Money, Banking & FinanceLecture 4

The Theory and Practice of Equity Trading

Aims

• Examine the process by which investment decisions are translated into the action of buying or selling shares.

• Understand how a trading environment operates and how the players interact.

• Appreciate how the actions of traders influence the market.

• Examine the Trader-Ex software for training of stock-market traders.

Trading and Investing• Important distinction between Investing and

Trading.• Trading is about converting an investment

decision at the least cost point.• Trading is also about price discovery. The

investment manager will have an idea of the equilibrium price but this could change in a dynamic and fast moving situation.

• Trading is also about finding price discrepancies and exploiting these for profit

Investment DecisionsTime Taken by Fund Managers to make buy/sell decision

%5 4 3 2 1 Mean

frequency

< 1 hr 3.1 6.2 13.8 46.1 30.8 2.05

1 hr – 1 day

7.7 9.2 41.6 24.6 17.0 2.66

1 day – 1 wk

10.7 32.3 27.7 20.0 9.2 3.15

1 wk – 1 m

7.5 40.9 21.2 18.2 12.1 3.14

1 m 15.2 22.7 19.7 24.2 18.2 2.92

Score 5 = very frequently (75 – 100% of the time); 1 = neverSource: 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

Trading and Time

• Investment decisions are made in discrete time.• Trading decisions are made in continuous time.• Once a decision to invest has been activated to a

trade, time takes on a different meaning.• The trader wants to satisfy the instruction before

the end of the trading day and show a good performance.

• Performance can be measured in terms of opportunity cost and/or actual cash surplus.

Bid-Ask Spread

• A bid order is an offer made by a trader to BUY a security.

• An ask order is the price a trader is willing to SELL a security. Sometimes called the OFFER price.

• A bid or an ask can stipulate the amount the trader will buy or sell and this is called a LIMIT ORDER.

• A market sell is a willingness to accept a bid order and a market buy is a willingness to accept an ask.

Order Arrival

• Orders to buy and sell will arrive during the market day.• The Trader may be a short-term trader with orders to work

for a client or working for a pension fund or hedge fund.• Traders don’t have the luxury of time. Their decision is to

buy sell or wait• To gauge the market – the balance of buy and sell orders• At above equilibrium prices the arrival rate of sell orders

are faster than the arrival rate of buy orders.• Similarly at prices below some notional equilibrium, the

arrival rate of buys are greater than sells.

Price Discovery

Bid

Ask

Sells Buys

P*

Informed Traders

• Informed Traders – agents who trade knowing that the current price level has diverged from the fundamental.

• Buy orders are sent to market if P* > P• Sell orders are made when P* < P. When P* > P(offer) or P*

< P(bid).• In the theoretical world of costless trading, complete

markets, instantaneous information dissemination, price adjustments are instantaneous.

• In reality prices adjust rapidly with ‘new’ news, but news could be changes in fundamentals, uncertainty, rumour or noise.

• The informed Trader will exploit information and act with a short lag to news about fundamentals.

P* and Best Bid and Offer Quotes

$21.00

$22.00

$23.00

$24.00

$25.00

$26.00

$27.00

$28.00

Liquidity Traders

• Idiosyncratic reasons for trade.• Orders are two-sided. They can be market orders

or limit orders and arrive randomly. • Sometimes called ‘noise traders’.• Liquidity traders differ in that they issue both

market and limit orders but informed traders submit market orders only.

• Liquidity traders will not drive a price back to some previous level or reinforce a trend because informed traders drive the price to equilibrium.

Technical (Momentum) Traders

• These Traders are prevalent in the market.• Market technician – using chartist analysis• Algo trader – using a black-box device• Arbitrageur – exploit price inefficiencies to profit.• Market maker or Day Trader – profiting from the

bid-ask spread or profiting from changing market conditions to buy low and sell high.

What Drives a Market?

Trading MechanismOrder Book, Market Makers, Call Auction

Informed

Is p*>offeror p*<bid?

LiquidityOrder Flow

Quotes,Prices,Volume

Momentum

Is there a trend/pattern?

P*

TraderEX Purpose

1) Make trading decisions

2) Understand price discovery

3) Evaluate trading rules for:– market participants

– market quality

– intermediaries and dealer roles

4) Compare alternative market systems

5) Have Fun

Computer’s Role

Establish “market background”– Generate order flow

– Update display and bid-ask quotes

2) Give participants orders to execute3) Maintain transactions records for

subsequent analysis on– Participants’ order placement decisions

– Market quality (e.g., bid-ask spread)

Teaching Trading and Markets with TraderEx simulations (I)

e.g., cardiff2

cardiff

Teaching Trading and Markets with TraderEx simulations (II)

Limit orders

Market orders

Buy orders

Sell orders

Order book marketOrder book market

Ask: 213 Ask: 213 offered at offered at

20.6020.60

20.40 Bid 20.40 Bid for 59for 59

User has User has entered 2 entered 2

limit orders limit orders to sellto sell

Entering a Entering a limit orderlimit order

User is User is entering a entering a

market order market order to sellto sell

(44) units (44) units ahead of your ahead of your

1010

Click to cancel Click to cancel your limit order to your limit order to

sell 10 at 19.90sell 10 at 19.90

Sold!Sold!

Mark-to-market P&L = -2.00Mark-to-market P&L = -2.00

The Order Driven Market in TraderEx

Day’s High Price

Ask: 46 Ask: 46 offered offered at 20.00at 20.00

Your limit Your limit orders to sellorders to sell

40 units 40 units aheadahead of of

your 10your 10

Ticker of tradesTicker of trades

Can enter Can enter Chat Chat

messagesmessages

Performance Performance measuresmeasures

1) Average prices1) Average prices

Performance Performance measuresmeasures2) P&L2) P&L

Performance Performance measuresmeasures3) VWAP3) VWAP

Market Structures

1. Order-driven: Buy-side trader with large order

2. Quote-driven: Market maker/ liquidity provider

3. Order book w/ Periodic call auction (3x day)

4. Order book w/ Dark liquidity pool

Order driven market

“Take”/ Market Buy 5,000 shares of CAB

Order to sell 5,000 shares of CAB executes at $48.10

InvestmentManagers’Decision

Buy-SideTrader(YOU)

Order BookMarket

Add 250,000 shares to portfolio’s holding of CAB

Trade Occurs

Performance

• Average Cost• You purchased

140,000 shares at 3.5 cents below VWAP

• But 23.6 cents above the last price of the day.

• Your P&L position is • -33

Buy side performance

• P&L per share

• = Mark-to-Market Price – Average Purchase Cost

• Good trading:*

• VWAP – Average Purchase Cost > 0

• Good stock selection:

• Last Price – Price at time

Summary

• We have seen that investing is not the same as trading

• Investing is a strategic decision made by the portfolio manager.

• Trading involves meeting the instructions of the portfolio manager at the least cost or best price.

• The TraderEx software is a computer package that simulates trading in different market structures

• It also allows for interactive trading in real time.