy,
    which is the bid-ask spread.

Market order Example 1
  • Suppose that the quote is 20 bid, 24 offered.
    Suppose that the best estimate of the true value
    of the security is 22.
  • A market buy order would be executed at 24 for a
    security worth 22.
  • The price paid would be 24 and therefore the
    price of immediacy would then be 2.

Market order Example 2
  • A market sell order would be executed at 20 for a
    security worth 22.
  • The price received would be 20 and therefore the
    price of immediacy would then be 2.
  • The price of immediacy is the bid-ask spread.

Price improvement
  • Price improvement is when a trader is willing to
    step up and offer a better price than that of the
    prevailing quotes (at order arrival).
  • Who benefits from price improvement?
  • Who loses from price improvement?

Market impact
  • Large market orders tend to move prices.
  • Liquidity might not be sufficient at the inside
    quotes for large orders to fill at the best
  • Prices might move further following the trade.
  • Information and liquidity reasons.

Market impact Example
  • For example, suppose that a 10K share market buy
    order arrives in IBM and the best offer is 100
    for 5K shares.
  • Half the order will fill at 100, but the next 5K
    will have to fill at the next price in the book,
    say at 100.02 (where we assume that there is
    also 5K offered).
  • The volume-weighted average price for the order
    will be 100.01, which is larger than 100.00.

Limit orders
  • A limit order is an instruction to trade at the
    best price available, but only if it is no worse
    than the limit price specified by the trader.
  • For a limit buy order, the limit price specifies
    a maximum price.
  • For a limit sell order, the limit price specifies
    a minimum price.

Limit orders Examples
  • If you submit a limit buy order for 100 shares
    (round lot) of Dell with limit price of 20. This
    means that you do not want to buy those 100
    shares of Dell at a price above 20.
  • If you submit a limit sell order for 100 shares
    (round lot) of Dell with limit price of 24. This
    means that you do not want to sell those 100
    shares of Dell at a price below 24.

  • If the limit order is executable (marketable),
    than the broker (or an exchange) will fill the
    order right away.
  • If the order is not executable, the order will be
    a standing offer to trade.
  • Waiting for incoming order to obtain a fill.
  • Cancel the order.
  • Standing orders are placed in a file called a
    limit order book.

Limit price placement (from very aggressive to
least aggressive)
  • Marketable limit order order that can
    immediately execute upon submission (limit price
    of a buy order is at or above the best offer),
  • At the market limit order limit buy order with
    limit price equal to the best bid and limit sell
    order with limit price equal to the best offer,
  • Behind the market limit order limit buy order
    with limit price below the best bid and limit
    sell order with limit price above the best offer.

Market Microstructure Seminar - TE Chapter 4
Market Microstructure Seminar - TE Chapter 4
A standing limit order is a trading option that
offers liquidity
  • A limit sell order is a call option and a limit
    buy order is a put option. Their strike prices
    are the limit prices.
  • A limit order is not an option contract (not
  • The option is good until cancelled or until the
    order expires.
  • The value of the implicit limit order option
    increases with maturity.

Why would anyone use limit orders?
  • The compensation that limit order traders hope to
    receive for giving away free trading options is
    to trade at a better price.
  • However, options might not fill (execution
  • Chasing the price.

  • Limit order traders might also regret having had
    their order filled (adverse selection)
  • What could cause a limit order to regret
    obtaining a fill?
  • How would this fact affect strategies involving
    limit orders?

Market Microstructure Seminar - TE Chapter 4
Market Microstructure Seminar - TE Chapter 4
Market Microstructure Seminar - TE Chapter 4
Stop orders
  • Activates when the price of the stock reaches or
    passes through a predetermined limit (stop
    price). When the trade takes place the order
    becomes a market order (conditional market
  • Buy only after price rises to the stop price.
  • Sell only after price falls to the stop price.

  • Stop orders are typically used to close down
    losing positions (stop loss orders).
  • Mainly used on market orders and few on limit

  • Example Suppose that the market for Dell is
    currently 20 bid, 24 offered.
  • Suppose that you place a stop loss order for
    1,000 shares of Dell at a stop price of 15.
  • Suppose that after having placed that order, the
    market falls to 13 bid, 15 offered. The bid
    price passed your stop price.
  • Your order is then executed at 13 provided there
    is enough quantity at that price.
  • The stop price may not be the price at which you
    are executed, as above.

Difference between stop orders and limit orders
  • The difference lies in their relation with
    respect to the order flow.
  • A stop loss order transacts when the market is
    falling and it is a sell order. Therefore such an
    order takes liquidity away from the market (it
    must be accommodated so it provides impetus to
    any downward movement).

  • A limit order trades on the opposite side of the
    market movement. If the market is rising, the
    upward movement triggers limit sell orders.
  • Outstanding limit orders provide liquidity to the

Tick-sensitive orders
  • Traders who want to condition their orders on the
    last price change submit tick-sensitive orders.
  • Uptick current price is above the last price
  • Downtick current price is below the last price
  • Zero-tick current price is the same as last

Tick-sensitive orders
  • Do tick-sensitive orders demand or supply
  • How do tick-sensitive orders compare to limit
  • How are tick-sensitive orders affected by the
    minimum price-increment?

Order validity and expiration instructions
  • Day orders (DAY)
  • Good-till-cancel (GTC) orders
  • Good until orders
  • Good-this-week (GTW) orders, good-this-month
    (GTM) orders
  • Immediate-or-cancel (IOC) orders
  • Fill-or-kill (FOK) orders, good-on-sight orders
  • Good-after-orders
  • Market-on-open (MOO) orders
  • Market-on-close (MOC) orders

Quantity instructions
  • All-or-none (AON) orders
  • Minimum-or-none (MON) orders
  • All-or-nothing, and minimum acceptable quantity

Other order instructions
  • Spread orders
  • Display instructions
  • Hidden/Ice-berg/reserve orders
  • Substitution ordersSpecial settlement
  • Regular-way settlement
  • Cash settlement
  • How do these affect the cost of trading?

  • Chapter 5
  • Market Structures

Trading sessions
  • Trades take place during trading sessions.
  • Continuous market sessions
  • Call market sessions

Continuous markets
  • Traders may trade at anytime while the market is
  • Traders may continuously attempt to arranger
    their trades.
  • Dealer markets or quote driven markets are, by
    definition, continuous markets.

Pros and cons of continuous markets
  • Pros for continuous markets
  • Traders can arrange their trades whenever they
  • Information may be incorporated very fast into
  • Cons for continuous markets
  • more volatile

Call markets
  • Traders may trade in call markets only when the
    market is called.
  • You may have all securities called at the same
    time or only some. The market may be called
    several times per day.
  • Used to open sessions in continuous markets
    (Bourse de Paris, NYSE,). Also used for less
    active securities, bonds,.

Pros and cons of call markets
  • Pros for call markets
  • Focus the attention of traders on the same
  • security at the same time.
  • Less volatility
  • Cons for call markets
  • Information may need a lot of time to be
  • incorporated into prices.

Execution systems
  • The execution system matches the buyers with the
  • quote-driven markets
  • order-driven markets
  • brokered markets
  • hybrid markets

Quote-driven dealer markets
  • In pure quote-driven markets, dealers participate
    in every trade.
  • Dealers provide all the liquidity and quote bid
    and ask prices. Those quotes are firm for some
    specified size, i.e., the dealers must honor
  • If the investor wants to trade a different size,
    there will be negotiation between the investor
    and the dealer.

  • Buy orders decrease the dealers inventory
    position whereas sell orders increase the
    dealers inventory position.
  • The dealer can then attract or reject order flow
    given her inventory position. The bid-ask
    spreads placement will then reflect her
    inventory position.

  • When the dealers inventory position is low, she
    sets both a high bid price and a high ask price.
  • When the dealers inventory position is high, she
    sets both a low bid and a low ask.

  • Examples of Dealer Markets
  • London International Stock Exchange (SEAQ)
  • OTC Bond Markets
  • Foreign Exchange Markets

General features of a dealer market
  • Multiple dealers, geographically dispersed,
    electronically linked.
  • No consolidation of trading No floor.
  • Virtually all customer trades are with a dealer.
  • The dealer is the intermediary.
  • Customers rarely trade against other customers.
  • Dealers trade among themselves.
  • Regulation and transparency are poor relative to
    floor markets.
  • Dealers may compete among themselves, but have a
    lot of information and market power relative to

Dealer market NASDAQ/SEAQ
  • Two or more market makers per stock
  • Trades were mainly phone negotiated
  • Roughly 95 of the volume went through MM book
  • No central limit order book.
  • Small order execution automated, but not larger
  • Complete decentralization

Dealer obligations
  • Provide quotes during trading hours
  • Offer best execution
  • Report trades in a timely manner
  • Fair communication

Order-driven markets (Ch. 6)
  • In an order-driven auction market, all traders
    issue orders to the exchange.
  • Buyers and sellers regularly trade with each
    other without the intermediation of dealers.
  • But dealers may choose to trade.
  • Order driven markets may be organized as
    continuous markets or as call markets.

Brokered markets
  • Brokers match up buyer and seller.
  • Search is often required to match buyer and
    sellers for less liquid items, and for large
    blocks of securities
  • Brokers specialize in locating counterparts to
    difficult orders
  • Concealed traders
  • Latent traders

  • Examples of brokered markets include
  • Block trading (stocks and bonds)
  • Real estate
  • Business concerns

Hybrid markets
  • Hybrid markets mix aspects of the various
  • The most common hybrid markets are those with
  • These markets are order-driven auction markets in
    which the specialist must provide liquidity under
    some circumstances.
  • Most US stock exchanges and options exchanges
    have specialist systems.

Market information systems
  • It is of utmost important that orders are not
    lost and that order instructions are understood.
  • Ticker symbols
  • Order routing systems
  • Order presentation systems
  • Messaging systems

  • The information created by trading is valuable.
  • Market data systems report trades to the public
  • Broadcast services
  • Price and sale feeds
  • Ticker tapes
  • Quotation feeds
  • Transparency is a key feature of markets.
  • Ex ante vs. ex post transparency

  • Chapter 6
  • Order-driven Markets

Order-driven markets
  • Most important exchanges are order-driven
  • Most newly organized trading systems are
    electronic order-driven markets.
  • All order-driven markets use order precedence
    rule and trade pricing rule.

Examples of pure order-driven markets
  • - Tokyo Stock Exchange,
  • - Paris Bourse,
  • - Toronto Stock Exchange,
  • - Most Future Markets,
  • - Most European Exchanges for equities (Milan,
    Barcelona, Madrid, Bilbao, Zurich,.)

Types of order-driven markets
  • Oral auctions
  • Rule-based order matching systems
  • Single price auctions
  • Continuous order book auctions
  • Crossing networks

  • In order-driven markets, trading rules specify
    how trades are arranged
  • - order precedence rules match buy orders with
    sell orders
  • 1. Price priority
  • 2. Time precedence or time priority
  • trade price rules determine the trade price
  • 1. Uniform pricing rule (single price auction)
  • 2. Discriminatory pricing rule

Oral auctions
  • Used by many futures, options, and stock
  • The largest example is the US government long
    treasury bond futures market (CBOT, 500 floor
  • Traders arrange their trades face-to-face on an
    exchange trading floor.
  • Cry out bids and offers (offer liquidity)
  • Listen for bids and offers (take liquidity)
  • Take it accept offer
  • Sold accept bid

  • Open outcry rule the first rule of oral
  • Traders must publicly announce their bids and
    offers so that all other traders may react to
    them (no whispering).
  • Traders must also publicly announce that they
    accept bids/offers.
  • Why is this necessary?

  • Order precedence rules
  • Price priority
  • Should a trader be allowed to bid below the best
    bid, above the best ask in an oral auction?
  • Time precedence
  • Is time precedence maintained for subsequent
    orders at the best bid or offer? Why? Why not?
  • How can a trader keep his bid or offer live?
  • The minimum tick size is the price a trader has
    to pay to acquire precedence.
  • Public order precedence
  • Why do you think this is necessary?

  • Trade pricing rule
  • Trades take place at the price that is accepted,
    i.e., the bid or offer.
  • Discriminatory pricing rule.
  • Why do you think it is called discriminatory?
    Who gets the surplus?

  • Trading floors
  • Trading floors can be arranged in several rooms
    as on the NYSE, with each stock being traded at a
    specific trading post.
  • Trading floors can also be arranged in pits as
    in the futures markets.

Rule-based order-matching systems
  • Used by most exchanges and almost all ECNs.
  • Trading rules arrange trades from the orders that
    traders submit to them.
  • No face-to-face negotiation.
  • Most systems accept only limit orders.
  • Why do you think most systems are reluctant to
    accept market orders?

  • Orders are for a specified size.
  • Electronic trading systems process the orders.
  • Trades may take place in a call, or continuously.
  • A new order arrival activates the trading
  • Systems match orders using order precedence
    rules, determine which matches can trade, and
    price the resulting trades.

Order precedence rules
  • Price priority
  • Market orders always rank above limit orders.
  • Limit buy orders with high prices have priority
    over limit buy orders with low prices
  • Limit sell orders with low prices have priority
    over limit sell orders with high prices.

  • Time precedence
  • Under time precedence, the first order at a given
    price has precedence over all other orders at
    that price. Gives orders precedence according to
    their time of submission.
  • The pure price-time rule uses only price priority
    and time precedence.
  • Floor time precedence to first order at price.
    All subsequent orders at that price have parity
    (Oral auction)

  • Display precedence
  • Why do markets use display precedence?
  • Size precedence
  • Some markets give precedence to small orders,
    other markets favor large orders (NYSE).
  • Public order precedence
  • Public orders have precedence over member orders
    at a given price.

  • Trades are arranged by matching the highest
    ranking buy orders with the highest ranking sell
  • Order precedence rules are used to rank orders.
  • Order precedence rules vary across markets.
    However, the first rule is almost always price

Trade pricing rules
  • Single price auctions use the uniform pricing
    rule. Most continuous order-driven markets use
    the discriminatory pricing rule.


Uniform pricing rule
  • All matched orders are executed at the same
  • This rule is used for opening markets in many
    equities markets, following trading halts for
    many continuous markets, and in the AZX,.


Discriminatory pricing rule
  • In a continuous market trade takes place when an
    incoming order is matched with a standing limit
  • Under the discriminatory pricing rule, the trade
    price is the limit price of the standing limit

Example Pure price-time precedence
Time Trader Buy/Sell Size Price
1202 Sammy Sell 100 20.05
1206 Steve Sell 200 20.06
1215 Bern Buy 500 20.06
1216 Susie Sell 300 20.08
1220 Ben Buy 200 Infinite
1221 Bob Buy 100 20.08
1224 Sandy Sell 500 20.12
1225 Bev Buy 500 20.08
1227 1227 Bill Seth Buy Sell 200 200 20.05 20.10
Example the order book
Sellers Buyers
Trader Size Price Size Trader
Sammy 100 20.05 200 Bill
Steve 200 20.06 500 Bern
20.08 100 Bob
Susie 300 20.08 500 Bev
Seth 200 20.10
Sandy 500 20.12
Infinite 200 Ben
Clearing the order book with a call at 1230
Sellers Buyers
Trader Size Price Size Trader
Sammy 100 0 20.05 200 Bill
Steve 200 100 0 20.06 500 Bern
20.08 100 Bob
Susie 300 0 20.08 500 200 Bev
Seth 200 20.10
Sandy 500 20.12
Infinite 200 0 Ben
Trades in the example - call
Buyer Seller Quantity Price?
Ben Sammy 100 Infinity, 20.05
Ben Steve 100 Infinity, 20.06
Bob Steve 100 20.08, 20.06
Bev Susie 300 20.08
Examplethe order book after the call
Sellers Buyers
Trader Size Price Size Trader
20.05 200 Bill
20.06 500 Bern
20.08 200 Bev

Seth 200 20.10
Sandy 500 20.12

Example - What should be the price/prices?
  • Possibilities include
  • Infinite
  • 20.05
  • 20.06
  • 20.08
  • The price/prices depends on the trade pricing

What should be the price/prices?
  • Single price auctions use the uniform pricing
  • Everyone gets the same price.
  • Continuous two-sided auctions and a few call
    markets use the discriminatory pricing rule.
  • Trades occur at different prices.
  • Crossing networks use the derivative pricing
  • The price is determined by another market.

Uniform pricing rule
  • All trades take place at the same market
    clearing price.
  • The market clearing price is determined by the
    last feasible trade.
  • Matching by price priority implies that this
    market clearing price is also feasible for all
    previously matched orders.

  • In Example 1, the last feasible trade is between
    Bev and Susie, so the market clearing price is
  • Sam, Steve and Susie are happy with a market
    clearing price of 20.08 since they were willing
    to sell at 20.08 or lower.
  • Ben, Bob, and Bev are happy to with a market
    clearing price of 20.08 since they were willing
    to buy at 20.08 or higher.

  • If the buy and sell orders in the last feasible
    trade specify different prices, the market
    clearing price can be at either the price of the
    buy or the price of the sell order.
  • The trade pricing rules will dictate which one to

Supply and Demand
  • The single-price auction clears at the price
    where supply equals demand.
  • At prices below the market clearing price, there
    is excess demand.
  • At prices above the market clearing price, there
    is excess supply.

  • Single price auctions maximize the volume of
    trading by setting the price where supply equals
  • Because prices in most securities markets are
    discrete, there is typically excess demand or
    excess supply at the market clearing price.
  • In the Example, what is the excess demand or

  • The single price auction also maximizes the
    benefits that traders derive from participating
    in the auction.
  • Trader surplus for a seller the difference
    between the trade price and the sellers
  • Trader surplus for a buyer the difference
    between the buyers valuation and the trade
  • Valuations are unobservable, but we may assume
    that they at least are linked to limit prices.

Example Demand and Supply
Discriminatory Pricing Rule
  • Continuous two-sided auction markets maintain an
    order book.
  • The buy and sell orders are separately sorted by
    their precedence.
  • The highest bid and the lowest offer are the best
    bid and offer respectively.

  • When a new order arrives, the system tries to
    match this order with orders on the other side.
  • If a trade is possible, e.g., the limit buy order
    is for a price at or above the best offer, the
    order is called a marketable order.
  • If a trade is not possible, the order will be
    sorted into the book according to its precedence.

Discriminatory Pricing Rule
  • Under the discriminatory pricing rule, the limit
    price of the standing order dictates the price
    for the trade.
  • If the incoming order fills against multiple
    standing orders with different prices, trades
    will take place at multiple prices.

Continuous trading _at_1202
Sellers Buyers
Trader Size Price Size Trader
Sammy 100 20.05
Continuous trading _at_1206
Sellers Buyers
Trader Size Price Size Trader
Sammy 100 20.05
Steve 200 20.06
Continuous trading _at_1215
Sellers Buyers
Trader Size Price Size Trader
Sammy 100 0 20.05
Steve 200 0 20.06 500 200 Bern
Continuous trading _at_1216
Sellers Buyers
Trader Size Price Size Trader
Sammy 100 0 20.05
Steve 200 0 20.06 500 200 Bern
Susie 300 20.08
Continuous trading _at_1220
Sellers Buyers
Trader Size Price Size Trader
Sammy 100 0 20.05
Steve 200 0 20.06 500 200 Bern
Susie 300 100 20.08
Infinite 200 0 Ben
Continuous trading _at_1221
Sellers Buyers
Trader Size Price Size Trader
Sammy 100 0 20.05
Steve 200 0 20.06 500 200 Bern
Susie 300 100 0 20.08 100 0 Bob
Infinite 200 0 Ben
Continuous trading _at_1224
Sellers Buyers
Trader Size Price Size Trader
Sammy 100 0 20.05
Steve 200 0 20.06 500 200 Bern
Susie 300 100 0 20.08 100 0 Bob
Sandy 500 20.12
Infinite 200 0 Ben
Continuous trading _at_1225
Sellers Buyers
Trader Size Price Size Trader
Sammy 100 0 20.05
Steve 200 0 20.06 500 200 Bern
Susie 300 100 0 20.08 100 0 Bob
20.08 500 Bev
Sandy 500 20.12
Infinite 200 0 Ben
Continuous trading _at_1227
Sellers Buyers
Trader Size Price Size Trader
Sammy 100 0 20.05 200 Bill
Steve 200 0 20.06 500 200 Bern
Susie 300 100 0 20.08 100 0 Bob
20.08 500 Bev
Seth 200 20.10
Sandy 500 20.12
Infinite 200 0 Ben
Summary continuous trading
Buyer Seller Size Price Bid Offer
Bern Sammy 100 20.05
Bern Steve 200 20.06
20.06x200 20.08x300
Ben Susie 200 20.08
20.06x200 20.08x100
Bob Susie 100 20.08
20.06x200 20.12x500
20.08x500 20.12x500
20.08x500 20.10x200
Discriminatory vs. uniform pricing rules
  • Taking the orders as given, large impatient
    traders (e.g., liquidity demanders marketable
    limit orders) prefer the discriminatory pricing
    rule (to exploit better price).
  • Taking the orders as given, standing limit order
    traders (liquidity suppliers) prefer the uniform
    pricing rule (to maximize surplus).

  • However, orders are not given.
  • Limit order traders tend to price their orders
    more aggressively under the uniform pricing rule.
  • Can you explain this prediction?
  • Why would large traders want to split their
    orders when trading under the uniform pricing
  • What role can trading halts have in affecting the
    pricing rules?

Continuous versus call markets
  • The single price auction produces a larger trader
    surplus than the continuous auction when
    processing the same order flow (example).
  • Concentration of order flow increases total
    trader surplus.
  • In practice, traders will not send the same order
    flow to call and continuous markets.

  • The single price auction will typically trade a
    lower volume than the continuous auction.
  • In our example, both trade 600 shares
  • See textbook example (Table 6-7 6-8)
  • However, there is another benefit of the
    continuous market it allows traders to trade
    when they state their demands.

Additional examples
Example 2 Batch market and surplus
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Example 3 Batch and continuous Trading volume
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Continuous system
  • In that case orders are arranged as soon as they
    arrive if they can be matched with outstanding
  • At 1000, Sean submits the first order (a limit
    buy order with price 200 for 300 shares). As the
    book is empty, his order will have to wait in the
    order book.
  • At 1002, Siobhan submits the second order (a
    limit sell order with price 201 for 200 shares).
    As the maximum price for the limit buy order is
    lower than the minimum price for the limit sell
    order, those two orders cannot be matched. As a
    result, the market is 200 bid for 300, 200
    offered at 201. The bid-ask spread is 1.

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Electronic trading platforms
  • Centralized order-driven market with automated
    order routing.
  • Decentralized computer network for access.
  • Member firms act as brokers or principals.
  • No designated market makers
  • Central limit order book/information
    system/clearing and settlement
  • Off-book trading is sometimes significant

The (limit order) book
  • The broker might have other limit orders besides
    ours. A collection of unexecuted limit orders is
    a book.
  • The book may have buy and sell orders.
  • In US futures pits, each broker may have his/her
    own book.
  • In many other markets, the book is consolidated
    all unexecuted limit orders are recorded in one

The electronic limit order book
  • All orders are limit orders.
  • The book is electronically visible.
  • Anyone may enter an order.
  • There has to be some established relationship for
    clearing and credit purposes.
  • The electronic limit order book is probably the
    most common form of new market organization
    today, but it is far from universal.

The Island ECN (now INET)
  • Island is a limit order market
  • Island is an Electronic Communications Network
  • It has no trading floor. All orders are sent

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A likely scenario
  • Seller(s), using market orders, took out the
  • 113.25 bid and the 113.00 bid, leaving 112.5 as
    the best bid.
  • On the sell side of the book, sellers realized
  • 113.375 was unrealistically high. Theyre now
  • offering at a lower price (112.95)

A survey of usage
  • Some markets have a single consolidated limit
    order book, where everything happens.
  • This is mostly true of the Tokyo Stock Exchange,
    Euronext, the Singapore Stock Exchange, the
    Taiwan Stock Exchange, etc., etc.
  • Other markets are fragmented.
  • There are multiple limit order books in
    different physical venues (or computers).

  • In addition to the Island ECN, there is a limit
    order book for IBM at the New York Stock
    Exchange, the Boston Stock Exchange, the Pacific
    Stock Exchange, etc., etc.
  • The largest (deepest) limit order book for IBM is
    at the NYSE.

Different markets/different solutions
  • The pit markets in US futures exchanges do not
    have a centralized limit order book.
  • The Chicago Board Options Exchange does have a
    centralized book (run by a clerk).
  • The NYSE has a limit order book, run by the
    specialist. (But there are other books in
    NYSE-listed stocks on regional exchanges and
    other dealers.)
  • NASDAQ has multiple books.

  • A centralized limit order book is often referred
    to as a CLOB (pron. kl.b)
  • Hard CLOB All activity is forced (by law)
    through the book.
  • Soft CLOB A CLOB exists, but trades can take
    place outside of it.

Limit order books The problem areas
  • Electronic limit order books are the predominant
    continuous trading mechanism.
  • They do not seem to work well, however, in all
    circumstances. These include large trades, low
    activity securities and market breaks (crashes)
  • In these circumstances, some sort of active
    marketmaking presence (a dealer) seems to be

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  • Chapter 10
  • Informed Traders and Market Efficiency

Informed traders
  • Acquire and act on information about fundamental
  • Buy (sell) when prices are below their estimates
    of fundamental value.
  • Include value traders, news traders,
    information-oriented technical traders, and

Fundamental values
  • The true values
  • Not perfect foresight values
  • Prices are said to informative when they are
    equal to fundamental values
  • Fundamental values are not predictable (why?)
  • Price changes in efficient markets are not
    predictable (why?)

Informed traders make prices informative
  • Because they buy (sell) when price is below
    (above) their estimates of fundamental value,
    their trading move prices toward their estimates
    of fundamental value.
  • When informed traders accurately estimate values,
    their trading makes prices more informative.

The market price is more informative (accurate)
than individual value estimates
  • V the true fundamental value,
  • P the market price,
  • vi value estimate of trader i vi V ei,
    where E(ei) 0,
  • Di trader is desired position in the security
  • Di a(vi P), where a is a constant.
  • From ? Di ? a(vi P) 0 (i.e., zero net
    supply), we have
  • ? a(vi P) 0 ? a?(vi P) 0 ? ?(vi P)
    0 ? ?vi ?P 0
  • ? ?vi ?P N P ? P (1/N) ?vi
  • P (1/N) ?vi (1/N) ?(V ei) V eM, where
    eM (1/N) ?ei 0.

Informed trading strategies
  • Must minimize price impact to maximize profits.
  • Trade aggressively when their private information
    will soon become common knowledge.
  • Trade slowly when their private information will
    not soon become common knowledge.
  • Trade aggressively when other traders will act on
    the same information.

Liquidity and Predictability-Strategic Trading
with Private Information and Price Impact
  • If you buy a contract, you receive 1 with a
    probability of p and zero with 1- p.
  • The market price of the contract is
  • P 0.3 ¼(Q/L), where Q is your trade size
    and L denotes liquidity.
  • Your profit pQ PQ pQ 0.3 ¼(Q/L)Q
  • Your profit is maximized when Q 2L(p 0.3)
  • Your maximum profit L(p 0.3)2

Styles of informed trading
  • Value traders all information
  • News traders new information
  • Information-oriented technical traders
    predictable price patterns
  • Arbitragers relative instrument values rather
    than absolute instrument values

Informed trading profits
  • Precise and orthogonal estimates
  • Impossibility of informationally efficient
    markets (Grossman and Stiglitz)
  • Three forms of efficient markets hypothesis

  • Chapter 13 14
  • Dealers and Bid-Ask Spreads

What defines a dealer?
  • A broker acts as an agent for a customer,
  • representing customer orders in the market (e.g.,
    a real estate broker).
  • A dealer takes the other side of customer trades
    (e.g., a used-car dealer).
  • Much of US securities regulation applies to both
    brokers and dealers. The US Securities and
    Exchange Commission (SEC) refers to such people
    as broker-dealers. In fact, broker and dealer
    functions are quite distinct.

Dealer quotes
  • Dealer spread vs. inside spread
  • One-sided vs. two-sided market
  • Firm vs. soft quotes
  • Quoted vs. realized spread
  • Best execution rule
  • Order preferencing

The bid-ask spread
  • The bid-ask spread is the difference between the
    ask price and the bid price (quoted spread).
  • The quoted spread gives an estimation of the
    remuneration of the service provided by dealers
    to traders. The remuneration increases with the
  • Dealers make money by buying low and selling
    high. They lose money when market conditions
    lead them to buy at high prices and sell at low

The realized spread
  • The realized spread (difference between the price
    at which dealers effectively buy and sell their
    securities) is the true remuneration of providing

Dealer inventories
  • Inventories are positions that dealers have on
    the security they trade. They may hold a long
    position or a short position.
  • Target Inventories are positions that dealers
    want to hold.
  • Dealers inventories are in balance when they are
    near the dealers target levels and out of
    balance otherwise.

Inventory risk
  • For risk averse dealers any difference between
    inventories is costly.
  • They then require compensation for absorbing
    transitory mismatches in supply and demand over
    time (transitory risk premium).
  • The larger the mismatch, the greater the risk the
    dealer must assume and the greater the
    compensation required by dealers.

  • Dealer inventory control
  • Dealers may act to control their inventories.
  • As dealers prices affect other traders trading
    decisions, the placement of the dealers bid-ask
    spread may be used to control their inventories.
  • When dealers inventories are below (above) their
    target inventories, they must buy (sell) the

  • Dealers increase their prices (bid and ask) when
    they want to increase their inventory.
  • Higher bid prices encourage traders from selling
    to them and higher ask prices discourage traders
    from buying from them.
  • Dealers decrease their prices when they want to
    decrease their inventory.
  • Lower bid prices discourage traders from selling
    to dealers and lower ask prices encourage traders
    from buying from the dealers.

Depth (size) control
Inventory risk
  • Diversifiable inventory risk
  • When future price changes are independent of
    inventory imbalances
  • Can be minimized by dealing in many instruments
  • Adverse selection risk
  • When future price changes are inversely related
    to inventory imbalances
  • Arises when dealers trade with informed traders

Adverse selection losses
  • Informed traders buy when they think that prices
    will rise and sell otherwise.
  • When dealers trade with informed traders,
  • prices tend to fall after the dealers buy and
    rise after the dealers sell (i.e., future price
    changes are inversely related to inventory
  • their realized spreads are often negative.

Dealer optimization problem
  • Dealers always gain to liquidity-motivated
  • Dealers can balance the losses made on informed
    trading with the profits made on uninformed

Dealer optimal responses when sold to an informed
  • Raise ask price and lower ask size
  • Raise bid price and increase bid size
  • Buy from another trader at his ask price
  • Buy a correlated instrument

Dealer optimal responses when bought from an
informed trader
  • Lower ask price and raise ask size
  • Lower bid price and reduce bid size
  • Sell to another trader at his bid price
  • Sell a correlated instrument

Dealer optimal responses when the next trader is
an informed traders
  • Ask price the best estimate of fundamental
    value, conditional on the next trader being a
    buyer. (regret-free price)
  • Bid price the best estimate of fundamental
    value, conditional on the next trader being a
  • Because dealers generally do not know whether the
    next trader is well informed, they use the
    probability that the next trader is well informed.

Bid/ask spreads Chapter 14
  • The spread is the compensation dealers and limit
    order traders receive for offering immediacy.
  • The most important factor in order placement
    decision (market vs. limit orders)
  • The most important factor in dealers liquidity
    provision decision
  • The most important chapter of the book.

Dealer spreads
  • Monopoly dealers
  • Low barriers to entry in most markets
  • In many markets, dealers face competition from
    public limit order traders
  • Normal vs. economic profits Dealers earn only
    normal profits in competitive dealer markets

Components of the spread
  • Transaction cost component
  • Transitory spread component
  • Covers the normal costs of doing business,
    monopoly profits, risk premium
  • Responsible for bid-ask bounce
  • Adverse selection component
  • Compensate dealers for losses to informed traders
  • Permanent spread component

Two explanations for adverse selection component
  • Information perspective
  • The difference in the value estimates that
    dealers make conditional on the next trader being
    a buyer or a seller
  • Accounting perspective
  • The portion of the spread that dealers must quote
    to recover from uninformed traders what they lose
    to informed traders

Definition and assumption
  • V the unconditional value of a security
  • P the probability that the next trader is an
    informed trader
  • VE the value of the security when an informed
    trader wants to buy
  • V-E the value of the security when an informed
    trader wants to sell
  • The next trader is equally likely to be a buyer
    or a seller.

Information model
  • Conditional expectation of the security value
    given that the next trader is a buyer
  • (1-P)V P(VE) V PE
  • Conditional expectation of the security value
    given that the next trader is a seller
  • (1-P)V P(V-E) V - PE
  • Adverse selection component of the spread
  • (V PE) (V - PE) 2PE

Accounting model
  • Let B is the dealers bid price and A is the
    dealers ask price.
  • Conditional expectation of dealer profit given
    that the next trader is a seller
  • (1-P)(V-B) P(V-E) - B V - B PE.
  • Conditional expectation of dealer profit given
    that the next trader is a buyer
  • (1-P)(A-V) PA - (VE) A - V PE.
  • Since the next trader is equally likely to be a
    buyer or a seller, the expected dealer profit is
  • ½(V B PE) ½(A V PE) ½(A B)
  • Finally, setting ½(A B) PE 0, we obtain A
    B 2PE.

Uninformed traders lose to informed traders
  • When uninformed traders use limit orders
  • Informed traders trade on either the other side
    or the same side, depending on their private
  • Uninformed traders either regret trading or
    regret not trading.
  • When uninformed traders use market orders
  • Pay large spreads (due to informed trading)

Determinants of equilibrium spreads in continuous
order-driven markets
  • Information asymmetry among traders ()
  • Time to cancel limit orders ()
  • Volatility ()
  • Limit order management costs ()
  • Value of trader time ()
  • Differential commission between limit and market
  • Trader risk aversion ()

Cross-sectional determinants of equilibrium
spreads Primary
  • Information asymmetry
  • Volatility
  • Limit order option values increase with
  • Inventory risks increase with volatility
  • Asymmetry problem increases with volatility
  • Utilitarian trading interest
  • Utilitarian traders are uninformed - lower
    adverse selection
  • High volume stocks have lower order processing
    costs, smaller inventory risks, more limit order
    trading, smaller timing option value, and more
    dealer competition

An example
  • I buy 100 shares of ABC. When I decide to buy the
    shares, the market is 50 bid, 51 offered. I
    actually buy at 51.20, paying a 29 commission.
  • Cash outflow 5,120 29 5,149
  • When I make the decision to sell, the market is
    54 bid, 54.50 offered. I actually sell at 54,
    paying a 29 commission.
  • Cash inflow 5,400 29 5,371
  • My net cash flow is 5,371 5,149 222. A
    return of 4.31( 222/5,149)
  • In my paper portfolio, I buy and sell at the
    midpoint of the bid and ask quotes at the time I
    decide to trade.
  • I buy 100 shares at 50.50 and sell at 54.25 375
    (a 7.43 return)
  • The implementation shortfall is 375 222 153
    (ignoring interest)
  • Alternatively, the implementation shortfall is
    7.43 4.31 3.12

Further analysis
  • The cost of a trade is explicit cost implicit
  • Explicit cost commission (net of any rebates
    of goods or services, soft dollars)
  • Implicit cost the cost of interacting with
    the market.
  • The initial purchase was made 0.70/sh above
    the BAM,
  • so the implicit cost 70
  • The final sale was made 0.25/sh below the
  • so the implicit cost 25
  • The implicit cost computed with respect to the
    BAM is the effective cost.
  • The effective cost is a useful measure for
    market orders.

Effective cost
The effective spread
  • Effective spread 2 x effective cost
  • For the initial purchase, the effective
  • 2 x 0.70 1.40 / share.
  • Intuition
  • The quoted (posted) spread is 51 50 1. If a
    buyer pays 0.70 above the BAM and sells 0.70
    below the BAM, they are effectively facing a
    bid-ask spread of 1.40.

Realized cost and realized spread
  • For executed trades, the realized cost is the
    transaction price relative to the BAM at some
    time subsequent to the trade.
  • This impounds price movements after the trade
    (including the price impact due to the
    information in the trade).

Realized cost and realized spread
An interpretation of the realized cost
  • This cost can be interpreted as the profit
    realized by the other (contra) side (e.g.,
    dealer) of the trade, assuming the contra side
    could lay off the position at the new BAM.
  • Example
  • The dealer sells to the customer at 100.09.
  • Five minutes later, the market is bid 100.02,
    100.12 offered (BAM (100.02100.12)/2
  • The realized cost is 0.02.
  • This would be the dealers profit if he could
    reverse the trade (purchase the stock) at the
    subsequent BAM.

  • Quoted Spread (Ask Bid)
  • (Ask M) (M Bid),
  • where M (1/2)(Ask Bid)
  • the midpoint of the bid and ask.
  • Effective Spread 2Abs(T M) 2D(T M)
  • 2 x Effective Cost,
  • where T the transaction price,
  • D 1 for customer buy order and
  • -1 for customer sell

  • Price Impact D(M M).
  • Price Impact measures decreases in M following
    customer sells and increases in asset value
    following customer buys, which reflect the
    markets assessment of the private information
    the trades convey. Such price moves constitutes
    a cost to market makers, who buy prior to price
    decreases and sell prior to price increases.
  • Realized Spread Effective Spread - Price Impact
  • 2D(T M) - 2D(M M) 2D(T - M)
  • 2 x Realized Cost
  • Market making revenue, net of losses to
  • better-informed traders

The effective cost of a sequence of market
  • Oftentimes traders break up large orders into
    smaller ones, and feed them to the market over
  • In a sequence of orders, the cumulative price
    impact means that later orders will trade at
    worse prices than early ones.
  • For a buy sequence, the effective cost is
  • (volume weighted average purchase price)
  • (BAM prevailing at time of trading decision)
  • Suppose the BAM is 10.00. We buy 100 shares at
    10.10, 500 shares at 10.25 and 400 shares at
  • The vol wtd average purchase price is
  • The effective cost is 0.335 per share.

Inferring impact costs from effective and
realized spreads
  • Suppose the BAM 10.00. We want to buy 1,000
  • The effective cost of one 1,000 share order is
  • If we split the order into two 500 share trades,
    we pay
  • 500 x (10.00 0.20) 500 x (10.00 0.35)
  • 10,275
  • Relative to the initial midpoint, the trading
    cost is 275 (0.275/sh)

Measuring market impact
  • Statistical tools from time series analysis
    attempt to correlate orders with subsequent price
    movements. See Chung et al. (2004)
  • General considerations.
  • Market impact is not the same for all orders in
    all markets.
  • Large orders have higher impact than smaller
  • Orders perceived as originating from smart
    traders will have high impact.
  • Orders that execute in markets that cater to
    retail investors will have low impact.

Measuring the cost of limit orders
  • For a single limit