FEC FINANCIAL ENGINEERING CLUB

AGENDA Trading The Order Book and Order Types Market Participants

WHAT IS TRADING? Economics: Multiple parties participating in the voluntary

negotiation and then exchange of one’s goods and services for the desired goods and services of another.

Finance: Purchasing and selling of securities.

As a career, trading involves selling and purchasing securities at a fast-pace for some purpose, generally to profit. Heavy integration of technology for executing trades and gathering

information Filtering through information and risk management are key

TRADING & MARKET MICROSTRUCTURE

THE ORDER BOOK How much would you pay for a bag of cash whose contents are

unknown? There is at least $1 in the bag and less than $10

THE ORDER BOOK

If we put this bag up for auction, we might see the following:SELLERS

BUYERS

THE ORDER BOOK A collection of buy and sell orders

Orders sitting in the book are called resting orders The number of orders at each price level is referred to as the

depth

The highest bid is referred to as the best bid The highest ask is referred to as the best ask/offer

Their difference is the bid-ask spread

Here, the bid-ask spread is 522.22-522.17 = .05

Bids or buy orders

Asks or sell orders

Price

Best bidBest ask

ORDER TYPES Limit order: Buying a specified number of an asset only at a

specified price or better

Example) AAPL is at 522. You put in a limit buy for 40 shares at 520. This means that your order is executed when AAPL is at 520 or lower, if there are sellers.

Liquidity: Limit orders sit and wait in the order book until an individual with the opposite position enters the market. In this case, when an individual submits a trade to sell for 520 or less.

ORDER TYPES Example) You want to put in a limit bid to

buy 40 shares of AAPL at 522.14

How does this change the order book? Current best-bid is 522.17 Best ask is 522.22

+40 No sell orders at 522.14

ORDER TYPES Example) You want to put in a limit bid to

buy 40 shares of AAPL at 522.14

How does this change the order book? Current best-bid is 522.17 Best ask is 522.22

Here, we added liquidity by increasing the number of resting orders

ORDER TYPES Example) NOW, suppose you want to put

in a limit bid to buy 700 shares of AAPL at 522.22

+700

675 sell orders at 522.22

ORDER TYPES Example) NOW, suppose you want to put

in a limit bid to buy 40 shares of AAPL at 522.22

Here, we took and added liquidity This is known as a marketable limit order A limit order at a price that will execute

immediately (best bid or ask)

ORDER TYPES Market order: Buying a specified number of an asset at the best

prevailing price on the opposite side of the order book

Example) AAPL is at 522. You put in a buy for 40 shares. Your order is executed immediately—that is, you buy 40 shares at the best ask.

Liquidity: Market orders always execute

ORDER TYPES Example) You want to sell 20 shares of

AAPL immediately. You submit a market sell.

How does this change the order book? Current best-bid is 522.22 Best ask is 522.23

+20

ORDER TYPES Example) You want to sell 20 shares of

AAPL immediately. You submit a market sell.

Again, we took liquidity

ORDER TYPES Example) Now, you want to sell an

additional 20 shares of AAPL immediately. You submit a market sell.

+20Only 5 shares at best bid

ORDER TYPES Example) Now, you want to sell an

additional 20 shares of AAPL immediately. You submit a market sell.

-5

-15

ORDER TYPES Example) Now, you want to sell an

additional 20 shares of AAPL immediately. You submit a market sell.

ORDER TYPES

What are the pro’s of market orders? Execute immediately

What are the con’s of market orders? Unlimited price risk—potential to get

bad fill prices Cost of bid-ask spread

What are the pro’s of limit orders? No price risk They provide liquidity—can sometimes

earn a rebate

What are the con’s of limit orders? They may never execute

Conclusion: always use limit orders. Marketable limit orders capture (nearly) all the pro’s of market orders without the con’s

MORE COMPLICATED ORDER TYPES Fill or kill (FOK): If the full quantity cannot be filled, don’t fill any. Stop orders: Buy/sell once the price exceeds/falls below a specified

price Pegged orders: Buying/selling at a competitive offset to the best

bid/ask

Combinations of orders: Iceberg orders, hidden orders

Cancelling orders: A feature that is currently being reconsidered

EXTREME ORDER CANCELLING

MARKET PARTICIPANTS

EXCHANGES Exchanges are organized venues where buyers and sellers meet and

transact Historically, physical venues Now, collections of servers and computer infrastructure to maintain an

order-book for one of many listed (traded) products

To trade on an exchange, one must become an exchange member, which costs a fee. Traders providing liquidity (adding resting orders) often earn a rebate Those taking liquidity (using marketable orders) often pay a fee

To be have a security listed on an exchange, the lister is required to maintain certain qualifications (in the case of a company) as well as pay listing and entry fees.

EXCHANGES

Exchange fees for CME

EXCHANGES Exchange companies compete on fees, types of products listed, and order priority rules

Hire market makers (traders) to continuously provide liquidity Oftentimes one holding company containing many exchanges and clearing corporations

CME Group—Chicago Mercantile Exchange Group Several options and futures exchanges CME, NYMEX, CBOT, KCBOT

BATS Global BATS BZX, BATS BYX exchanges

NYSE Euronext NYSE, Euronext, NYSE Arca exchanges

EXCHANGES One security can be listed on multiple exchanges

This creates market fragmentation issuesNASDAQ BATS

What’s opportunities do we have here?

BUY on NASDAQ @ 522.21Sell on BATS @ 522.22

Profit: (522.22-522.21)*quantity = .01*quantity

MARKET FRAGMENTATION ISSUES More importantly, institutional investors do not want to worry

about trading on particular exchanges Multiple exchanges institutional investing unnecessarily complicated

Competition amongst exchanges is good—cheaper fees Market fragmentation is bad

Regulation NMS: Regulation passed in 2005/2006 (effective 2007) attempting to consolidate exchanges while promoting competition

FEATURES OF REGULATION NMS Sub-penny rule: Cheapest tick (increment) in a trade price is a

penny Access rule: Trading fees must be reasonable Market-data rule: Each exchange must provide affordable data Order protection rule: Marketable orders routed to best price

NBBO: National best bid and offer—best bids and best asks across all exchanges

Market orders routed to exchange with NBB or NBO

DARK POOLS A trading venue where prices and trades are not publicized

Pro’s? You have less market impact People cannot benefit from knowledge conveyed in your orders

Con’s Leeching from price discovery in “lit markets”

THE TRADING ECOSYSTEM Three main types of trading:

Hedgers Speculators Arbitrageurs

Trading vs investing Investing generally has longer

holding periods Investors intend to never sell their

investments Trading is generally the opposite

Hedging Arbitrage

Speculators

HEDGERS Traders who seek to mitigate risks in their business by trading

Example) You are a trader at BP. Your business has fixed costs of $2 million. Your portfolio is long 20,000 barrels of crude oil (currently $100/barrel). What is your position?

Crude Price/Barrel

How can you hedge some of this downside risk?

You can 2,000 buy put options with strike 100. Suppose these cost $1.

HEDGERS

HEDGERS

You can 2,000 buy put options with strike 100. Suppose these cost $1.

SPECULATORS Traders who speculate on asset prices via information and trade

accordingly.

Example) You believe that AAPL will exceed earnings expectations this quarter due to product development. You buy shares of AAPL based on this sentiment and further research.

ARBITRAGEURS Traders who trade on mispricings in asset prices.

Usually there is some model asserting a price different from the market

Example) Suppose , , and . It should hold that

=1

(that is if you convert GBP to Euros, then Euros to USD, then USD to GBP, you should have the same amount of money you started with, ignoring bid-ask spreads)

However =1.0248

How can we profit from this mispricing?

ARBITRAGEURS

1) Start with $1,000,000.00 USD, buy GBP at Now we have £ 600,000.00

2) Buy Euros at Now we have € 732,000.00

3) Buy USD at Now we have USD 1,024,800.00

AGENCY TRADING Trading on behalf of another individual.

Large-scale brokerage firms have traders trade on behalf of clients

Example) A client calls TD Ameritrade to sell a large sum of bonds in their portfolio.

They do this to avoid others from identifying him/her in the markets. TD Ameritrade has its traders sell off the bonds according to certain rules to avoid a steep decline in the price of the bonds.

EFFICIENT MARKET HYPOTHESIS Markets are informationally—efficient

To some degree, new information is already priced into assets; lucrative trading strategies have been used up

Weak form: Future prices cannot be predicted by analyzing the past (technical analysis). Some forms of fundamental analysis can produce excess returns.

Semi-strong Form: Share prices adjust very quickly to new information. Technical analysis and fundamental analysis cannot produce excess returns.

Strong Form: Share prices reflect all information, public and private. No one can earn excess returns

EFFICIENT MARKETS

FINANCIAL ENGINEERING IN TRADING Pricing Models and asset dynamics

Execution strategies: How to split up your orders to receive the best fill price

Computing: Designing and programming high-performance systems with efficient software

QUESTIONS?

NEXT WEEK Trading in simulated markets

Introduction to the Rotman Interactive Trader

7PM @ the Margolis Market Information Lab Seats available to FEC via sign-up

THANK YOU!

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Internal Vice PresidentMatthew Reardonmreardon5@gmail.com

PresidentGreg Pastorekgfpastorek@gmail.

com