Market Structure



Market Structure

Order – specifies what to trade, how much, buy or sell, and conditions

Orders are made because traders do not usually arrange their own trades – go through a broker or dealer

Terms

Dutch Auction

Double Dutch Auction

Ask = offer

Bid

Size = quantity

Firm Price – for actively traded securities

Soft Price – for thinly traded securities

Best Bid and Best Offer

Inside Spread

Market liquidity – degree to which traders can trade without affecting prices

Offering or supplying liquidity (posting bid and ask quotes) – gives other traders an opportunity to trade

Dealers make money by selling liquidity – posting bid and ask quotes

Standing order = open order → an open offer to trade

Taking liquidity – accepting an offer to trade

Market order – trade at the best price currently available in the market

Fills quickly, but perhaps at an inferior price

Market orders take liquidity from the market

Transaction cost = ½ the spread

Price Improvement – trader steps in front of best bid or ask to take an incoming market order

Market Impact – traders move prices in order to fill their orders – the most significant cost of trading large orders

Limit Orders – trade at the best price available, but only if it is no worse than the limit price.

Limit Buy – trade at or below limit price

Limit Sell – trade at or above limit price

Marketable limit order – can be executed immediately

Standing limit orders are free options – but, unlike regular options, they can be cancelled by the writer at any time

Options to trade

Sell limit orders are calls

Buy limit orders are puts

Strike is the limit price

Option value depends on the limit price and the volatility

Since bid and ask are limit orders (options), and options are worth more in volatile markets, spreads tend to be wider as volatility increases

Compensation for offering liquidity – expect better prices than with market orders

You make money on the spread with a limit order, but the spread costs you money with a market order

Stop orders – buy only after price rises to the stop price or sell only after price falls to the stop price

Stop-loss orders are the most common

No guarantee sale will be at your specified price if price drops through it

Stop orders accelerate price changes

Market-not-held orders – trader instructs broker to use his/her discretion when filling the order

Usually found with large orders and given to brokers who work on floor of exchange

Day orders – good for that trading day only

GTC – good till cancelled

Fill-or-kill – no partial completions of this order – and do it now or not at all

Markets

Continuous Markets – arrange trades whenever the market is open

Call Markets – trade only when the market is called

Primary mkt for Treasuries is an example

NYSE starts as call but switches to continuous each day

Execution Systems

Quote driven with dealers = Dealer markets – dealers arrange trades and trade with customers. Public traders don’t trade with each other.

Nasdaq is example

Interdealer brokers may help dealers arrange trades among themselves – offer anonymity. Common in treasury market – Cantor Fitzgerald is most well-known

Order driven – buyers and sellers are matched by order precedence and trading price rules

They trade directly – without dealers

Traders offer or take liquidity

Futures exchanges, most stock and option exchanges and primary mkt for Treasuries are examples

Hybrid markets – NYSE is order driven, but specialists will offer liquidity if needed

Order Precedence Rules – which buyers match with which sellers?

Trading Price Rules – once matched – at what price do they trade?

Minimum price increase – tick size

Transparency – degree and speed with which quotes and orders are made public

Stock markets are more transparent than bond markets

Most of the important exchanges in the world are order driven.

Most newly organized trading systems choose an electronic order-driven market structure.

Oral Auctions

Example: U.S. Gov. T-bond Futures on CBT

500+ floor traders

bids and offers are called out

“take it” to accept offer

“sold” to accept bid

take turns bidding and offering as negotiating

All bids and offers must be public

First trader to accept gets to trade

Acceptances must be expressed publicly

Order precedence Rules

Primary – price priority

Secondary – time priority on futures exchanges

- public order precedence on U.S. stock exchanges

Price priority – precedence to traders who bid and offer the best prices (the inside spread) Taders cannot accept bids or offers at any inferior price.

Can only bid or offer with price improvement

Time precedence – precedence to the traders whose bid or offer first improves the current best bid or offer

After a bid or offer is accepted or withdrawn, anyone may bid or offer at a new price

Traders who want to trade ahead of a trader who has time precedence must improve the price – this rewards aggressive pricing

But you must improve by at least the minimum price increment

This can involve some strategy

Public order precedence – members of the exchange cannot trade ahead of a public trader who is willing to trade at the same price. This rule supersedes time precedence.

Decimalization has weakened this rule since it only costs a penny to step in front of public orders.

All order matching markets use price priority as their primary order precedence rule.

There must be at least one secondary precedence rule to determine priority when several traders bid or offer the same price

Time precedence

Display precedence (fully displayed vs. undisclosed)

Size precedence (can be smaller or larger)

Pro rata size allocations (used in Treasury Auction)

Discriminatory Pricing – used in oral auctions – every trade takes place at the price proposed by the trader whose bid or offer is accepted.

Single Price Auction = Uniform Pricing – all trades take place at the same market-clearing price.

The last match that leads to a trade determines the clearing price

Used with Treasury auctions

Clears where supply meets demand

Continuous markets must use discriminating pricing

Call markets can use discriminating pricing or uniform pricing

Continuous rule-based order matching system with discriminatory pricing:

Order book is kept

When new order arrives – matching system attempts to trade with the order on the opposite side with the highest precedence

If new order can’t trade immediately, it is placed in the order book according to precedence

The limit price of the standing order determines the price for each trade

If an incoming order is large, it may be matched with several standing limit orders – at each of their prices

Large impatient traders prefer discriminatory pricing rule over uniform pricing rule. It allows them to trade the first parts of their orders at better prices than the latter parts.

Standing limit orders prefer uniform pricing rule so that large traders can’t discriminate among them.

Limit order traders tend to issue more aggressively priced orders under uniform pricing than discriminatory pricing

U.S. Treasury acuction switched from discriminating to uniform about 10 years ago.

................
................

In order to avoid copyright disputes, this page is only a partial summary.

Google Online Preview   Download