Part-02
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Tarheel Consultancy Services Corporate Training and Consulting
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Part-02
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Introduction
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Introduction to Orders
What is an “Order”? A trade instruction given to a broker/an exchange
When a trader wishes to buy/sell a security he/she indicates
What he/she wishes to accomplish
The terms and conditions
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• Long /Short position • Name of the security places an order trader
• No. of shares • Price • How long order should remain valid Order information
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Order Information
Long / Short position
Long position buy order needs to be placed
Short position sell order needs to be placed
places an order trader
• • • • •
Long /Short position Name of the security No. of shares Price How long order should remain valid Order information
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Order Information
The security to be bought / sold must be clearly identified
E.g. Assume the investor wishes to go long in IBM stock Place a buy order for IBM shares
places an order trader
• • • • •
Long /Short position Name of the security No. of shares Price How long order should remain valid Order information
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Order Information
No. of shares to be bought / sold
This is called the Order Size
E.g. Assume the investor places a buy order for 200 shares of IBM Order size is 200
places an order trader
• • • • •
Long /Short position Name of the security No. of shares Price How long order should remain valid Order information
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Order Information
No. of shares to be bought / sold
This is called the Order Size
E.g. Assume the investor places a buy order for 200 shares of IBM Order size is 200
places an order trader
• • • • •
Long /Short position Name of the security No. of shares Price How long order should remain valid Order information
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Order Information Trader wants to buy/sell
Is trader willing to accept best Price in the mrkt?
No
Specify the max / min price trader is prepared to accept
Market Order
Yes
Limit Order or Limit Price
How long should order remain valid? Copyright Tarheel Consultancy Services
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Order Information
Prepared to accept the best terms available in the market Market Orders
Wish to place a ceiling or a floor Limit Orders
Price ceiling / Floor Limit Price
E.g. The investor places a Limit buy order Limit price= $95
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Order Information
The trader needs to specify how long he/she would like the order to remain valid
E.g. A trader may specify that
the order should be either executed on submission or canceled
He/she may be prepared to specify a period of time for which he/she is prepared to wait
E.g. Day Order means that if a suitable match is not found by the end of the day on which the order is entered, it should be canceled Copyright Tarheel Consultancy Services
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Order Information
Exchanges do not permit orders to stay alive forever
Specify a maximum validity period
Orders which fail to get executed within this period are automatically canceled
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Order Information…
Is it acceptable to partially fill the order?
E.g. Take the case of a buy order for 200 shares. What if a counterparty is found for only 100 shares?
The order can be partially executed
If investor does not wish this to happen place an All or None (AON) order.
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Importance of an ‘Order’
Orders are the building blocks of trading strategies
A proper order issued at the right time can:
Make the difference between a profitable trade and a costly trade
It can at times even make a difference between a trade and no trade
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Why Orders?
Orders are essential
most investors do not personally arrange their trades
to ensure that others execute their trades as per their intent, they must specify all relevant information
Envisage all possible contingencies
Prescribe suitable courses of action Copyright Tarheel Consultancy Services
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Revocation of order
If investor wishes to modify the terms of trade
He/she has to cancel his/her existing order and resubmit a fresh order
Problems with modification
By the time a fresh order is issued, market conditions may have changed adversely
An existing order may get executed before the trader is able to have it canceled Copyright Tarheel Consultancy Services
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Revocation (Cont…)
Correct specification of order is critical
Speed is the essence in order placement, execution, and cancellation
Computer based trading systems are superior to manual systems
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Terminology
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Terminology Bid When trader wants to indicate that he wishes to buy a security, he will make a bid
Offer When he wishes to convey that he is seeking to sell he will make an offer
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Terminology When a dealer wishes to trade on his own account he will quote ‘a bid’ or ‘an offer’ If dealer is trading on behalf of a client he will convey the buy/sell order placed by the client to a broker/an automated trading system Copyright Tarheel Consultancy Services
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Terminology
Order Size Bids and offers include information the price, and also about the quantity sought to be transacted. This is known as the order size.
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Terminology Bidding price The price specified in a buy order is called ‘the bid’ or ‘bidding price’ Asking price The price specified in a sell order is called ‘the offer’, ‘offering’, ‘ask’, or ‘asking price’ Best bid The highest bid price in the market is called the ‘best bid’ Best offer The lowest offer price in the market is called the ‘best offer’ Copyright Tarheel Consultancy Services
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Terminology The best bid and offer are also known as the ‘Market Bid’ and ‘Market Offer’ Best Bid and Offer (BBO) A ‘Market Quotation’ often called a ‘Best Bid and Offer’ reports the best bid and offer in the market at a point in time National Best Bid and Offer (NBBO) The best bid and offer available anywhere in the U.S. at a point in time is known as the ‘National Best Bid and Offer’
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Terminology Bid-Ask Spread The difference between the best ask and the best bid is the ‘bid-ask spread’ Inside Spread Bid-Ask spread is also known as the ‘inside spread’ since it is observed within the market Touch In England the bid-ask spread is often referred to as the touch Trade Price Once an order is accepted, the price at which the trade is executed is known as Copyright Tarheel Consultancy Services
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Terminology Working Order An order may not be released for trading as soon as it is submitted. A broker may need to check whether a particular account is authorized to trade. Once an order is accepted, but before it is executed, it is known as a ‘Working Order’ Copyright Tarheel Consultancy Services
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Order Driven Markets
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Order Driven Markets
Markets may be classified based on the execution system
Execution system a set of procedures for matching buyers and sellers
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Order Driven Markets
A market in which buyers and sellers can trade with each other without the intermediation of a dealer
These markets have specified trading rules which stipulate as to how trades should be executed
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Illustration – Order Driven Markets specified trading rules
Buyer
trade directly with each other
Seller
specified trading rules Copyright Tarheel Consultancy Services
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Trading Rules Order Driven Markets Trading Rules
Order Precedence Rules
Trade Pricing Rules
how buy and sell orders should be arranged and matched
determine the price at which a trade is to be executed
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Example – Order Driven Markets
Auction Markets
Trading rules define the process by which
buyers seek the lowest available prices
sellers seek the highest available prices
This is called the ‘Price Discovery Process’
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Traders - Order Driven Markets
Public traders are not the only traders. Dealers can also trade.
There are in fact markets where they provide most of the liquidity.
In a pure order driven market however, a dealer is on par with any other public trader. Copyright Tarheel Consultancy Services
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Auctions
Many order driven
Auction Markets
markets conduct continuous two-sided auctions
buyers and sellers can continuously attempt to arrange their trades at prices that vary
Open outcry systems
Electronic rule based systems
through time Copyright Tarheel Consultancy Services
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Open Outcry Systems
Also called Oral Auction
Traders negotiate face to face on the floor of an exchange
The trading rules determine as to who can negotiate and when
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Electronic Based System
The trading rules are coded into the order-processing software
There are still some outdated systems where incoming orders are matched manually by clerks
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Order Driven Markets
These markets employ clearly specified trading rules
Traders cannot choose with whom they will trade A trader may end up trading with someone with whom he does not have a credit relationship To prevent settlement failure, such exchanges employ elaborate procedures to ensure that all traders are creditworthy and trustworthy
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Market Orders
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Market Orders
In the case of a market order there is no specified price limit
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Market Buy Orders
A market buy order
will be executed at the best available price from the standpoint of the trader
this will be the lowest of the limit prices specified by all traders who have placed unexecuted limit sell orders prior to the placement of the market order Copyright Tarheel Consultancy Services
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Market Sell Orders
A market sell orders
will get executed at the best available price from the standpoint of the trader
this will be the highest of the limit prices specified by the traders who have placed unexecuted limit buy orders prior to the incoming market sell order Copyright Tarheel Consultancy Services
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Priority Rules
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Priority Rules
In order to ensure that
Priority Rules
market orders get executed at the best available prices, the unexecuted but valid limit orders at any point in time must be sorted according to
Price Priority Rule
Time Priority Rule
Priority Rules Copyright Tarheel Consultancy Services
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Price Priority Rule Buy side
Sell side
A ‘limit buy order’ with a higher limit price ranks higher than all other ‘limit buy orders’ with lower limit prices
A ‘limit sell order’ with a lower limit price ranks higher than all other ‘limit sell orders’ with higher limit prices
An incoming ‘market buy An incoming ‘market sell order’ is guaranteed order’ is guaranteed to get executed at the to get executed at the lowest available price on highest available price the sell side of the on the buy side of the market market Copyright Tarheel Consultancy Services
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Time Priority Rule
E.g. How should 2 or more ‘limit buy orders’ or ‘limit sell orders’ with the same limit price be prioritized?
First-in-first-out the one which comes in first is automatically accorded priority
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Limit Order Books
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Limit Order Books
Limit Order Book (LOB) contains details of those limit orders which are currently valid, yet have not been executed so far due to unavailability of a suitable match
In the earlier days this record was physically maintained in the form of a book of orders
These days everything is in electronic form Copyright Tarheel Consultancy Services
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Illustration
How orders are arranged on the basis of the priority rules How matching between orders on the opposite sides of the market takes place
Assume that today is 2 January and that shares of a company have just been listed for trading Assume that in the first 30 minutes the following orders are placed Copyright Tarheel Consultancy Services
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Chronological Sequence of Orders Time
Trader
Order Side Order Size Limit Price
10:01
Arvind
Buy
100
100.00
10:03
Beena
Buy
200
100.20
10:07
Charu
Sell
200
100.10
10:10
Dhiraj
Sell
500
100.25
10:15
Ejaz
Buy
200
100.00
10:18
Francis
Buy
400
Market
10:20
Gauri
Sell
500
100.00
10:25
Harish
Sell
200
99.90
10:30
Leena
Buy
500
99.75
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Illustration (Cont…)
At 10:01
Arvind’s order will enter the system.
It is the very first order so it cannot be matched with an order on the other side.
Since it is a buy order it will go to the top of the buy side of the LOB.
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Table-2 Snapshot of the LOB at 10:01 Buyers Sellers
Trader
Order Size
Limit Price
Arvind
100
100.00
Limit Price
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Order Size
Trader
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Illustration (Cont…)
At 10:03
Beena’s order will enter the system.
It too cannot be matched because there are no sell orders in the book at that point in time.
Her order will queue up on the buy side.
Beena’s limit price of 100.20 > Arvind’s limit price of 100.00. Hence Beena will get priority.
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Table-3 Snapshot of the LOB at 10:03 Buyers Sellers
Trader
Order Size
Limit Price
Beena
200
100.20
Arvind
100
100.00
Limit Price
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Order Size
Trader
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Illustration (Cont…)
At 10:07
Charu’s sell order will enter the system.
Her limit price of 100.10 indicates that she is prepared to sell at this price or more
The system will try and match it with the best buy order in the LOB
The system finds a match with Beena’s limit price order of 100.20
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Illustration (Cont…)
Summary
A trade is feasible.
Charu has sought to sell 200 shares and Beena has sought to buy 200 shares
In the process of execution, both the orders will be completely filled.
One question remains
At what price will the trade be executed? Copyright Tarheel Consultancy Services
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Illustration (Cont…)
On the National Stock Exchange (NSE) an incoming or Active order will get executed at the price of the existing or Passive order with which it is matched
So in this case the trade will get executed at 100.20 Copyright Tarheel Consultancy Services
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Table-4 Snapshot of the LOB after the trade
Sellers
Trader
Order Size
Limit Price
Arvind
100
100.00
Limit Price
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Order Size
Trader
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Illustration (Cont…)
At 10:10
Dhiraj’s sell order will enter the system with a limit price of 100.25
The system will try and match it with the best order on the buy side which has a limit price of 100.00
A trade is infeasible
So Dhiraj’s order will take its place at the top of the sell side of the LOB. Copyright Tarheel Consultancy Services
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Table-5 Snapshot of the LOB at 10:10
Buyers
Sellers
Trader
Arvind
Order Size
100
Limit Price
Limit Price
Order Size
100.00 100.25 500
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Trader
Dhiraj
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Illustration (Cont…)
At 10:15
Ejaz’s buy order for 200 shares with a limit price of 100.00 comes in It cannot be matched with the best sell order In terms of the limit price it will have equal priority with Arvind’s order However since it came in later it will be accorded lower priority based on the time priority rule. Hence it will be placed below Arvind’s order.
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Table-6 Snapshot of the LOB at 10:15 Buyers
Sellers
Trader Order Size
Limit Price
Limit Price
Arvind
100
100.00 100.25
Ejaz
200
100.00
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Order Trader Size 500
Dhiraj
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Illustration (Cont…)
At 10:18
Francis’ market buy order for 400 shares will come in. This order is assured of execution if there happens to be >1 order on the opposite side with a cumulative order size > or = the size of the incoming order In this case there is a sell order for 500 shares. Hence the incoming order will be fully filled. The trade price will be the price of the passive order which 100.25. Copyright Tarheel Consultancy Services
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Table-7 Snapshot of the LOB after the trade
Buyers
Sellers
Trader
Order Size
Limit Price
Limit Price
Order Size
Trader
Arvind
100
100.00
100.25
100
Dhiraj
Ejaz
200
100.00
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Illustration (Cont…)
At 10:20
Gauri’s sell order for 500 shares with a limit price of 100.00 will enter.
The system will try and match it with Arvind’s order.
A trade will result for 100 shares. However 400 shares will remain to be filled on Gauri’s order
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Illustration (Cont…)
The system will try and match the remainder of the order with Ejaz’s order A trade will result for 200 shares. However Gauri’s order will still not be fully filled. For the balance 200 shares there is no possibility of a match. So the unfilled portion will stay in the LOB. It will go to the top of the sell side since Gauri’s limit price of 100.00 is less than the price of 100.25 specified by Dhiraj.
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Table-8 Snapshot of the LOB after the trade
Buyers
Sellers
Trader
Order Size
Limit Price
Limit Price
Order Size
Trader
100.00
200
Gauri
100.25
100
Dhiraj
Copyright Tarheel Consultancy Services
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Illustration (Cont…)
At 10:25
Harish’s sell order with a limit price of 99.90 will enter
Based on the price priority rule it will go to the top of the sell side of the LOB
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Table-9 Snapshot of the LOB at 10:25 Buyers
Sellers
Trader
Order Size
Limit Price
Limit Price
Order Size
Trader
99.90
200
Harish
100.00
200
Gauri
100.25
100
Dhiraj
Copyright Tarheel Consultancy Services
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Illustration (Cont…)
At 10:30
Leena’s buy order with a limit price of 99.75 will enter The system will try and match it with the best sell order which has a limit price of 99.90 Obviously a trade is infeasible The incoming order will therefore go to the top of the buy side of the LOB
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Table-10 Snapshot of the LOB at 10:30
Buyers
Sellers
Trader
Order Size
Limit Price
Limit Price
Order Size
Trader
Leena
500
99.75
99.90
200
Harish
100.00
200
Gauri
100.25
100
Dhiraj
Copyright Tarheel Consultancy Services
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Question
What would happen if a ‘market order’ were to enter the system and there were to be no ‘limit orders’ on the opposite side?
Every exchange will specify a solution for this eventuality E.g. On the NSE the incoming order will become a limit order with a limit price equal to the last recorded trade price
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Table-11 The LOB at a Particular Instant Buyers
Sellers
Trader
Order Size
Limit Price
Limit Price
Order Size
Trader
99.90
200
Harish
100.00
200
Gauri
100.25
100
Dhiraj
Copyright Tarheel Consultancy Services
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Illustration
Assume that the last recorded trade took place at a price of 99.80
Assume that a ‘market sell order’ for 500 shares placed by Raghu enters the system
Obviously a suitable match cannot be found.
The incoming order will therefore be converted to a ‘limit sell order’ with a ‘limit price’ of 99.80
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Table-12 Post Submission Snapshot of the LOB Buyers Trader
Order Size
Sellers Limit Price
Limit Price
Order Size
Trader
99.80
500
Raghu
99.90
200
Harish
100.00
200
Gauri
100.25
100
Dhiraj
Copyright Tarheel Consultancy Services
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Question
What if a ‘market order’ were to enter the system at the start of a trading day and there were to be no ‘limit orders’ on the other side?
The incoming order in such cases will be converted to a ‘limit order’ with a ‘limit price’ equal to the previous day’s closing price.
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Market Orders vs. Limit Orders
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Market Orders vs. Limit Orders Limit Order
Market Order
Gives the investor more control over the trade
Investor has less control over the trade
Traders can control the execution price using limit orders
Traders cannot control the execution price
No guarantee that a suitable match for such orders can be found within a reasonable period of time
Guarantee that trade will be executed immediately
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Illustration - Table-13
Buyers
Assume that the last trade price was 600.20 and the order book at a point in time looks as follows
Sellers
Trader
Order Size
Limit Price
Limit Price
Order Size
Trader
Arvind
100
100.00
100.25
500
Dhiraj
100.30
300
Solomon
100.30
1,700
Suniti
100.40
1,500
Sunil
100.50
1,000
Kumar
100.50
1,000
Swamy
Copyright Tarheel Consultancy Services
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Illustration (cont…)
Assume that Ejaz places a buy order for 200 contracts with a limit price of 100.00
It cannot be matched with an existing order
So it will take its place in the queue behind Arvind’s order
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Table-14 Snapshot of the LOB after Ejaz’s Order
Buyers
Sellers
Trader
Order Size
Limit Price
Limit Price
Order Size
Trader
Arvind
100
100.00
100.25
500
Dhiraj
Ejaz
200
100.00
100.30
300
Solomon
100.30
1,700
Suniti
100.40
1,500
Sunil
100.50
1,000
Kumar
100.50
1,000
Swamy
Copyright Tarheel Consultancy Services
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Illustration (cont…)
Assume that Simeran places a market buy order for 1,500 shares
It will obviously get executed immediately.
500 shares will be bought at 100.25
1000 shares will be bought at 100.30
So the last reported trade price will be 100.30
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Table-15 Snapshot of the LOB after the trade Buyers
Sellers
Trader
Order Size
Limit Price
Limit Price
Order Size
Trader
Arvind
100
100.00
100.30
1,000
Suniti
Ejaz
200
100.00
100.40
1,500
Sunil
100.50
1,000
Kumar
100.50
1,000
Swamy
Copyright Tarheel Consultancy Services
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Illustration (cont…)
Assume that another market order is placed for 1500 shares by Rahul
It too will get executed
1000 shares will get traded at 100.30
And 100 shares at 100.40
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Table-16 Snapshot of the LOB after the trade Buyers
Sellers
Trader
Order Size
Limit Price
Limit Price
Order Size
Trader
Arvind
100
100.00
100.40
1,000
Sunil
Ejaz
200
100.00
100.50
1,000
Kumar
100.50
1,000
Swamy
Copyright Tarheel Consultancy Services
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Illustration (cont…)
Seeing the market price jump from 100.20 to 100.40 in a short span, other traders wishing to place buy orders may be induced to place limit orders with prices higher than that of the best order on the buy side.
Assume Pooja places a buy order for 500 shares at 100.10 Assume Ajay who places a buy order for 1,500 shares at 100.15 Copyright Tarheel Consultancy Services
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Table-17 The LOB at the End
Trader
Order Size
Limit Price
Limit Price
Order Size
Trader
Ajay
1,500
100.15
100.40
1,000
Sunil
Pooja
500
100.10
100.50
1,000
Kumar
Arvind
100
100.00
100.50
1,000
Swamy
Ejaz
200
100.00 Copyright Tarheel Consultancy Services
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Illustration (cont…)
As can be seen Ejaz’s order has been pushed back in the queue.
There is no way of telling when it will get executed There is no guarantee that it will get executed at all
Had Ejaz placed a market order instead at the outset it would have been immediately executed at 100.25 Copyright Tarheel Consultancy Services
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Market Orders
Market orders are guaranteed to be executed if there are sufficient limit orders on the other side
But the trader has no control over the execution price
The trade price will depend on the limit price of the matching limit order
Copyright Tarheel Consultancy Services
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Marketable Limit Orders
Copyright Tarheel Consultancy Services
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Marketable Limit Orders
Aggressively Priced
Limit buy orders with high prices
Limit sell orders with low prices
Copyright Tarheel Consultancy Services
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Marketable Limit Orders A ‘Limit Order’
Buy Order
Sell Order
marketable
if it can be executed on submission
marketable
if higher the limit price
marketable
if lower the limit price
Copyright Tarheel Consultancy Services
91
Marketable Limit Orders in practice
• less than the best available price in Limit Buy Order
in practice
the market • equal to price of best sell order in LOB
Copyright Tarheel Consultancy Services
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Marketable Limit Orders in practice
• greater than the best available price in Limit Sell Order
in practice
the market • equal to price of best buy order in LOB
Copyright Tarheel Consultancy Services
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Illustration - Table-18 Snapshot of an LOB Buyers
Sellers
Trader
Order Size
Limit Price
Limit Price
Order Size
Trader
Anil
500
100.00
100.25
1300
Prasad
Ashraf
1000
99.90
100.40
1200
Ahmed
Mohan
1500
99.75
100.50
1500
Kumar
Copyright Tarheel Consultancy Services
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Illustration…(Cont…)
if limit price Limit Buy Order
executed immediately
greater than 100.25 or more The limit price for a marketable buy order must be greater than or equal to the best available offer
Copyright Tarheel Consultancy Services
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Illustration…(Cont…)
Limit Sell Order
executed immediately
if limit price is 100.25 or less
The limit price for a marketable sell order must be less than or equal to the best bid Copyright Tarheel Consultancy Services
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Marketable…(Cont…) “A marketable limit order seems similar to a market order”
“Hence why would anyone wish to place a ‘marketable limit order’ instead of a ‘market order’?”
Copyright Tarheel Consultancy Services
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Rationale Market orders
Marketable limit orders
A desire for quick A desire for quick execution execution on the part of on the part of the trader the trader Trader has no control Trader can specify a floor or over the execution pricea ceiling The freedom to specify a floor is significant if circumstances were to preclude a marketable limit order from getting executed 98 as planned Copyright Tarheel Consultancy Services
Rationale Marketable limit orders
Market orders
A desire for quick execution A desire for quick on the part of the trader execution on the part of the trader Trader can specify a floor or Trader has no control a ceiling over the execution price The freedom to specify a floor is significant if circumstances were to preclude a marketable limit order from getting executed as planned Copyright Tarheel Consultancy Services
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Table-18 Snapshot of an LOB
Trader
Buyers Order Size
Limit Price
Limit Price
Anil
500
100.00
Ashraf
1000
Mohan
1500
Sellers Order Size
Trader
100.25
1300
Prasad
99.90
100.40
1200
Ahmed
99.75
100.50
1500
Kumar
Copyright Tarheel Consultancy Services
100
Rationale Marketable limit orders
Ravi issues a limit buy order
Market orders
Assume that a large
with a limit price of 100.30 for market buy order for 300 shares.
3000 shares enters just
His expectation is that it will
before* Ravi’s order.
get matched with the best offer It pushes the trade price which is at 100.25
up to 100.50
*Traders throughout the world are monitoring the situation. A split second’s delay in order entry can lead to another order acquiring time priority Copyright Tarheel Consultancy Services
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Rationale Marketable limit orders
Market orders
Since Ravi has specified a limit of 100.30 his order will not be executed. Instead it will go to the top of the LOB on the buy side.
Had he placed a market order it would have got executed at 100.50, an outcome that may not be satisfactory
Marketable limit orders give the trader control over the execution price but there is execution uncertainty Copyright Tarheel Consultancy Services
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Limit Orders as Options
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Limit Orders as Options Standing Limit Order It is an offer of liquidity to other traders. It gives them an option to trade at the limit price. Limit Sell Order It is a call option that gives other traders the right to buy Limit Buy Order It is a put option that gives other traders the right to sell
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Options… Limit Order What it is The specified limit prices are the exercise prices of the corresponding options
Limit Order What it is not Although a limit order represents an option, it is not an options contract in the conventional sense An options contract is an option to trade that is sold by a writer to a buyer in return for a price or premium
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Options… Limit Orders What it is
Limit Orders What it is not
Limit orders however are options given away for free. Traders who place such orders do not receive a premium
A trader who places a limit order does not get an option premium even though the order represents an option.
There is no exclusive owner of So why should the trader the option on the other side. offer an option for free? Any trader can exercise the It is because the trader hopes option by placing a market to trade at a better price order or a marketable limit order Copyright Tarheel Consultancy Services
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Compensation for traders placing limit orders A buyer who has submitted Had he submitted a a ‘standing limit order’
‘market order’ instead he
expects to buy at the bid
would have to buy at the
price represented by his
ask price
order Consider the following LOB
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Table-19 Snapshot of the Petronet LOB
Trader
Buyers Order Size
Limit Price
Limit Price
Vivek
500
20.85
Vikas
1000
Vinod
Sellers Order Size
Trader
20.95
1300
Usha
20.80
21.05
1200
Uma
1500
20.75
21.15
1500
Urmila
Vijay
1000
20.70
21.20
2000
Urvi
Vinay
1500
20.65
21.15
1000
Uttara
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Compensation… Marketable limit orders
The trader who has
Market orders
Had he placed a market
placed the best bid
order he would have
expects to trade at 20.85
ended up buying at 20.95
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Problems with Limit Orders Marketable limit orders
Market orders
A trader placing a limit order will not always get what he is seeking. Sometimes the market could move away from him and his order never gets traded If trader still wants to trade he Trader may get a better will have to chase the market price than a limit order and the price he gets may be worse price Bidders will have to increase their bids Sellers will have to lower their 110 Copyright Tarheel Consultancy Services offers
Illustration… A trader has placed the best bid for Petronet at 20.85 A market order for 3000 shares comes in & gets executed
A new limit buy order comes in at 20.90 & 21.00
The trader observes this, cancels his limit order and: Places a fresh limit order at 21.00
Places a market order which then gets executed at 21.15
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Risks Traders may face risks with ‘limit orders’
Execution uncertainty {When prices move away from their orders limit order traders will fail to trade}
Trader may trade and later regret it {When the price moves towards and through the limit price}
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Execution Uncertainty
When prices move away from their orders limit order traders will fail to trade
E.g. in the case of Petronet:
If market buy orders keep entering, the best offer will move up from 20.85
From the point of view of a trader who has placed a buy order at 20.65 the odds of execution will be reduced
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Regret
When the price moves towards and through traders limit price
The order will get executed
If the market continues to move sharply against the trader, it could mean significant losses
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Illustration… In the case of Petronet, assume that a market sell order for 4000 shares comes in It will cause a buy order for 1000 shares at 20.70 to get executed
If price were to keep declining the buyer may have to offload the shares at a lower price
The trader observes this, cancels his limit order and: Places a fresh limit order at 21.00
Places a market order which then gets executed at 21.15
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Risks (Cont…)
This is called ex-post regret
This kind of regret is an occupational hazard for all traders and not just those who place limit orders.
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Stop-Loss Order
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Stop-Loss Orders
Order placed by a trader who has a position in the market and would like to cut his losses and quit immediately if the conditions were to turn adverse.
Such a person may have no desire to close out his position at the time of placing his order.
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Illustration… Take the case of an investor who is long in a stock and expects the price to rise Trader may like to ensure that the loss does not exceed an acceptable level
There is a sudden unanticipated decline in the market
Assume that trader’s threshold loss corresponds to a price of P*. :
He can place a stop order with a trigger price of P* Copyright Tarheel Consultancy Services
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Stop-Loss Orders (Cont…)
The stop instruction will prevent the order from getting activated until and unless the trigger is hit or breached.
Once the trigger is hit or breached the order will get triggered off and will become a market order.
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Table-20: LOB prior to the placement of a stop-sell order Buyers
Seller
Trader
Order Size
Limit Price
Limit Price
Order Size
Trader
Aarti
1200
100.00
100.20
500
Arvind
Anita
1000
99.85
100.30
1000
Anurag
Aakanksha
500
99.75
100.35
500
Amitabh
Anamika
800
99.55
100.40
700
Arjun
Anushua
500
99.25
100.50
300
Ajay
Anjali
1000
98.00
102.00
1000
Avinash
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Illustration… Assume that Vijay is currently long in 800 shares
He has no intention of selling
If the market were to trade at 99.60 or below
He would like to exit the market immediately
He can therefore place a stop sell order with a trigger price of 99.60
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Illustration… Assume that a market sell order for 4000 shares comes in
The last trade price will be 99.25
It will ensure that Aarti’s, Anita’s, Aakanksha’s, Anamika’s, and Anushua’s orders are fully filled
This is less than Vijay’s trigger
Vijay’s order will get activated and will get executed at 98.00 Trigger price in the case ‘stop sell order’ will always be less than the best price that is available at the time of placing the order which in Vijay’s case is 100.00
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Stop Orders (Cont…)
Stop Orders can also be used by those who wish to buy in the event of adverse market conditions
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Illustration…
Assume that Rajiv has a short position in 800 shares
He expects the market to fall
However if the price were to rise and hit or cross 100.50…
…then he would like to offset his short position and exit the market
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Illustration… Assume that Rajiv places a stop buy order with a trigger of 100.50
Assume that a market order for 3000 shares enters
Arvind’s, Anurag’s, Amitabh’s, Arjun’s, and Ajay’s orders will be completely filled The last trade price will be 100.50 which corresponds to Rajiv’s trigger
The stop buy order will get activated and will get executed at 102.00 Copyright Tarheel Consultancy Services
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Illustration…
In the case of stop buy orders the trigger price will always be greater than the best price available in the market which is 100.20
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Stop-Limit Orders
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Stop-Limit Orders
An instruction to hold the order in abeyance until a specified trigger is hit or breached
If the order is triggered off it will become a limit order
Two threshold prices have to specified 1.
Activation level for the limit order
2.
Limit price for the limit order
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Illustration…Vijay’s case
Vijay had specified a trigger of 99.60
He had no control over the execution price
His order got executed at 98.00
Because the order became a market order on activation
Vijay could have protected himself against such an eventuality
He could have placed a ‘stop limit order’ with a trigger price of 99.60 and a limit price of say 99.25
In this case if the stop order is activated it will become a limit order at 99.25
So Vijay is assured of a price of 99.25 Copyright Tarheel Consultancy Services
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Illustration…Rajiv’s case
Rajiv had specified a trigger of 100.50
When Rajiv placed a stop buy order it eventually got executed at 102.00
To protect himself he could have specified a ‘stoplimit order’ with a trigger of 100.50 and a limit price of say 101
In this case he will have to pay a maximum price of 101
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Market-If-Touched Order
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Market-if-Touched (MIT) Orders
This order will get activated if the price touched or breaches a pre-specified trigger Once activated it will become a market order So: What is the difference between such an order and a stop order?
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Diff. btwn MIT Order and Stop Order Stop loss sell order
MIT sell order
The trigger price will be The trigger price will be less than the best more than the best available price available price Will be activated if the market falls and breaches the trigger
Will be activated if the market rises and breaches the trigger
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Diff. btwn MIT Order and Stop Order Stop loss buy order
MIT buy order
The trigger price will be greater than the best price that is currently available
The trigger price will be less than the best price that is currently available
Will get activated if the market rises and breaches the trigger
Will get activated if the market falls and breaches the trigger
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Diff. btwn MIT Order and Stop Order Limit order
MIT order
A limit order can only On activation an MIT order trade at the limit price or will become a market better order and will get executed at the best available price MIT orders are guaranteed to be executed on activation but are subject to execution price uncertainty 136
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Table-21: Snapshot of an LOB prior to the placement of an MIT buy order
Trader
Buyers Order Size
Limit Price
Limit Price
Vijay
200
100.00
Virender
600
Vinay Vasudev
Sellers Order Size
Trader
100.25
200
Ravi
99.80
100.35
800
Ramesh
900
99.75
100.40
700
Ruchir
500
99.60
100.50
800
Rishi
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Illustration… Assume that a trader named Rohit places an MIT buy order for 500 shares at a trigger price of 100.15
Also assume that a market sell order for 500 shares enters the system immediately thereafter
The last trade price after the market order is filled will be 99.80
Rohit’s order will be triggered off and will get executed at 100.25 Had Rohit placed a limit buy order with a limit price of 100.15 he would have been assured of a trade price of 600.15 or less
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Market Impact
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Market Impact
Large market orders are more difficult to fill than small ones
Large market orders result in large price moves Large buy order
Prices may move up substantially
Large sell order Prices may move down substantially
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Market Impact (Cont…)
The movement in price due to a large order is called the Market Impact or the Price Impact of the order
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Table-20
Trader
Buyers Order Size
Limit Price
Limit Price
Aarti
1200
100.00
Anita
1000
Aakanksha
Sellers Order Size
Trader
100.20
500
Arvind
99.85
100.30
1000
Anurag
500
99.75
100.35
500
Amitabh
Anamika
800
99.55
100.40
700
Arjun
Anushua
500
99.25
100.50
300
Ajay
Anjali
1000
98.00
102.00
1000
Avinash
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Illustration (Cont…)
A large market buy order for 4000 shares would get executed at prices ranging from 100.20 to 102.00.
A large market sell order for 5000 shares would get executed at prices ranging from 100.00 to 98.00
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Lot Size
The usual unit of trading is referred to as a Round Lot
Normally traders trade in multiples of a round lot
Anything less than a round lot is an odd lot.
The definition of a round lot depends on the instrument being traded and the market on which it trades Copyright Tarheel Consultancy Services
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Examples - Lot Size
American Stock Exchange No standard lot size & a trade can be for any number of shares
Most stock exchanges in the U.S. Specify a round lot as constituting 100 shares
Japan Round lot is equivalent to 1000 shares
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Time Conditions
Traders specify time period validity instructions
They also specify expiration instructions to indicate when and how their orders become void
In principle such instructions can be specified for any kind of an order
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Time Conditions (Cont…)
These conditions are particularly important for ‘standing limit orders’ and ‘stop orders’
This is because such orders rarely trade on submission, and some may never trade
Consequently there is a need to specify what is to be done with unfilled orders
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Open & Good Orders Open Order
Good Order
An order that that has An order that is eligible not yet been executed or for execution is a good canceled is an open order order All good orders by definition are open orders
every open order need not be a good order
Consider an order placed on 1 July to buy a stock on or after 3 July
On 1 July the order is an ‘open order’
But is not a ‘good order’ Copyright Tarheel Consultancy Services
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Order Validity
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Order Validity
Day Orders
Good Till Cancelled Orders
Immediate / Good Till Cancel Days Orders Orders
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Day Orders
Valid only for the duration of the day on which it is entered
If not executed during the course of the day, the system automatically cancels it at the end of the day
E.g. As of 1999 the Stock Exchange of Singapore has been permitting only ‘good today’ limit orders Every morning the Exchange opens with no outstanding orders carried over from the previous day Copyright Tarheel Consultancy Services
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Good-Till-Canceled Orders
Such orders remain in the system till they are executed / canceled
If they are not executed on the day on which they are entered, they will be carried over to the next day and so forth.
Obviously they cannot remain in the system indefinitely
The exchange notifies a max time period after which such orders are automatically canceled Copyright Tarheel Consultancy Services
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GTC Orders validity
Many brokers give their clients a list of unfilled GTC orders at the end of the month
Some brokers cancel GTC orders after prespecified time periods
In the U.S. GTC orders have a max validity of 6 months
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Good-Till-Days Order
The investor has to specify the number of days for which the order can stay in the system unless executed
The number of days that can be specified cannot exceed the time limit set for GTC orders
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GTD Orders (Cont…)
Not all brokers accept such orders
It requires them to keep track of expiry dates
GTD Orders
Good-This-Week Orders
Good-This-Month Orders
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Immediate or Cancel Orders
Such orders have to be executed as soon as they are released into the system
Sometimes only a partial match may be found
Else they have to be canceled
If so a part of the order will be executed and the unmatched portion will be immediately canceled
They are also known as Fill-or-Kill (FOK) orders or Good-on-sight orders
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Other Types of Orders
Good-after-orders are activated or become valid only after a pre-specified date
Market-on-open orders can be filled only at the beginning of the trading session
Market-on-close orders can be filled only at the close of the trading session
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Quantity Instructions
All-or-nothing / All-or-none (AON) orders must be either filled all at once or remain unexecuted
There are also trades with a minimum or none instruction
In such cases multiple trades can be used to fill an order
Each trade must be for a quantity that is >= a specified minimum size
Such orders are also known as Minimum Acceptable Quantity (MAQ) orders
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Spread Orders
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Spread Orders
It is a combination of two orders 1.
To buy an instrument
2.
To simultaneously sell another instrument
Spread orders may be market spread orders or limit spread orders
The trader will specify a limit for the acceptable difference between the two prices
The limit will be specified as a premium on either the buy side or the sell side Copyright Tarheel Consultancy Services
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Sell Side Premium
Buy Side Premium
If trader wants to sell an instrument that is priced higher than the instrument he seeks to buy
If trader wants to buy an instrument that is priced higher than the one he wishes to sell
Such orders can be filled only if the difference between the sale and purchase prices is >= the premium
Such orders can be filled only if the difference between the purchase and sale price is <= the premium
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Tick Sensitive Orders
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Tick Sensitive Orders
A Tick is the minimum price increment or variation observable in the market
Smallest amount by which two prices can differ
A trader who wants to condition his order on the last price change can submit a tick sensitive order Copyright Tarheel Consultancy Services
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Tick Sensitive Orders
Tick size is set by exchange regulations
U.S. (until 2000) Was 1/16 of a dollar (6.25 cents)
U.S. (today) the system is decimalized 0.01 dollars (1 cent)
Tokyo Stock Exchange a function of the price
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Tick Size Price
Tick Size
P ≤ 2000 Yen
1 Yen
2000 < P ≤ 3000
5 Yen
3000 < P ≤ 30000
10 Yen
30000 < P ≤ 50000
50 Yen
50000 < P ≤ 100000
100 Yen
100000 < P ≤ 1000000
1000 Yen
P ≥ 1000000
10000 Yen
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Tick Sensitive
Traders classify prices by their relation to previous prices
uptick if price is higher than the last observed price downtick if price is lower than the last observed price zero tick if price is = the last observed price zero downtick if the last different price observed was higher zero uptick if the last different price observed was lower Copyright Tarheel Consultancy Services
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Illustration Previous to Last Price
Last Price
Current Price
Term
72.00
72.00
72.10
Uptick
72.00
72.00
71.90
Downtick
72.10
72.00
72.00
Zero Downtick
71.90
72.00
72.00
Zero Uptick
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Tick Sensitive (Cont…) A ‘buy downtick order’ A ‘sell uptick order’ can can be filled only on a
be filled only on an
downtick or a zero
uptick or a zero uptick
downtick The trade price must be The trade price must be lower than the last
higher than the last
different price observed different price observed
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Tick Sensitive (Cont…)
When a broker receives a tick sensitive order:
Broker will check to see whether it can be matched without violating the tick condition
If not, the order will be held in abeyance until a suitable opportunity were to arise
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Tick Condition (Cont…)
Tick condition ensures that tick sensitive orders do not have a market impact
A broker holding a buy downtick order cannot bid up prices to encourage sellers
A broker cannot fill a sell uptick order by driving prices down
Broker will have to wait
Broker will have to wait till
until someone is willing to
someone is prepared to
trade at a price lower than trade at a price that is the last different price higher than the last different price
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Illustration… An investor wants to buy shares of CISCO at a price that is lower than the best available ask price which is currently 19.76
One alternative is to submit a limit order at say 19.75
Another alternative is to submit a
If mkt were to move against him to ensure execution of his order he will have to cancel the existing order & resubmit a mkt order / limit order with a higher price
buy
downtick order Copyright Tarheel Consultancy Services
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Illustration…Buy Downtick Order Assume that when the order is placed, CISCO is on a zero uptick at 19.74
Since the order is tick sensitive the trader cannot buy until the price drops to 19.73 or less
Assume that a market buy order comes in and the price rises to 19.76
If so, the broker can only execute the tick sensitive order at 19.75 or less
If another market sell order were to come in, the broker would execute the tick sensitive order at 19.75
A tick sensitive order is a limit order with a dynamically changing limit price
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Tick Sensitive (Cont…)
The ‘buy downtick order’ is equivalent to the following strategy
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Illustration… Submit a limit order at just below the last observed price which was 19.74
Effectively a limit order is placed at 19.73
If the trade price were to rise, then raise the limit price to just below the trade price
In this case the trade price was 19.76. So the limit price was effectively raised to 19.75
If the trade price falls, do not alter the limit price
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Tick Sensitive (Cont…)
This strategy is meant for traders who wish to keep their limit orders close to the market when prices move against them
The alternative to such an order would be a dynamic limit order submission strategy
But implementing such strategies is virtually impossible in fast moving markets
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Open-Outcry Systems of Trading
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Oral Auctions
Traders meet face-to-face on the floor of the exchange
Some cry out their bids while others call out offers Others listen for bids and offers that meet their requirements Most traders do both – shout and listen
Many futures / options / stock exchanges use oral auctions to trade
E.g. Market for T-bond futures on the CBOT attracts 500 floor traders Copyright Tarheel Consultancy Services
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Oral auctions - Trading Buyer accepts seller’s offer The buyer will shout ‘take it’ to accept the offer Seller accepts buyer’s bid The seller will call out ‘sold’ to accept the bid Buyers and sellers take turns bidding & offering until they agree on a price/quantity to trade Copyright Tarheel Consultancy Services
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Oral auctions - Trading A trader who makes a bid/offer to trade supplier of liquidity
A trader who accepts a bid/offer acceptor of liquidity
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Open Outcry Rule Open outcry rule
Trader must publicly express his bid/offer to enable others to react
Any trader can accept bid/ask called out even though both traders may not be actively negotiating at that point of time Copyright Tarheel Consultancy Services
The first person to accept a bid or an offer generally gets to trade 180
Oral Auctions…
Order precedence rules determine A. B.
who can bid/offer whose bids/offers other traders can accept
‘Primary order precedence rule’ Price priority ‘Secondary order precedence rule’ depends on the market
Futures markets time preference Stock markets public order preference, followed by time preference Copyright Tarheel Consultancy Services
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Price as a Priority Rule
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Price Priority Rule
The rule gives precedence to traders who offer the best prices
Buyers can only accept the lowest offers
Sellers can only accept the highest bid
This rule is self-enforcing
Because an honest trader will search for the best prices
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Price Priority Rule…
Most oral auctions will not allow a trader to
bid below the best bid
offer above the best offer
such bids/offers only add to the noise and create confusion
A trader can improve the best bid by bidding higher
A trader can improve the best offer by offering at a lower price
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Time as a Priority Rule
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Time Priority
Gives precedence to the trader whose bid/offer improves the current best bid/offer
When a trader has time preference no trader can bid/offer at the best bid/offer that is currently available Copyright Tarheel Consultancy Services
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Time Priority
A trader will retain his time preference
until another trader improves his quote
until another trader accepts his quote
Once a bid/offer is accepted, anyone may bid/offer at the new price
all orders at that price have equal standing Copyright Tarheel Consultancy Services
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Imp. of Priority
In an oral auction bids/offers are valid only for an instant
In practice traders maintain their precedence by repeating their bids/offers as often as is necessary to show their interest
In a large active market, a trader may continuously repeat his bid/offer
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Time Priority…
Encourages competition among traders
If a trader is aggressive the way to get ahead of someone who has time precedence is by improving the price
If he improves the price he automatically gets the right to trade first
Unlike ‘price priority’, ‘time priority’ is not self enforcing Copyright Tarheel Consultancy Services
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Time Priority…
Most traders do not care whose bid/ask they are accepting as long as they get the best price
Trader with time preference must defend it when someone improperly tries to quote at the same price
A trader whose priority is being challenged will yell
”That’s my bid”
“That’s my offer”
“That’s my market”
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Other Priority Rules
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Public Traders priority rule
Some equity exchanges prohibit members from trading ahead of a public trader who is willing to trade at the same price
Why is this rule required?
An exchange member can easily acquire time preference at a new price before a public trader, because he sees price changes first and can quote faster than a public trader can submit orders. Copyright Tarheel Consultancy Services
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Public Traders rule
This rule permits a public trader to take precedence over a member even when the member has time preference
The objective is to give public traders greater access to the market and weaken the information advantage possessed by the floor trader
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Trade Pricing Rule
This is used to determine the price at which a trade is accepted
In an oral auction every trade takes place at the price proposed by the trader whose bid/offer is accepted
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Size as a Priority Rule
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Illustration - NYSE
On NYSE primary priority price priority
Time priority is not absolute
Once a trade is executed at a price, all orders at that price are said to be ‘on parity’
The first bid or offer at a particular price will get executed first
Every completed transaction is said to clear the floor and lead to the commencement of a fresh auction
Take the following case where three orders are equal on the basis of price Copyright Tarheel Consultancy Services
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Illustration
Time
Buyers
Trader
Size
Price
10:08
Alex
1000
100.00
10:10
Brown
1000
100.00
10:12
Mark
2000
100.00
Time
Copyright Tarheel Consultancy Services
Trader
Sellers Size
Price
197
Analysis Sally places a market sell order for 1000 shares at 10:14
Alex’s bid for 1000 shares will be accepted because his order has priority on the basis of time
Once this trade is executed, Brown and Mark will be on parity
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Illustration… Assume Janet places a market sell order for 1000 shares at 10:15
500 shares each will be allotted to both Brown and Mark
What if Janet had placed an order for 1500 shares?
What if Janet had placed an order for 2500 shares? Copyright Tarheel Consultancy Services
• Both have large enough orders to fill the incoming order • Neither of • The entire lot would have themsince has this been sold to Mark priority will clear the floor • This despite the fact that Mark’s order was placed later
• 2000 shares would go to Mark • Balance 500 would go 199 to Brown
Illustration… The first trade at a price need not always clear the floor
Assume that Sally places a market sell order for 2000 shares
In the above case the remaining 1000 shares will be allotted to Brown whose order came in next chronologically Copyright Tarheel Consultancy Services
• Alex will get 1000 shares because of time priority. • That leaves 1000 shares to be filled • But since Sally’s order has not been fully filled, the auction will continue Subsequently when Janet’s order for 1000 shares arrives, Mark will receive 1000 shares 200
Illustration… Assume Sally places a market sell order for 500 shares
Assume that Janet places a market sell order for 1500 shares
Alex’s order will be partially executed
• 500 will be sold to Alex • 500 each will go to Brown and Mark • Neither has time priority • Both orders are large enough to fill the incoming order
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Illustration… Assume Sally places a market order for 500 shares
Alex’s order will get partially executed
Assume Janet then places a market sell order for 2000 shares
• 500 will go to Alex.
What if Janet had placed an order for 3000 shares?
Copyright Tarheel Consultancy Services
• 1500 will go to Mark since this will clear the floor • 2000 shares would have been sold to Mark. • The balance 500 would go to Brown
202
Illustration Buyers
Time
Trader
Size
Price
10:08
Alex
1000
100.0
10:10
Brown
2000
100.0
10:12
Mark
1000
100.0
10:14
Jacob
1200
100.0
10:15
Mike
800
100.0
Time
Copyright Tarheel Consultancy Services
Sellers
Trader
Size
Price
203
Illustration… Assume that Sally places a sell order for 1000 shares
What if Janet were to now place a sell order for 1000 shares?
Copyright Tarheel Consultancy Services
Alex’s order will be executed
• It will be split between Brown, Mark and Jacob • Each has specified an order size >= the size of the incoming order • Mike will not get anything
204
Priority
On NYSE, for orders at a given price, public orders have priority over specialists’ orders
Assume that a specialist is bidding $100 for 1000 shares
Subsequently a public trader places a bid at $100 for 1000 shares
Copyright Tarheel Consultancy Services
If a market sell order for 1200 shares were to come in • The public trader would get 1000 shares • The specialist would get only 200 205
Priority
Traders on the floor of the exchange can participate pro-rata with the limit order book, once there has been a trade at a given price
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Illustration… •Assume that a trader arrives on the floor with a market sell order for 100 shares •The best bid-offer is
The incoming order will get executed at 50
50.00 -50.12 •Assume that the bid at 50 is for 5000 shares
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Illustration… • Assume that a second
• Since the stock has
market sell order for 1200
already traded at 50,
shares arrives
these 5 traders can
• Assume that the market
trade pro-rata with the
continues to be at 50.00-
order in the book
50.12
• The order in the book
• Assume that 5 new
will get an allocation of
traders now wish to buy
200 shares.
at the market
• The 5 new traders will get 200 shares each Copyright Tarheel Consultancy Services
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Priority (Cont…)
How did we get this figure of 200?
(the size of the incoming order) / the no. of traders + 1
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Block Trades
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Block Trades
Block trade is a relatively large trade in terms of size
Size classification depends on
instrument
vary from exchange to exchange
E.g. On NYSE 10,000 shares is the criterion for defining a block
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Block Trades…
Mostly blocks can be handled using normal trading procedures
Beyond a point special procedures are needed
E.g. On NYSE large trades go to a broker on what is called the upstairs market
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Block Trades – Upstairs market
Normal rules of exchange do not apply
Brokers / dealers negotiate deals
Broker can actively solicit counterparty
Upstairs market Can earn profit from unwinding positions
Can charge a commission from both sides Copyright Tarheel Consultancy Services
Can act as broker & dealer in same transaction
213
Block Trades (Cont…)
Once a deal is struck, it must be crossed on the floor of the exchange
Problem there may be ‘limit order’ in the book that can interfere with the order being crossed
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Illustration… Assume that the best bidoffer is 50.00 - 50.12
A block trade is arranged upstairs for 1MM shares at 49.90
Besides limit buy orders at 49.90 will have time priority
Technically, all orders in the book with prices ranging from 49.91 till 50.00 have price priority
The broker executing the block trade has to in principle fill these orders first
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Illustration (Cont…)
If there is substantial demand at 49.90 the block trader may not have an adequate quantity left to trade with the counterparty that he has identified
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Illustration (Cont…)
The broker who is arranging the block trade would like to avoid trading with the book
Because when he trades with the book he gets a commission from only one side If the trade is finalised with the identified counterparty, he will receive commissions from both sides To tackle such a situation U.S. exchanges have adopted a size precedence rule
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Block Trades (Cont…)
For orders > 25,000 shares
The matched block orders are allowed to outsize the book at the trade price The matched order will jump ahead of the other orders in the book which are at the same price, inspite of a higher time priority All orders standing in the book at better prices will be incorporated into the block trade @ block price These orders will displace some of the matched orders that the block trader presents to the floor Copyright Tarheel Consultancy Services
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Assume that the best bidoffer is 50.00 - 50.12
A block trade is arranged upstairs for 1MM shares at 49.90
• When this order comes to the floor it will automatically get precedence over all ‘standing limit orders’ @ 49.90 • Orders between 49.91 & 50.00 will be incorporated into the Technically, all orders in block @ 49.90 the book with prices ranging from 49.91 till 50.00 have price priority
The broker executing the block trade has to in principle fill these orders first 219 Copyright Tarheel Consultancy Services
Besides limit buy orders at 49.90 will have time priority
Substitution Orders
Sometimes a trader may want to invest a specific amount or realize a specific amount by way of divestment
However he may not care as to which securities are bought or sold
The broker in such cases can use his discretion, based on his perception of the market Copyright Tarheel Consultancy Services
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Settlement Instructions
Normal/regular settlement (in U.S.) trades are settled on a T+3 basis
The exchange of securities for cash takes place 3 business days after the day of the trade
A trader may at times wish to settle on a non-standard basis Copyright Tarheel Consultancy Services
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Special Settlement A trader may desire cash settlement
Such trades are settled on the day of the trade itself
Such orders are more difficult to execute and usually cannot be filled on demand
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Some brokers charge higher fees for such orders
222
Call Markets
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Call Markets
Call market is also known as Batch Market
Orders are accumulated until the market is called for trading
All accumulated orders are then simultaneously executed The time interval between successive calls may be fixed or variable Copyright Tarheel Consultancy Services
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Call Markets…
Calling securities
All the securities are called simultaneously, or
They are called one at a time in rotation
Markets that call in a rotation may complete one or more rotation in a trading session
This is the exclusive market mechanism in certain cases
E.g. most governments sell their bonds/notes/bills in such a framework The Deutsche Borse and the Euronext Paris Bourse use the call mechanism to trade their least active securities
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Continuous vs. Call
The two trading methods need not be mutually exclusive
The NYSE, Tokyo Stock Exchange (TSE), and the Australian Stock Exchange, begin each day with a call market. Subsequently they operate as continuous markets for the rest of the day. Copyright Tarheel Consultancy Services
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Illustration
We will illustrate A.
the enforcement of order precedence rules
B.
the matching of orders using an example
C.
use of the trade pricing rule
We will assume that orders that are received until 10:30 a.m., are bunched together, & that the market is cleared at that time
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Order Precendence
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Order Precedence
Buy & Sell orders are ranked in descending order of priority
The ‘order precedence rules’ are hierarchical
Markets first rank orders using their ‘primary order precedence rule’ If 2 or more orders have the same priority based on this rule, then ‘secondary precedence’ rules are applied The secondary precedence rules are applied in sequence until all the orders have been ranked
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Primary Rule • Buy orders @ highest prices • Sell orders @ the
Price Priority
lowest prices • Market orders always rank the highest since there is no specified Copyright Tarheel Consultancy Services
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Secondary Precedence Rule • Time of submission • Floor time preference Secondary Rule
• Strict time preference • Pure price time preference
• Size of order • All systems have minimum one secondary231
Copyright Tarheel Consultancy Services
Time Preference
Floor time preference the first order that arrives at a given price is given precedence over all the other orders at that price
This system is identical to the rule used in oral auctions
Remaining orders will be at parity with each other
Strict time preference rule all orders at the same price are ranked according to the time of submission
Pure price-time precedence systems systems that rank on the basis of price priority and strict time preference
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Size Precedence
These rules vary from market to market
Larger orders get precedence over smaller orders
In other markets it is just the opposite
When two or more orders are at parity and cannot all be filled, some markets allocate the available size on a pro rata basis
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Illustration of Order Arrival Time
Trader
Order Size
Size
Price
10:01
Alex
Buy
100
100.00
10:03
Bob
Buy
200
100.20
10:07
Carol
Sell
200
100.10
10:10
David
Sell
500
100.25
10:15
Emma
Buy
200
100.00
10:18
Frank
Buy
400
market
10:20
George
Sell
500
100.00
10:25
Harry
Sell
200
99.90
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Ranking of Orders with Price Priority Buyers
Sellers
Trader
Size
Price
Trader
Size
Price
Frank
400
Market
Harry
200
99.90
Bob
200
100.20
George
500
100.00
Alex
100
100.00
Carol
200
100.10
Emma
200
100.00
David
500
100.25
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Analysis
Buyer’s side:
1.
Frank’s order is a market order gets top priority
2.
Bob’s order gets price priority comes next
3.
Alex & Emma have the same price limit but Alex gets time priority
Seller’s side:
1.
Harry, George, Carol, and David, are in order based on price priority Copyright Tarheel Consultancy Services
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Matching
The market will first match the highest ranking buy order with the highest ranking sell order Highest ranking buy order
match
Highest ranking sell order
A Trade If the ‘buyer’ is willing to pay at least as much as the ‘seller’ demands
Best buy order = market order
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Illustration
Frank’s order for 400 shares > Harry’s sell order for 200 shares
Harry’s order will be completely filled
Balance 200 shares demanded by Frank will get matched with George
Frank’s order will be completely filled
Frank’s order of 400 shares
match
Harry’s sell order for 200 shares & George’s sell order for 200 shares
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Illustration •
Bob is willing to pay a max of 100.20
•
Bob is demanding 200 shares
•
George still has 100 more shares to offer
•
George is demanding a min of 100.00
match
match
•
George is demanding a min of 100.00
•
George is offering 300 shares
•
Alex is demanding 100 shares
•
Alex is demanding a max of 100.00
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Illustration
Remaining orders will stay unexecuted
At what prices should the respective trades get executed?
Would depend on the trade pricing rules used by the system
We will illustrate the ‘uniform pricing rule’ that is used by many exchanges
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Single Price Auctions
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Single Price Auctions Such auctions are a feature of many call markets Most continuous orderMost electronic futures driven stock markets open markets open trading in trading with this the morning with a single price call auction The Arizona Stock Exchange uses this mechanism for trading equities
National treasuries use such auctions to sell Treasury instruments
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Uniform Pricing
All trades take place at the same market clearing price
The price is determined by the last match that leads to a feasible trade
Market clearing price
As per last match price of buy order = price of sell order Copyright Tarheel Consultancy Services
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Uniform Pricing…
The ‘market clearing price’ will be satisfactory from the perspective of all previously matched orders
This is because all previously matched order will have greater than or equal price priority
Buyers
Sellers
Buyers corresponding to Sellers are willing to accept such orders will be willing to the ‘market clearing price’ pay at least as much as the or less ‘market clearing price’ Any other price will be either Any other price will be too too high to satisfy the buy low to satisfy the sell order order corresponding to the corresponding to the last last match match Copyright Tarheel Consultancy Services
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Illustration
Market clearing price is 100.00
Price of last executable buy order
Price of last executable sell order
In practice the orders corresponding to the last feasible trade may specify different prices
Bid price of the buy order < Ask price of the sell order
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Illustration
Assume that Alex’s bid for 100 shares @ 100.05 not 100.00
In this case the market can clear @ 100.05 specified by Alex, or @ 100 specified by George, or @ in between
The system will specify rules for such eventualities
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Crossing Networks
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Crossing networks No auctioning
No price discovery
Trades take place at prices determined elsewhere Prices at which these mkts are cleared are obtained from other mkts trading in similar instruments Copyright Tarheel Consultancy Services
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Crossing networks Such networks are said to use a derivative pricing rule
Prices on such markets are completely independent of the orders submitted by the traders
The only function of such markets is to determine whether an order can be executed at the crossing price Copyright Tarheel Consultancy Services
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Examples
The most important networks trade U.S. equity securities
ITG’s POSIT Instinet’s Global Instinet Crossing NYSE’s after hours trading session I
These markets are call markets
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Crossing…Call Markets Traders have to submit their orders prior to the call
After the call, order precedence rules are used to match buy and sell orders All matches that can trade at the crossing price become trades Copyright Tarheel Consultancy Services
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Crossing…examples
“Global Instinet Crossing” & “NYSE’s after hours trading session I” both cross after hours,
Both use the 4:00 p.m. closing stock price on the NYSE Traders use these systems because it is a ‘2nd chance’ to trade at closing prices
POSIT crosses stocks 8 times a day during regular trading hours
Crossing prices are chosen by selecting a time at random within seven minutes following the call
Crossing price = avg of bid price & ask price of primary market
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Crossing…
There is invariably excess demand or supply at the crossing price
If buyers want more than If sellers want to sell what sellers wish to
more than what buyers
offer, all sell orders will
wish to buy, all buy
fill completely
orders will fill completely
The fully filled side is allocated to the oversubscribed side in accordance with ‘order 253 Copyright Tarheel Consultancy Services
Crossing…
In practice only a small fraction of the total orders submitted get cleared
Traders like such markets they allow buyers & sellers to discover each other without having a price impact
Commissions are low: 1% - 2 % per share
Crossing networks are completely confidential & anonymous
They don’t display orders
They don’t disclose order imbalances after the cross Copyright Tarheel Consultancy Services
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Quote Driven Markets
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Quote-Driven Markets
In a pure-quote driven market, a Dealer must participate in every trade
Thus anyone who wishes to trade, must trade with a Dealer
A trader can either directly negotiate with a Dealer or his representative/Broker may do so on his behalf Copyright Tarheel Consultancy Services
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Illustration
broker
trader
dealer
Dealers may trade among themselves, but public traders cannot
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Quote-Driven example
Ravi wants to buy 100 shares of ICICI Bank Raja wants to sell 100 shares of ICICI Bank Even though they may agree on the price, they cannot trade with each other in a pure quote-driven market Ravi will have to find a dealer who is willing to sell shares from his inventory Raja will have to find a dealer who is willing to buy shares in order to add to his inventory Of course it may so happen that the same dealer may take both the sides Copyright Tarheel Consultancy Services
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Quote-Driven…
Dealers supply two-way quotes, one to buy, and the other to sell
Also known as “dealer markets” because liquidity is supplied by the dealers
Not all quote-driven markets are entirely quote-driven
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Quote-Driven…
In certain markets, traders can trade with each other without the intervention of a dealer
Although the bulk of the trades occur with the dealer taking one side of the transaction
E.g. Nasdaq is largely quote-driven; but dealers often arrange trades among public traders on opposite sides Copyright Tarheel Consultancy Services
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Quote-Driven…
In most quote driven markets dealers and clients choose each other when they wish to trade
Customers choose dealers who offer good prices and good service. Dealers prefer clients who are perceived as trustworthy and creditworthy.
Many dealers specialize in servicing specific clienteles such as small retail investors or large institutional investors. Copyright Tarheel Consultancy Services
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Role of Brokers
Traders who do not have credit relationships with dealers route their orders through Brokers who provide a guarantee to settle on their behalf.
In some dealer markets there are ‘inter-dealer brokers’ who help dealers to arrange trades among themselves
Brokers’ services are useful because many dealers would not like to disclose their identity when they trade
Brokers facilitate anonymous trading
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Quote-Driven markets examples
Almost all bond and currency markets are quotedriven.
Most such markets are informal networks of dealers communicating with each other & with clients by telephone
Other structured dealer markets are characterized by proprietary electronic data systems that facilitate communication among dealers
Such markets may be organized by a dealer network/formal exchange/broker/by an electronic data vendor Copyright Tarheel Consultancy Services
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Quote Driven Markets TYPE
EXAMPLE
Nasdaq Stock Market
Dealer Association
London Stock Exchange
Exchange
eSpeed ( a government bond trading system)
Broker
Reuters 3000 ( a foreign exchange trading system)
Electronic Data Vendor
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Brokered Markets
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Brokered Markets
In such markets, brokers actively search to match buyers & sellers
In most cases the search for a counterparty will begin as soon as an order is received from a client
In some cases the broker himself may initiate the search
Such markets arise where the assets being traded are unique and not held in inventory by dealers Copyright Tarheel Consultancy Services
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Brokered markets examples
Large blocks of stocks & bonds are traded in such fashion – block trading is nothing but a brokered deal
Real estate transactions too involve brokers
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Hybrid Markets
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Hybrid Markets
They exhibit characteristics of more than one kind of structure
E.g. the NYSE is primarily order driven
However it requires the specialists to offer liquidity if no one else is willing.
Thus it does have elements of a quote driven system
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Hybrid Markets - NASDAQ
NASDAQ market is a hybrid
It is essentially quote driven but dealers are required to display & execute public limit orders
Block trades on both the NYSE & Nasdaq are examples of brokered trading
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Copyright Tarheel Consultancy Services
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Part-02
Copyright Tarheel Consultancy Services
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Introduction
Copyright Tarheel Consultancy Services
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Introduction to Orders
What is an “Order”? A trade instruction given to a broker/an exchange
When a trader wishes to buy/sell a security he/she indicates
What he/she wishes to accomplish
The terms and conditions
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• Long /Short position • Name of the security places an order trader
• No. of shares • Price • How long order should remain valid Order information
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Order Information
Long / Short position
Long position buy order needs to be placed
Short position sell order needs to be placed
places an order trader
• • • • •
Long /Short position Name of the security No. of shares Price How long order should remain valid Order information
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Order Information
The security to be bought / sold must be clearly identified
E.g. Assume the investor wishes to go long in IBM stock Place a buy order for IBM shares
places an order trader
• • • • •
Long /Short position Name of the security No. of shares Price How long order should remain valid Order information
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Order Information
No. of shares to be bought / sold
This is called the Order Size
E.g. Assume the investor places a buy order for 200 shares of IBM Order size is 200
places an order trader
• • • • •
Long /Short position Name of the security No. of shares Price How long order should remain valid Order information
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Order Information
No. of shares to be bought / sold
This is called the Order Size
E.g. Assume the investor places a buy order for 200 shares of IBM Order size is 200
places an order trader
• • • • •
Long /Short position Name of the security No. of shares Price How long order should remain valid Order information
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Order Information Trader wants to buy/sell
Is trader willing to accept best Price in the mrkt?
No
Specify the max / min price trader is prepared to accept
Market Order
Yes
Limit Order or Limit Price
How long should order remain valid? Copyright Tarheel Consultancy Services
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Order Information
Prepared to accept the best terms available in the market Market Orders
Wish to place a ceiling or a floor Limit Orders
Price ceiling / Floor Limit Price
E.g. The investor places a Limit buy order Limit price= $95
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Order Information
The trader needs to specify how long he/she would like the order to remain valid
E.g. A trader may specify that
the order should be either executed on submission or canceled
He/she may be prepared to specify a period of time for which he/she is prepared to wait
E.g. Day Order means that if a suitable match is not found by the end of the day on which the order is entered, it should be canceled Copyright Tarheel Consultancy Services
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Order Information
Exchanges do not permit orders to stay alive forever
Specify a maximum validity period
Orders which fail to get executed within this period are automatically canceled
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Order Information…
Is it acceptable to partially fill the order?
E.g. Take the case of a buy order for 200 shares. What if a counterparty is found for only 100 shares?
The order can be partially executed
If investor does not wish this to happen place an All or None (AON) order.
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Importance of an ‘Order’
Orders are the building blocks of trading strategies
A proper order issued at the right time can:
Make the difference between a profitable trade and a costly trade
It can at times even make a difference between a trade and no trade
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Why Orders?
Orders are essential
most investors do not personally arrange their trades
to ensure that others execute their trades as per their intent, they must specify all relevant information
Envisage all possible contingencies
Prescribe suitable courses of action Copyright Tarheel Consultancy Services
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Revocation of order
If investor wishes to modify the terms of trade
He/she has to cancel his/her existing order and resubmit a fresh order
Problems with modification
By the time a fresh order is issued, market conditions may have changed adversely
An existing order may get executed before the trader is able to have it canceled Copyright Tarheel Consultancy Services
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Revocation (Cont…)
Correct specification of order is critical
Speed is the essence in order placement, execution, and cancellation
Computer based trading systems are superior to manual systems
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Terminology
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Terminology Bid When trader wants to indicate that he wishes to buy a security, he will make a bid
Offer When he wishes to convey that he is seeking to sell he will make an offer
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Terminology When a dealer wishes to trade on his own account he will quote ‘a bid’ or ‘an offer’ If dealer is trading on behalf of a client he will convey the buy/sell order placed by the client to a broker/an automated trading system Copyright Tarheel Consultancy Services
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Terminology
Order Size Bids and offers include information the price, and also about the quantity sought to be transacted. This is known as the order size.
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Terminology Bidding price The price specified in a buy order is called ‘the bid’ or ‘bidding price’ Asking price The price specified in a sell order is called ‘the offer’, ‘offering’, ‘ask’, or ‘asking price’ Best bid The highest bid price in the market is called the ‘best bid’ Best offer The lowest offer price in the market is called the ‘best offer’ Copyright Tarheel Consultancy Services
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Terminology The best bid and offer are also known as the ‘Market Bid’ and ‘Market Offer’ Best Bid and Offer (BBO) A ‘Market Quotation’ often called a ‘Best Bid and Offer’ reports the best bid and offer in the market at a point in time National Best Bid and Offer (NBBO) The best bid and offer available anywhere in the U.S. at a point in time is known as the ‘National Best Bid and Offer’
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Terminology Bid-Ask Spread The difference between the best ask and the best bid is the ‘bid-ask spread’ Inside Spread Bid-Ask spread is also known as the ‘inside spread’ since it is observed within the market Touch In England the bid-ask spread is often referred to as the touch Trade Price Once an order is accepted, the price at which the trade is executed is known as Copyright Tarheel Consultancy Services
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Terminology Working Order An order may not be released for trading as soon as it is submitted. A broker may need to check whether a particular account is authorized to trade. Once an order is accepted, but before it is executed, it is known as a ‘Working Order’ Copyright Tarheel Consultancy Services
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Order Driven Markets
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Order Driven Markets
Markets may be classified based on the execution system
Execution system a set of procedures for matching buyers and sellers
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Order Driven Markets
A market in which buyers and sellers can trade with each other without the intermediation of a dealer
These markets have specified trading rules which stipulate as to how trades should be executed
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Illustration – Order Driven Markets specified trading rules
Buyer
trade directly with each other
Seller
specified trading rules Copyright Tarheel Consultancy Services
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Trading Rules Order Driven Markets Trading Rules
Order Precedence Rules
Trade Pricing Rules
how buy and sell orders should be arranged and matched
determine the price at which a trade is to be executed
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Example – Order Driven Markets
Auction Markets
Trading rules define the process by which
buyers seek the lowest available prices
sellers seek the highest available prices
This is called the ‘Price Discovery Process’
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Traders - Order Driven Markets
Public traders are not the only traders. Dealers can also trade.
There are in fact markets where they provide most of the liquidity.
In a pure order driven market however, a dealer is on par with any other public trader. Copyright Tarheel Consultancy Services
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Auctions
Many order driven
Auction Markets
markets conduct continuous two-sided auctions
buyers and sellers can continuously attempt to arrange their trades at prices that vary
Open outcry systems
Electronic rule based systems
through time Copyright Tarheel Consultancy Services
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Open Outcry Systems
Also called Oral Auction
Traders negotiate face to face on the floor of an exchange
The trading rules determine as to who can negotiate and when
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Electronic Based System
The trading rules are coded into the order-processing software
There are still some outdated systems where incoming orders are matched manually by clerks
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Order Driven Markets
These markets employ clearly specified trading rules
Traders cannot choose with whom they will trade A trader may end up trading with someone with whom he does not have a credit relationship To prevent settlement failure, such exchanges employ elaborate procedures to ensure that all traders are creditworthy and trustworthy
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Market Orders
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Market Orders
In the case of a market order there is no specified price limit
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Market Buy Orders
A market buy order
will be executed at the best available price from the standpoint of the trader
this will be the lowest of the limit prices specified by all traders who have placed unexecuted limit sell orders prior to the placement of the market order Copyright Tarheel Consultancy Services
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Market Sell Orders
A market sell orders
will get executed at the best available price from the standpoint of the trader
this will be the highest of the limit prices specified by the traders who have placed unexecuted limit buy orders prior to the incoming market sell order Copyright Tarheel Consultancy Services
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Priority Rules
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Priority Rules
In order to ensure that
Priority Rules
market orders get executed at the best available prices, the unexecuted but valid limit orders at any point in time must be sorted according to
Price Priority Rule
Time Priority Rule
Priority Rules Copyright Tarheel Consultancy Services
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Price Priority Rule Buy side
Sell side
A ‘limit buy order’ with a higher limit price ranks higher than all other ‘limit buy orders’ with lower limit prices
A ‘limit sell order’ with a lower limit price ranks higher than all other ‘limit sell orders’ with higher limit prices
An incoming ‘market buy An incoming ‘market sell order’ is guaranteed order’ is guaranteed to get executed at the to get executed at the lowest available price on highest available price the sell side of the on the buy side of the market market Copyright Tarheel Consultancy Services
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Time Priority Rule
E.g. How should 2 or more ‘limit buy orders’ or ‘limit sell orders’ with the same limit price be prioritized?
First-in-first-out the one which comes in first is automatically accorded priority
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Limit Order Books
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Limit Order Books
Limit Order Book (LOB) contains details of those limit orders which are currently valid, yet have not been executed so far due to unavailability of a suitable match
In the earlier days this record was physically maintained in the form of a book of orders
These days everything is in electronic form Copyright Tarheel Consultancy Services
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Illustration
How orders are arranged on the basis of the priority rules How matching between orders on the opposite sides of the market takes place
Assume that today is 2 January and that shares of a company have just been listed for trading Assume that in the first 30 minutes the following orders are placed Copyright Tarheel Consultancy Services
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Chronological Sequence of Orders Time
Trader
Order Side Order Size Limit Price
10:01
Arvind
Buy
100
100.00
10:03
Beena
Buy
200
100.20
10:07
Charu
Sell
200
100.10
10:10
Dhiraj
Sell
500
100.25
10:15
Ejaz
Buy
200
100.00
10:18
Francis
Buy
400
Market
10:20
Gauri
Sell
500
100.00
10:25
Harish
Sell
200
99.90
10:30
Leena
Buy
500
99.75
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Illustration (Cont…)
At 10:01
Arvind’s order will enter the system.
It is the very first order so it cannot be matched with an order on the other side.
Since it is a buy order it will go to the top of the buy side of the LOB.
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Table-2 Snapshot of the LOB at 10:01 Buyers Sellers
Trader
Order Size
Limit Price
Arvind
100
100.00
Limit Price
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Order Size
Trader
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Illustration (Cont…)
At 10:03
Beena’s order will enter the system.
It too cannot be matched because there are no sell orders in the book at that point in time.
Her order will queue up on the buy side.
Beena’s limit price of 100.20 > Arvind’s limit price of 100.00. Hence Beena will get priority.
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Table-3 Snapshot of the LOB at 10:03 Buyers Sellers
Trader
Order Size
Limit Price
Beena
200
100.20
Arvind
100
100.00
Limit Price
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Order Size
Trader
53
Illustration (Cont…)
At 10:07
Charu’s sell order will enter the system.
Her limit price of 100.10 indicates that she is prepared to sell at this price or more
The system will try and match it with the best buy order in the LOB
The system finds a match with Beena’s limit price order of 100.20
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Illustration (Cont…)
Summary
A trade is feasible.
Charu has sought to sell 200 shares and Beena has sought to buy 200 shares
In the process of execution, both the orders will be completely filled.
One question remains
At what price will the trade be executed? Copyright Tarheel Consultancy Services
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Illustration (Cont…)
On the National Stock Exchange (NSE) an incoming or Active order will get executed at the price of the existing or Passive order with which it is matched
So in this case the trade will get executed at 100.20 Copyright Tarheel Consultancy Services
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Table-4 Snapshot of the LOB after the trade
Sellers
Trader
Order Size
Limit Price
Arvind
100
100.00
Limit Price
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Order Size
Trader
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Illustration (Cont…)
At 10:10
Dhiraj’s sell order will enter the system with a limit price of 100.25
The system will try and match it with the best order on the buy side which has a limit price of 100.00
A trade is infeasible
So Dhiraj’s order will take its place at the top of the sell side of the LOB. Copyright Tarheel Consultancy Services
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Table-5 Snapshot of the LOB at 10:10
Buyers
Sellers
Trader
Arvind
Order Size
100
Limit Price
Limit Price
Order Size
100.00 100.25 500
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Trader
Dhiraj
59
Illustration (Cont…)
At 10:15
Ejaz’s buy order for 200 shares with a limit price of 100.00 comes in It cannot be matched with the best sell order In terms of the limit price it will have equal priority with Arvind’s order However since it came in later it will be accorded lower priority based on the time priority rule. Hence it will be placed below Arvind’s order.
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Table-6 Snapshot of the LOB at 10:15 Buyers
Sellers
Trader Order Size
Limit Price
Limit Price
Arvind
100
100.00 100.25
Ejaz
200
100.00
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Order Trader Size 500
Dhiraj
61
Illustration (Cont…)
At 10:18
Francis’ market buy order for 400 shares will come in. This order is assured of execution if there happens to be >1 order on the opposite side with a cumulative order size > or = the size of the incoming order In this case there is a sell order for 500 shares. Hence the incoming order will be fully filled. The trade price will be the price of the passive order which 100.25. Copyright Tarheel Consultancy Services
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Table-7 Snapshot of the LOB after the trade
Buyers
Sellers
Trader
Order Size
Limit Price
Limit Price
Order Size
Trader
Arvind
100
100.00
100.25
100
Dhiraj
Ejaz
200
100.00
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Illustration (Cont…)
At 10:20
Gauri’s sell order for 500 shares with a limit price of 100.00 will enter.
The system will try and match it with Arvind’s order.
A trade will result for 100 shares. However 400 shares will remain to be filled on Gauri’s order
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Illustration (Cont…)
The system will try and match the remainder of the order with Ejaz’s order A trade will result for 200 shares. However Gauri’s order will still not be fully filled. For the balance 200 shares there is no possibility of a match. So the unfilled portion will stay in the LOB. It will go to the top of the sell side since Gauri’s limit price of 100.00 is less than the price of 100.25 specified by Dhiraj.
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Table-8 Snapshot of the LOB after the trade
Buyers
Sellers
Trader
Order Size
Limit Price
Limit Price
Order Size
Trader
100.00
200
Gauri
100.25
100
Dhiraj
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Illustration (Cont…)
At 10:25
Harish’s sell order with a limit price of 99.90 will enter
Based on the price priority rule it will go to the top of the sell side of the LOB
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Table-9 Snapshot of the LOB at 10:25 Buyers
Sellers
Trader
Order Size
Limit Price
Limit Price
Order Size
Trader
99.90
200
Harish
100.00
200
Gauri
100.25
100
Dhiraj
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Illustration (Cont…)
At 10:30
Leena’s buy order with a limit price of 99.75 will enter The system will try and match it with the best sell order which has a limit price of 99.90 Obviously a trade is infeasible The incoming order will therefore go to the top of the buy side of the LOB
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Table-10 Snapshot of the LOB at 10:30
Buyers
Sellers
Trader
Order Size
Limit Price
Limit Price
Order Size
Trader
Leena
500
99.75
99.90
200
Harish
100.00
200
Gauri
100.25
100
Dhiraj
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Question
What would happen if a ‘market order’ were to enter the system and there were to be no ‘limit orders’ on the opposite side?
Every exchange will specify a solution for this eventuality E.g. On the NSE the incoming order will become a limit order with a limit price equal to the last recorded trade price
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Table-11 The LOB at a Particular Instant Buyers
Sellers
Trader
Order Size
Limit Price
Limit Price
Order Size
Trader
99.90
200
Harish
100.00
200
Gauri
100.25
100
Dhiraj
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Illustration
Assume that the last recorded trade took place at a price of 99.80
Assume that a ‘market sell order’ for 500 shares placed by Raghu enters the system
Obviously a suitable match cannot be found.
The incoming order will therefore be converted to a ‘limit sell order’ with a ‘limit price’ of 99.80
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Table-12 Post Submission Snapshot of the LOB Buyers Trader
Order Size
Sellers Limit Price
Limit Price
Order Size
Trader
99.80
500
Raghu
99.90
200
Harish
100.00
200
Gauri
100.25
100
Dhiraj
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Question
What if a ‘market order’ were to enter the system at the start of a trading day and there were to be no ‘limit orders’ on the other side?
The incoming order in such cases will be converted to a ‘limit order’ with a ‘limit price’ equal to the previous day’s closing price.
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Market Orders vs. Limit Orders
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Market Orders vs. Limit Orders Limit Order
Market Order
Gives the investor more control over the trade
Investor has less control over the trade
Traders can control the execution price using limit orders
Traders cannot control the execution price
No guarantee that a suitable match for such orders can be found within a reasonable period of time
Guarantee that trade will be executed immediately
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Illustration - Table-13
Buyers
Assume that the last trade price was 600.20 and the order book at a point in time looks as follows
Sellers
Trader
Order Size
Limit Price
Limit Price
Order Size
Trader
Arvind
100
100.00
100.25
500
Dhiraj
100.30
300
Solomon
100.30
1,700
Suniti
100.40
1,500
Sunil
100.50
1,000
Kumar
100.50
1,000
Swamy
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Illustration (cont…)
Assume that Ejaz places a buy order for 200 contracts with a limit price of 100.00
It cannot be matched with an existing order
So it will take its place in the queue behind Arvind’s order
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Table-14 Snapshot of the LOB after Ejaz’s Order
Buyers
Sellers
Trader
Order Size
Limit Price
Limit Price
Order Size
Trader
Arvind
100
100.00
100.25
500
Dhiraj
Ejaz
200
100.00
100.30
300
Solomon
100.30
1,700
Suniti
100.40
1,500
Sunil
100.50
1,000
Kumar
100.50
1,000
Swamy
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Illustration (cont…)
Assume that Simeran places a market buy order for 1,500 shares
It will obviously get executed immediately.
500 shares will be bought at 100.25
1000 shares will be bought at 100.30
So the last reported trade price will be 100.30
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Table-15 Snapshot of the LOB after the trade Buyers
Sellers
Trader
Order Size
Limit Price
Limit Price
Order Size
Trader
Arvind
100
100.00
100.30
1,000
Suniti
Ejaz
200
100.00
100.40
1,500
Sunil
100.50
1,000
Kumar
100.50
1,000
Swamy
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Illustration (cont…)
Assume that another market order is placed for 1500 shares by Rahul
It too will get executed
1000 shares will get traded at 100.30
And 100 shares at 100.40
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Table-16 Snapshot of the LOB after the trade Buyers
Sellers
Trader
Order Size
Limit Price
Limit Price
Order Size
Trader
Arvind
100
100.00
100.40
1,000
Sunil
Ejaz
200
100.00
100.50
1,000
Kumar
100.50
1,000
Swamy
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Illustration (cont…)
Seeing the market price jump from 100.20 to 100.40 in a short span, other traders wishing to place buy orders may be induced to place limit orders with prices higher than that of the best order on the buy side.
Assume Pooja places a buy order for 500 shares at 100.10 Assume Ajay who places a buy order for 1,500 shares at 100.15 Copyright Tarheel Consultancy Services
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Table-17 The LOB at the End
Trader
Order Size
Limit Price
Limit Price
Order Size
Trader
Ajay
1,500
100.15
100.40
1,000
Sunil
Pooja
500
100.10
100.50
1,000
Kumar
Arvind
100
100.00
100.50
1,000
Swamy
Ejaz
200
100.00 Copyright Tarheel Consultancy Services
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Illustration (cont…)
As can be seen Ejaz’s order has been pushed back in the queue.
There is no way of telling when it will get executed There is no guarantee that it will get executed at all
Had Ejaz placed a market order instead at the outset it would have been immediately executed at 100.25 Copyright Tarheel Consultancy Services
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Market Orders
Market orders are guaranteed to be executed if there are sufficient limit orders on the other side
But the trader has no control over the execution price
The trade price will depend on the limit price of the matching limit order
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Marketable Limit Orders
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Marketable Limit Orders
Aggressively Priced
Limit buy orders with high prices
Limit sell orders with low prices
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Marketable Limit Orders A ‘Limit Order’
Buy Order
Sell Order
marketable
if it can be executed on submission
marketable
if higher the limit price
marketable
if lower the limit price
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Marketable Limit Orders in practice
• less than the best available price in Limit Buy Order
in practice
the market • equal to price of best sell order in LOB
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Marketable Limit Orders in practice
• greater than the best available price in Limit Sell Order
in practice
the market • equal to price of best buy order in LOB
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Illustration - Table-18 Snapshot of an LOB Buyers
Sellers
Trader
Order Size
Limit Price
Limit Price
Order Size
Trader
Anil
500
100.00
100.25
1300
Prasad
Ashraf
1000
99.90
100.40
1200
Ahmed
Mohan
1500
99.75
100.50
1500
Kumar
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Illustration…(Cont…)
if limit price Limit Buy Order
executed immediately
greater than 100.25 or more The limit price for a marketable buy order must be greater than or equal to the best available offer
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Illustration…(Cont…)
Limit Sell Order
executed immediately
if limit price is 100.25 or less
The limit price for a marketable sell order must be less than or equal to the best bid Copyright Tarheel Consultancy Services
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Marketable…(Cont…) “A marketable limit order seems similar to a market order”
“Hence why would anyone wish to place a ‘marketable limit order’ instead of a ‘market order’?”
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Rationale Market orders
Marketable limit orders
A desire for quick A desire for quick execution execution on the part of on the part of the trader the trader Trader has no control Trader can specify a floor or over the execution pricea ceiling The freedom to specify a floor is significant if circumstances were to preclude a marketable limit order from getting executed 98 as planned Copyright Tarheel Consultancy Services
Rationale Marketable limit orders
Market orders
A desire for quick execution A desire for quick on the part of the trader execution on the part of the trader Trader can specify a floor or Trader has no control a ceiling over the execution price The freedom to specify a floor is significant if circumstances were to preclude a marketable limit order from getting executed as planned Copyright Tarheel Consultancy Services
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Table-18 Snapshot of an LOB
Trader
Buyers Order Size
Limit Price
Limit Price
Anil
500
100.00
Ashraf
1000
Mohan
1500
Sellers Order Size
Trader
100.25
1300
Prasad
99.90
100.40
1200
Ahmed
99.75
100.50
1500
Kumar
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Rationale Marketable limit orders
Ravi issues a limit buy order
Market orders
Assume that a large
with a limit price of 100.30 for market buy order for 300 shares.
3000 shares enters just
His expectation is that it will
before* Ravi’s order.
get matched with the best offer It pushes the trade price which is at 100.25
up to 100.50
*Traders throughout the world are monitoring the situation. A split second’s delay in order entry can lead to another order acquiring time priority Copyright Tarheel Consultancy Services
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Rationale Marketable limit orders
Market orders
Since Ravi has specified a limit of 100.30 his order will not be executed. Instead it will go to the top of the LOB on the buy side.
Had he placed a market order it would have got executed at 100.50, an outcome that may not be satisfactory
Marketable limit orders give the trader control over the execution price but there is execution uncertainty Copyright Tarheel Consultancy Services
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Limit Orders as Options
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Limit Orders as Options Standing Limit Order It is an offer of liquidity to other traders. It gives them an option to trade at the limit price. Limit Sell Order It is a call option that gives other traders the right to buy Limit Buy Order It is a put option that gives other traders the right to sell
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Options… Limit Order What it is The specified limit prices are the exercise prices of the corresponding options
Limit Order What it is not Although a limit order represents an option, it is not an options contract in the conventional sense An options contract is an option to trade that is sold by a writer to a buyer in return for a price or premium
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Options… Limit Orders What it is
Limit Orders What it is not
Limit orders however are options given away for free. Traders who place such orders do not receive a premium
A trader who places a limit order does not get an option premium even though the order represents an option.
There is no exclusive owner of So why should the trader the option on the other side. offer an option for free? Any trader can exercise the It is because the trader hopes option by placing a market to trade at a better price order or a marketable limit order Copyright Tarheel Consultancy Services
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Compensation for traders placing limit orders A buyer who has submitted Had he submitted a a ‘standing limit order’
‘market order’ instead he
expects to buy at the bid
would have to buy at the
price represented by his
ask price
order Consider the following LOB
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Table-19 Snapshot of the Petronet LOB
Trader
Buyers Order Size
Limit Price
Limit Price
Vivek
500
20.85
Vikas
1000
Vinod
Sellers Order Size
Trader
20.95
1300
Usha
20.80
21.05
1200
Uma
1500
20.75
21.15
1500
Urmila
Vijay
1000
20.70
21.20
2000
Urvi
Vinay
1500
20.65
21.15
1000
Uttara
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Compensation… Marketable limit orders
The trader who has
Market orders
Had he placed a market
placed the best bid
order he would have
expects to trade at 20.85
ended up buying at 20.95
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Problems with Limit Orders Marketable limit orders
Market orders
A trader placing a limit order will not always get what he is seeking. Sometimes the market could move away from him and his order never gets traded If trader still wants to trade he Trader may get a better will have to chase the market price than a limit order and the price he gets may be worse price Bidders will have to increase their bids Sellers will have to lower their 110 Copyright Tarheel Consultancy Services offers
Illustration… A trader has placed the best bid for Petronet at 20.85 A market order for 3000 shares comes in & gets executed
A new limit buy order comes in at 20.90 & 21.00
The trader observes this, cancels his limit order and: Places a fresh limit order at 21.00
Places a market order which then gets executed at 21.15
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Risks Traders may face risks with ‘limit orders’
Execution uncertainty {When prices move away from their orders limit order traders will fail to trade}
Trader may trade and later regret it {When the price moves towards and through the limit price}
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Execution Uncertainty
When prices move away from their orders limit order traders will fail to trade
E.g. in the case of Petronet:
If market buy orders keep entering, the best offer will move up from 20.85
From the point of view of a trader who has placed a buy order at 20.65 the odds of execution will be reduced
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Regret
When the price moves towards and through traders limit price
The order will get executed
If the market continues to move sharply against the trader, it could mean significant losses
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Illustration… In the case of Petronet, assume that a market sell order for 4000 shares comes in It will cause a buy order for 1000 shares at 20.70 to get executed
If price were to keep declining the buyer may have to offload the shares at a lower price
The trader observes this, cancels his limit order and: Places a fresh limit order at 21.00
Places a market order which then gets executed at 21.15
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Risks (Cont…)
This is called ex-post regret
This kind of regret is an occupational hazard for all traders and not just those who place limit orders.
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Stop-Loss Order
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Stop-Loss Orders
Order placed by a trader who has a position in the market and would like to cut his losses and quit immediately if the conditions were to turn adverse.
Such a person may have no desire to close out his position at the time of placing his order.
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Illustration… Take the case of an investor who is long in a stock and expects the price to rise Trader may like to ensure that the loss does not exceed an acceptable level
There is a sudden unanticipated decline in the market
Assume that trader’s threshold loss corresponds to a price of P*. :
He can place a stop order with a trigger price of P* Copyright Tarheel Consultancy Services
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Stop-Loss Orders (Cont…)
The stop instruction will prevent the order from getting activated until and unless the trigger is hit or breached.
Once the trigger is hit or breached the order will get triggered off and will become a market order.
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Table-20: LOB prior to the placement of a stop-sell order Buyers
Seller
Trader
Order Size
Limit Price
Limit Price
Order Size
Trader
Aarti
1200
100.00
100.20
500
Arvind
Anita
1000
99.85
100.30
1000
Anurag
Aakanksha
500
99.75
100.35
500
Amitabh
Anamika
800
99.55
100.40
700
Arjun
Anushua
500
99.25
100.50
300
Ajay
Anjali
1000
98.00
102.00
1000
Avinash
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Illustration… Assume that Vijay is currently long in 800 shares
He has no intention of selling
If the market were to trade at 99.60 or below
He would like to exit the market immediately
He can therefore place a stop sell order with a trigger price of 99.60
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Illustration… Assume that a market sell order for 4000 shares comes in
The last trade price will be 99.25
It will ensure that Aarti’s, Anita’s, Aakanksha’s, Anamika’s, and Anushua’s orders are fully filled
This is less than Vijay’s trigger
Vijay’s order will get activated and will get executed at 98.00 Trigger price in the case ‘stop sell order’ will always be less than the best price that is available at the time of placing the order which in Vijay’s case is 100.00
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Stop Orders (Cont…)
Stop Orders can also be used by those who wish to buy in the event of adverse market conditions
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Illustration…
Assume that Rajiv has a short position in 800 shares
He expects the market to fall
However if the price were to rise and hit or cross 100.50…
…then he would like to offset his short position and exit the market
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Illustration… Assume that Rajiv places a stop buy order with a trigger of 100.50
Assume that a market order for 3000 shares enters
Arvind’s, Anurag’s, Amitabh’s, Arjun’s, and Ajay’s orders will be completely filled The last trade price will be 100.50 which corresponds to Rajiv’s trigger
The stop buy order will get activated and will get executed at 102.00 Copyright Tarheel Consultancy Services
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Illustration…
In the case of stop buy orders the trigger price will always be greater than the best price available in the market which is 100.20
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Stop-Limit Orders
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Stop-Limit Orders
An instruction to hold the order in abeyance until a specified trigger is hit or breached
If the order is triggered off it will become a limit order
Two threshold prices have to specified 1.
Activation level for the limit order
2.
Limit price for the limit order
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Illustration…Vijay’s case
Vijay had specified a trigger of 99.60
He had no control over the execution price
His order got executed at 98.00
Because the order became a market order on activation
Vijay could have protected himself against such an eventuality
He could have placed a ‘stop limit order’ with a trigger price of 99.60 and a limit price of say 99.25
In this case if the stop order is activated it will become a limit order at 99.25
So Vijay is assured of a price of 99.25 Copyright Tarheel Consultancy Services
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Illustration…Rajiv’s case
Rajiv had specified a trigger of 100.50
When Rajiv placed a stop buy order it eventually got executed at 102.00
To protect himself he could have specified a ‘stoplimit order’ with a trigger of 100.50 and a limit price of say 101
In this case he will have to pay a maximum price of 101
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Market-If-Touched Order
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Market-if-Touched (MIT) Orders
This order will get activated if the price touched or breaches a pre-specified trigger Once activated it will become a market order So: What is the difference between such an order and a stop order?
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Diff. btwn MIT Order and Stop Order Stop loss sell order
MIT sell order
The trigger price will be The trigger price will be less than the best more than the best available price available price Will be activated if the market falls and breaches the trigger
Will be activated if the market rises and breaches the trigger
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Diff. btwn MIT Order and Stop Order Stop loss buy order
MIT buy order
The trigger price will be greater than the best price that is currently available
The trigger price will be less than the best price that is currently available
Will get activated if the market rises and breaches the trigger
Will get activated if the market falls and breaches the trigger
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Diff. btwn MIT Order and Stop Order Limit order
MIT order
A limit order can only On activation an MIT order trade at the limit price or will become a market better order and will get executed at the best available price MIT orders are guaranteed to be executed on activation but are subject to execution price uncertainty 136
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Table-21: Snapshot of an LOB prior to the placement of an MIT buy order
Trader
Buyers Order Size
Limit Price
Limit Price
Vijay
200
100.00
Virender
600
Vinay Vasudev
Sellers Order Size
Trader
100.25
200
Ravi
99.80
100.35
800
Ramesh
900
99.75
100.40
700
Ruchir
500
99.60
100.50
800
Rishi
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Illustration… Assume that a trader named Rohit places an MIT buy order for 500 shares at a trigger price of 100.15
Also assume that a market sell order for 500 shares enters the system immediately thereafter
The last trade price after the market order is filled will be 99.80
Rohit’s order will be triggered off and will get executed at 100.25 Had Rohit placed a limit buy order with a limit price of 100.15 he would have been assured of a trade price of 600.15 or less
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Market Impact
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Market Impact
Large market orders are more difficult to fill than small ones
Large market orders result in large price moves Large buy order
Prices may move up substantially
Large sell order Prices may move down substantially
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Market Impact (Cont…)
The movement in price due to a large order is called the Market Impact or the Price Impact of the order
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Table-20
Trader
Buyers Order Size
Limit Price
Limit Price
Aarti
1200
100.00
Anita
1000
Aakanksha
Sellers Order Size
Trader
100.20
500
Arvind
99.85
100.30
1000
Anurag
500
99.75
100.35
500
Amitabh
Anamika
800
99.55
100.40
700
Arjun
Anushua
500
99.25
100.50
300
Ajay
Anjali
1000
98.00
102.00
1000
Avinash
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Illustration (Cont…)
A large market buy order for 4000 shares would get executed at prices ranging from 100.20 to 102.00.
A large market sell order for 5000 shares would get executed at prices ranging from 100.00 to 98.00
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Lot Size
The usual unit of trading is referred to as a Round Lot
Normally traders trade in multiples of a round lot
Anything less than a round lot is an odd lot.
The definition of a round lot depends on the instrument being traded and the market on which it trades Copyright Tarheel Consultancy Services
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Examples - Lot Size
American Stock Exchange No standard lot size & a trade can be for any number of shares
Most stock exchanges in the U.S. Specify a round lot as constituting 100 shares
Japan Round lot is equivalent to 1000 shares
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Time Conditions
Traders specify time period validity instructions
They also specify expiration instructions to indicate when and how their orders become void
In principle such instructions can be specified for any kind of an order
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Time Conditions (Cont…)
These conditions are particularly important for ‘standing limit orders’ and ‘stop orders’
This is because such orders rarely trade on submission, and some may never trade
Consequently there is a need to specify what is to be done with unfilled orders
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Open & Good Orders Open Order
Good Order
An order that that has An order that is eligible not yet been executed or for execution is a good canceled is an open order order All good orders by definition are open orders
every open order need not be a good order
Consider an order placed on 1 July to buy a stock on or after 3 July
On 1 July the order is an ‘open order’
But is not a ‘good order’ Copyright Tarheel Consultancy Services
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Order Validity
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Order Validity
Day Orders
Good Till Cancelled Orders
Immediate / Good Till Cancel Days Orders Orders
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Day Orders
Valid only for the duration of the day on which it is entered
If not executed during the course of the day, the system automatically cancels it at the end of the day
E.g. As of 1999 the Stock Exchange of Singapore has been permitting only ‘good today’ limit orders Every morning the Exchange opens with no outstanding orders carried over from the previous day Copyright Tarheel Consultancy Services
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Good-Till-Canceled Orders
Such orders remain in the system till they are executed / canceled
If they are not executed on the day on which they are entered, they will be carried over to the next day and so forth.
Obviously they cannot remain in the system indefinitely
The exchange notifies a max time period after which such orders are automatically canceled Copyright Tarheel Consultancy Services
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GTC Orders validity
Many brokers give their clients a list of unfilled GTC orders at the end of the month
Some brokers cancel GTC orders after prespecified time periods
In the U.S. GTC orders have a max validity of 6 months
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Good-Till-Days Order
The investor has to specify the number of days for which the order can stay in the system unless executed
The number of days that can be specified cannot exceed the time limit set for GTC orders
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GTD Orders (Cont…)
Not all brokers accept such orders
It requires them to keep track of expiry dates
GTD Orders
Good-This-Week Orders
Good-This-Month Orders
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Immediate or Cancel Orders
Such orders have to be executed as soon as they are released into the system
Sometimes only a partial match may be found
Else they have to be canceled
If so a part of the order will be executed and the unmatched portion will be immediately canceled
They are also known as Fill-or-Kill (FOK) orders or Good-on-sight orders
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Other Types of Orders
Good-after-orders are activated or become valid only after a pre-specified date
Market-on-open orders can be filled only at the beginning of the trading session
Market-on-close orders can be filled only at the close of the trading session
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Quantity Instructions
All-or-nothing / All-or-none (AON) orders must be either filled all at once or remain unexecuted
There are also trades with a minimum or none instruction
In such cases multiple trades can be used to fill an order
Each trade must be for a quantity that is >= a specified minimum size
Such orders are also known as Minimum Acceptable Quantity (MAQ) orders
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Spread Orders
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Spread Orders
It is a combination of two orders 1.
To buy an instrument
2.
To simultaneously sell another instrument
Spread orders may be market spread orders or limit spread orders
The trader will specify a limit for the acceptable difference between the two prices
The limit will be specified as a premium on either the buy side or the sell side Copyright Tarheel Consultancy Services
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Sell Side Premium
Buy Side Premium
If trader wants to sell an instrument that is priced higher than the instrument he seeks to buy
If trader wants to buy an instrument that is priced higher than the one he wishes to sell
Such orders can be filled only if the difference between the sale and purchase prices is >= the premium
Such orders can be filled only if the difference between the purchase and sale price is <= the premium
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Tick Sensitive Orders
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Tick Sensitive Orders
A Tick is the minimum price increment or variation observable in the market
Smallest amount by which two prices can differ
A trader who wants to condition his order on the last price change can submit a tick sensitive order Copyright Tarheel Consultancy Services
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Tick Sensitive Orders
Tick size is set by exchange regulations
U.S. (until 2000) Was 1/16 of a dollar (6.25 cents)
U.S. (today) the system is decimalized 0.01 dollars (1 cent)
Tokyo Stock Exchange a function of the price
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Tick Size Price
Tick Size
P ≤ 2000 Yen
1 Yen
2000 < P ≤ 3000
5 Yen
3000 < P ≤ 30000
10 Yen
30000 < P ≤ 50000
50 Yen
50000 < P ≤ 100000
100 Yen
100000 < P ≤ 1000000
1000 Yen
P ≥ 1000000
10000 Yen
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Tick Sensitive
Traders classify prices by their relation to previous prices
uptick if price is higher than the last observed price downtick if price is lower than the last observed price zero tick if price is = the last observed price zero downtick if the last different price observed was higher zero uptick if the last different price observed was lower Copyright Tarheel Consultancy Services
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Illustration Previous to Last Price
Last Price
Current Price
Term
72.00
72.00
72.10
Uptick
72.00
72.00
71.90
Downtick
72.10
72.00
72.00
Zero Downtick
71.90
72.00
72.00
Zero Uptick
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Tick Sensitive (Cont…) A ‘buy downtick order’ A ‘sell uptick order’ can can be filled only on a
be filled only on an
downtick or a zero
uptick or a zero uptick
downtick The trade price must be The trade price must be lower than the last
higher than the last
different price observed different price observed
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Tick Sensitive (Cont…)
When a broker receives a tick sensitive order:
Broker will check to see whether it can be matched without violating the tick condition
If not, the order will be held in abeyance until a suitable opportunity were to arise
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Tick Condition (Cont…)
Tick condition ensures that tick sensitive orders do not have a market impact
A broker holding a buy downtick order cannot bid up prices to encourage sellers
A broker cannot fill a sell uptick order by driving prices down
Broker will have to wait
Broker will have to wait till
until someone is willing to
someone is prepared to
trade at a price lower than trade at a price that is the last different price higher than the last different price
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Illustration… An investor wants to buy shares of CISCO at a price that is lower than the best available ask price which is currently 19.76
One alternative is to submit a limit order at say 19.75
Another alternative is to submit a
If mkt were to move against him to ensure execution of his order he will have to cancel the existing order & resubmit a mkt order / limit order with a higher price
buy
downtick order Copyright Tarheel Consultancy Services
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Illustration…Buy Downtick Order Assume that when the order is placed, CISCO is on a zero uptick at 19.74
Since the order is tick sensitive the trader cannot buy until the price drops to 19.73 or less
Assume that a market buy order comes in and the price rises to 19.76
If so, the broker can only execute the tick sensitive order at 19.75 or less
If another market sell order were to come in, the broker would execute the tick sensitive order at 19.75
A tick sensitive order is a limit order with a dynamically changing limit price
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Tick Sensitive (Cont…)
The ‘buy downtick order’ is equivalent to the following strategy
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Illustration… Submit a limit order at just below the last observed price which was 19.74
Effectively a limit order is placed at 19.73
If the trade price were to rise, then raise the limit price to just below the trade price
In this case the trade price was 19.76. So the limit price was effectively raised to 19.75
If the trade price falls, do not alter the limit price
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Tick Sensitive (Cont…)
This strategy is meant for traders who wish to keep their limit orders close to the market when prices move against them
The alternative to such an order would be a dynamic limit order submission strategy
But implementing such strategies is virtually impossible in fast moving markets
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Open-Outcry Systems of Trading
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Oral Auctions
Traders meet face-to-face on the floor of the exchange
Some cry out their bids while others call out offers Others listen for bids and offers that meet their requirements Most traders do both – shout and listen
Many futures / options / stock exchanges use oral auctions to trade
E.g. Market for T-bond futures on the CBOT attracts 500 floor traders Copyright Tarheel Consultancy Services
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Oral auctions - Trading Buyer accepts seller’s offer The buyer will shout ‘take it’ to accept the offer Seller accepts buyer’s bid The seller will call out ‘sold’ to accept the bid Buyers and sellers take turns bidding & offering until they agree on a price/quantity to trade Copyright Tarheel Consultancy Services
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Oral auctions - Trading A trader who makes a bid/offer to trade supplier of liquidity
A trader who accepts a bid/offer acceptor of liquidity
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Open Outcry Rule Open outcry rule
Trader must publicly express his bid/offer to enable others to react
Any trader can accept bid/ask called out even though both traders may not be actively negotiating at that point of time Copyright Tarheel Consultancy Services
The first person to accept a bid or an offer generally gets to trade 180
Oral Auctions…
Order precedence rules determine A. B.
who can bid/offer whose bids/offers other traders can accept
‘Primary order precedence rule’ Price priority ‘Secondary order precedence rule’ depends on the market
Futures markets time preference Stock markets public order preference, followed by time preference Copyright Tarheel Consultancy Services
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Price as a Priority Rule
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Price Priority Rule
The rule gives precedence to traders who offer the best prices
Buyers can only accept the lowest offers
Sellers can only accept the highest bid
This rule is self-enforcing
Because an honest trader will search for the best prices
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Price Priority Rule…
Most oral auctions will not allow a trader to
bid below the best bid
offer above the best offer
such bids/offers only add to the noise and create confusion
A trader can improve the best bid by bidding higher
A trader can improve the best offer by offering at a lower price
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Time as a Priority Rule
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Time Priority
Gives precedence to the trader whose bid/offer improves the current best bid/offer
When a trader has time preference no trader can bid/offer at the best bid/offer that is currently available Copyright Tarheel Consultancy Services
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Time Priority
A trader will retain his time preference
until another trader improves his quote
until another trader accepts his quote
Once a bid/offer is accepted, anyone may bid/offer at the new price
all orders at that price have equal standing Copyright Tarheel Consultancy Services
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Imp. of Priority
In an oral auction bids/offers are valid only for an instant
In practice traders maintain their precedence by repeating their bids/offers as often as is necessary to show their interest
In a large active market, a trader may continuously repeat his bid/offer
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Time Priority…
Encourages competition among traders
If a trader is aggressive the way to get ahead of someone who has time precedence is by improving the price
If he improves the price he automatically gets the right to trade first
Unlike ‘price priority’, ‘time priority’ is not self enforcing Copyright Tarheel Consultancy Services
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Time Priority…
Most traders do not care whose bid/ask they are accepting as long as they get the best price
Trader with time preference must defend it when someone improperly tries to quote at the same price
A trader whose priority is being challenged will yell
”That’s my bid”
“That’s my offer”
“That’s my market”
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Other Priority Rules
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Public Traders priority rule
Some equity exchanges prohibit members from trading ahead of a public trader who is willing to trade at the same price
Why is this rule required?
An exchange member can easily acquire time preference at a new price before a public trader, because he sees price changes first and can quote faster than a public trader can submit orders. Copyright Tarheel Consultancy Services
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Public Traders rule
This rule permits a public trader to take precedence over a member even when the member has time preference
The objective is to give public traders greater access to the market and weaken the information advantage possessed by the floor trader
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Trade Pricing Rule
This is used to determine the price at which a trade is accepted
In an oral auction every trade takes place at the price proposed by the trader whose bid/offer is accepted
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Size as a Priority Rule
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Illustration - NYSE
On NYSE primary priority price priority
Time priority is not absolute
Once a trade is executed at a price, all orders at that price are said to be ‘on parity’
The first bid or offer at a particular price will get executed first
Every completed transaction is said to clear the floor and lead to the commencement of a fresh auction
Take the following case where three orders are equal on the basis of price Copyright Tarheel Consultancy Services
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Illustration
Time
Buyers
Trader
Size
Price
10:08
Alex
1000
100.00
10:10
Brown
1000
100.00
10:12
Mark
2000
100.00
Time
Copyright Tarheel Consultancy Services
Trader
Sellers Size
Price
197
Analysis Sally places a market sell order for 1000 shares at 10:14
Alex’s bid for 1000 shares will be accepted because his order has priority on the basis of time
Once this trade is executed, Brown and Mark will be on parity
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Illustration… Assume Janet places a market sell order for 1000 shares at 10:15
500 shares each will be allotted to both Brown and Mark
What if Janet had placed an order for 1500 shares?
What if Janet had placed an order for 2500 shares? Copyright Tarheel Consultancy Services
• Both have large enough orders to fill the incoming order • Neither of • The entire lot would have themsince has this been sold to Mark priority will clear the floor • This despite the fact that Mark’s order was placed later
• 2000 shares would go to Mark • Balance 500 would go 199 to Brown
Illustration… The first trade at a price need not always clear the floor
Assume that Sally places a market sell order for 2000 shares
In the above case the remaining 1000 shares will be allotted to Brown whose order came in next chronologically Copyright Tarheel Consultancy Services
• Alex will get 1000 shares because of time priority. • That leaves 1000 shares to be filled • But since Sally’s order has not been fully filled, the auction will continue Subsequently when Janet’s order for 1000 shares arrives, Mark will receive 1000 shares 200
Illustration… Assume Sally places a market sell order for 500 shares
Assume that Janet places a market sell order for 1500 shares
Alex’s order will be partially executed
• 500 will be sold to Alex • 500 each will go to Brown and Mark • Neither has time priority • Both orders are large enough to fill the incoming order
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Illustration… Assume Sally places a market order for 500 shares
Alex’s order will get partially executed
Assume Janet then places a market sell order for 2000 shares
• 500 will go to Alex.
What if Janet had placed an order for 3000 shares?
Copyright Tarheel Consultancy Services
• 1500 will go to Mark since this will clear the floor • 2000 shares would have been sold to Mark. • The balance 500 would go to Brown
202
Illustration Buyers
Time
Trader
Size
Price
10:08
Alex
1000
100.0
10:10
Brown
2000
100.0
10:12
Mark
1000
100.0
10:14
Jacob
1200
100.0
10:15
Mike
800
100.0
Time
Copyright Tarheel Consultancy Services
Sellers
Trader
Size
Price
203
Illustration… Assume that Sally places a sell order for 1000 shares
What if Janet were to now place a sell order for 1000 shares?
Copyright Tarheel Consultancy Services
Alex’s order will be executed
• It will be split between Brown, Mark and Jacob • Each has specified an order size >= the size of the incoming order • Mike will not get anything
204
Priority
On NYSE, for orders at a given price, public orders have priority over specialists’ orders
Assume that a specialist is bidding $100 for 1000 shares
Subsequently a public trader places a bid at $100 for 1000 shares
Copyright Tarheel Consultancy Services
If a market sell order for 1200 shares were to come in • The public trader would get 1000 shares • The specialist would get only 200 205
Priority
Traders on the floor of the exchange can participate pro-rata with the limit order book, once there has been a trade at a given price
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Illustration… •Assume that a trader arrives on the floor with a market sell order for 100 shares •The best bid-offer is
The incoming order will get executed at 50
50.00 -50.12 •Assume that the bid at 50 is for 5000 shares
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Illustration… • Assume that a second
• Since the stock has
market sell order for 1200
already traded at 50,
shares arrives
these 5 traders can
• Assume that the market
trade pro-rata with the
continues to be at 50.00-
order in the book
50.12
• The order in the book
• Assume that 5 new
will get an allocation of
traders now wish to buy
200 shares.
at the market
• The 5 new traders will get 200 shares each Copyright Tarheel Consultancy Services
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Priority (Cont…)
How did we get this figure of 200?
(the size of the incoming order) / the no. of traders + 1
Copyright Tarheel Consultancy Services
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Block Trades
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Block Trades
Block trade is a relatively large trade in terms of size
Size classification depends on
instrument
vary from exchange to exchange
E.g. On NYSE 10,000 shares is the criterion for defining a block
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Block Trades…
Mostly blocks can be handled using normal trading procedures
Beyond a point special procedures are needed
E.g. On NYSE large trades go to a broker on what is called the upstairs market
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Block Trades – Upstairs market
Normal rules of exchange do not apply
Brokers / dealers negotiate deals
Broker can actively solicit counterparty
Upstairs market Can earn profit from unwinding positions
Can charge a commission from both sides Copyright Tarheel Consultancy Services
Can act as broker & dealer in same transaction
213
Block Trades (Cont…)
Once a deal is struck, it must be crossed on the floor of the exchange
Problem there may be ‘limit order’ in the book that can interfere with the order being crossed
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Illustration… Assume that the best bidoffer is 50.00 - 50.12
A block trade is arranged upstairs for 1MM shares at 49.90
Besides limit buy orders at 49.90 will have time priority
Technically, all orders in the book with prices ranging from 49.91 till 50.00 have price priority
The broker executing the block trade has to in principle fill these orders first
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Illustration (Cont…)
If there is substantial demand at 49.90 the block trader may not have an adequate quantity left to trade with the counterparty that he has identified
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Illustration (Cont…)
The broker who is arranging the block trade would like to avoid trading with the book
Because when he trades with the book he gets a commission from only one side If the trade is finalised with the identified counterparty, he will receive commissions from both sides To tackle such a situation U.S. exchanges have adopted a size precedence rule
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Block Trades (Cont…)
For orders > 25,000 shares
The matched block orders are allowed to outsize the book at the trade price The matched order will jump ahead of the other orders in the book which are at the same price, inspite of a higher time priority All orders standing in the book at better prices will be incorporated into the block trade @ block price These orders will displace some of the matched orders that the block trader presents to the floor Copyright Tarheel Consultancy Services
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Assume that the best bidoffer is 50.00 - 50.12
A block trade is arranged upstairs for 1MM shares at 49.90
• When this order comes to the floor it will automatically get precedence over all ‘standing limit orders’ @ 49.90 • Orders between 49.91 & 50.00 will be incorporated into the Technically, all orders in block @ 49.90 the book with prices ranging from 49.91 till 50.00 have price priority
The broker executing the block trade has to in principle fill these orders first 219 Copyright Tarheel Consultancy Services
Besides limit buy orders at 49.90 will have time priority
Substitution Orders
Sometimes a trader may want to invest a specific amount or realize a specific amount by way of divestment
However he may not care as to which securities are bought or sold
The broker in such cases can use his discretion, based on his perception of the market Copyright Tarheel Consultancy Services
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Settlement Instructions
Normal/regular settlement (in U.S.) trades are settled on a T+3 basis
The exchange of securities for cash takes place 3 business days after the day of the trade
A trader may at times wish to settle on a non-standard basis Copyright Tarheel Consultancy Services
221
Special Settlement A trader may desire cash settlement
Such trades are settled on the day of the trade itself
Such orders are more difficult to execute and usually cannot be filled on demand
Copyright Tarheel Consultancy Services
Some brokers charge higher fees for such orders
222
Call Markets
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Call Markets
Call market is also known as Batch Market
Orders are accumulated until the market is called for trading
All accumulated orders are then simultaneously executed The time interval between successive calls may be fixed or variable Copyright Tarheel Consultancy Services
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Call Markets…
Calling securities
All the securities are called simultaneously, or
They are called one at a time in rotation
Markets that call in a rotation may complete one or more rotation in a trading session
This is the exclusive market mechanism in certain cases
E.g. most governments sell their bonds/notes/bills in such a framework The Deutsche Borse and the Euronext Paris Bourse use the call mechanism to trade their least active securities
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Continuous vs. Call
The two trading methods need not be mutually exclusive
The NYSE, Tokyo Stock Exchange (TSE), and the Australian Stock Exchange, begin each day with a call market. Subsequently they operate as continuous markets for the rest of the day. Copyright Tarheel Consultancy Services
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Illustration
We will illustrate A.
the enforcement of order precedence rules
B.
the matching of orders using an example
C.
use of the trade pricing rule
We will assume that orders that are received until 10:30 a.m., are bunched together, & that the market is cleared at that time
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Order Precendence
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Order Precedence
Buy & Sell orders are ranked in descending order of priority
The ‘order precedence rules’ are hierarchical
Markets first rank orders using their ‘primary order precedence rule’ If 2 or more orders have the same priority based on this rule, then ‘secondary precedence’ rules are applied The secondary precedence rules are applied in sequence until all the orders have been ranked
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Primary Rule • Buy orders @ highest prices • Sell orders @ the
Price Priority
lowest prices • Market orders always rank the highest since there is no specified Copyright Tarheel Consultancy Services
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Secondary Precedence Rule • Time of submission • Floor time preference Secondary Rule
• Strict time preference • Pure price time preference
• Size of order • All systems have minimum one secondary231
Copyright Tarheel Consultancy Services
Time Preference
Floor time preference the first order that arrives at a given price is given precedence over all the other orders at that price
This system is identical to the rule used in oral auctions
Remaining orders will be at parity with each other
Strict time preference rule all orders at the same price are ranked according to the time of submission
Pure price-time precedence systems systems that rank on the basis of price priority and strict time preference
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Size Precedence
These rules vary from market to market
Larger orders get precedence over smaller orders
In other markets it is just the opposite
When two or more orders are at parity and cannot all be filled, some markets allocate the available size on a pro rata basis
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Illustration of Order Arrival Time
Trader
Order Size
Size
Price
10:01
Alex
Buy
100
100.00
10:03
Bob
Buy
200
100.20
10:07
Carol
Sell
200
100.10
10:10
David
Sell
500
100.25
10:15
Emma
Buy
200
100.00
10:18
Frank
Buy
400
market
10:20
George
Sell
500
100.00
10:25
Harry
Sell
200
99.90
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Ranking of Orders with Price Priority Buyers
Sellers
Trader
Size
Price
Trader
Size
Price
Frank
400
Market
Harry
200
99.90
Bob
200
100.20
George
500
100.00
Alex
100
100.00
Carol
200
100.10
Emma
200
100.00
David
500
100.25
Copyright Tarheel Consultancy Services
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Analysis
Buyer’s side:
1.
Frank’s order is a market order gets top priority
2.
Bob’s order gets price priority comes next
3.
Alex & Emma have the same price limit but Alex gets time priority
Seller’s side:
1.
Harry, George, Carol, and David, are in order based on price priority Copyright Tarheel Consultancy Services
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Matching
The market will first match the highest ranking buy order with the highest ranking sell order Highest ranking buy order
match
Highest ranking sell order
A Trade If the ‘buyer’ is willing to pay at least as much as the ‘seller’ demands
Best buy order = market order
Copyright Tarheel Consultancy Services
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Illustration
Frank’s order for 400 shares > Harry’s sell order for 200 shares
Harry’s order will be completely filled
Balance 200 shares demanded by Frank will get matched with George
Frank’s order will be completely filled
Frank’s order of 400 shares
match
Harry’s sell order for 200 shares & George’s sell order for 200 shares
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Illustration •
Bob is willing to pay a max of 100.20
•
Bob is demanding 200 shares
•
George still has 100 more shares to offer
•
George is demanding a min of 100.00
match
match
•
George is demanding a min of 100.00
•
George is offering 300 shares
•
Alex is demanding 100 shares
•
Alex is demanding a max of 100.00
Copyright Tarheel Consultancy Services
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Illustration
Remaining orders will stay unexecuted
At what prices should the respective trades get executed?
Would depend on the trade pricing rules used by the system
We will illustrate the ‘uniform pricing rule’ that is used by many exchanges
Copyright Tarheel Consultancy Services
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Single Price Auctions
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Single Price Auctions Such auctions are a feature of many call markets Most continuous orderMost electronic futures driven stock markets open markets open trading in trading with this the morning with a single price call auction The Arizona Stock Exchange uses this mechanism for trading equities
National treasuries use such auctions to sell Treasury instruments
Copyright Tarheel Consultancy Services
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Uniform Pricing
All trades take place at the same market clearing price
The price is determined by the last match that leads to a feasible trade
Market clearing price
As per last match price of buy order = price of sell order Copyright Tarheel Consultancy Services
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Uniform Pricing…
The ‘market clearing price’ will be satisfactory from the perspective of all previously matched orders
This is because all previously matched order will have greater than or equal price priority
Buyers
Sellers
Buyers corresponding to Sellers are willing to accept such orders will be willing to the ‘market clearing price’ pay at least as much as the or less ‘market clearing price’ Any other price will be either Any other price will be too too high to satisfy the buy low to satisfy the sell order order corresponding to the corresponding to the last last match match Copyright Tarheel Consultancy Services
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Illustration
Market clearing price is 100.00
Price of last executable buy order
Price of last executable sell order
In practice the orders corresponding to the last feasible trade may specify different prices
Bid price of the buy order < Ask price of the sell order
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Illustration
Assume that Alex’s bid for 100 shares @ 100.05 not 100.00
In this case the market can clear @ 100.05 specified by Alex, or @ 100 specified by George, or @ in between
The system will specify rules for such eventualities
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Crossing Networks
Copyright Tarheel Consultancy Services
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Crossing networks No auctioning
No price discovery
Trades take place at prices determined elsewhere Prices at which these mkts are cleared are obtained from other mkts trading in similar instruments Copyright Tarheel Consultancy Services
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Crossing networks Such networks are said to use a derivative pricing rule
Prices on such markets are completely independent of the orders submitted by the traders
The only function of such markets is to determine whether an order can be executed at the crossing price Copyright Tarheel Consultancy Services
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Examples
The most important networks trade U.S. equity securities
ITG’s POSIT Instinet’s Global Instinet Crossing NYSE’s after hours trading session I
These markets are call markets
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Crossing…Call Markets Traders have to submit their orders prior to the call
After the call, order precedence rules are used to match buy and sell orders All matches that can trade at the crossing price become trades Copyright Tarheel Consultancy Services
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Crossing…examples
“Global Instinet Crossing” & “NYSE’s after hours trading session I” both cross after hours,
Both use the 4:00 p.m. closing stock price on the NYSE Traders use these systems because it is a ‘2nd chance’ to trade at closing prices
POSIT crosses stocks 8 times a day during regular trading hours
Crossing prices are chosen by selecting a time at random within seven minutes following the call
Crossing price = avg of bid price & ask price of primary market
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Crossing…
There is invariably excess demand or supply at the crossing price
If buyers want more than If sellers want to sell what sellers wish to
more than what buyers
offer, all sell orders will
wish to buy, all buy
fill completely
orders will fill completely
The fully filled side is allocated to the oversubscribed side in accordance with ‘order 253 Copyright Tarheel Consultancy Services
Crossing…
In practice only a small fraction of the total orders submitted get cleared
Traders like such markets they allow buyers & sellers to discover each other without having a price impact
Commissions are low: 1% - 2 % per share
Crossing networks are completely confidential & anonymous
They don’t display orders
They don’t disclose order imbalances after the cross Copyright Tarheel Consultancy Services
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Quote Driven Markets
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Quote-Driven Markets
In a pure-quote driven market, a Dealer must participate in every trade
Thus anyone who wishes to trade, must trade with a Dealer
A trader can either directly negotiate with a Dealer or his representative/Broker may do so on his behalf Copyright Tarheel Consultancy Services
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Illustration
broker
trader
dealer
Dealers may trade among themselves, but public traders cannot
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Quote-Driven example
Ravi wants to buy 100 shares of ICICI Bank Raja wants to sell 100 shares of ICICI Bank Even though they may agree on the price, they cannot trade with each other in a pure quote-driven market Ravi will have to find a dealer who is willing to sell shares from his inventory Raja will have to find a dealer who is willing to buy shares in order to add to his inventory Of course it may so happen that the same dealer may take both the sides Copyright Tarheel Consultancy Services
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Quote-Driven…
Dealers supply two-way quotes, one to buy, and the other to sell
Also known as “dealer markets” because liquidity is supplied by the dealers
Not all quote-driven markets are entirely quote-driven
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Quote-Driven…
In certain markets, traders can trade with each other without the intervention of a dealer
Although the bulk of the trades occur with the dealer taking one side of the transaction
E.g. Nasdaq is largely quote-driven; but dealers often arrange trades among public traders on opposite sides Copyright Tarheel Consultancy Services
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Quote-Driven…
In most quote driven markets dealers and clients choose each other when they wish to trade
Customers choose dealers who offer good prices and good service. Dealers prefer clients who are perceived as trustworthy and creditworthy.
Many dealers specialize in servicing specific clienteles such as small retail investors or large institutional investors. Copyright Tarheel Consultancy Services
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Role of Brokers
Traders who do not have credit relationships with dealers route their orders through Brokers who provide a guarantee to settle on their behalf.
In some dealer markets there are ‘inter-dealer brokers’ who help dealers to arrange trades among themselves
Brokers’ services are useful because many dealers would not like to disclose their identity when they trade
Brokers facilitate anonymous trading
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Quote-Driven markets examples
Almost all bond and currency markets are quotedriven.
Most such markets are informal networks of dealers communicating with each other & with clients by telephone
Other structured dealer markets are characterized by proprietary electronic data systems that facilitate communication among dealers
Such markets may be organized by a dealer network/formal exchange/broker/by an electronic data vendor Copyright Tarheel Consultancy Services
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Quote Driven Markets TYPE
EXAMPLE
Nasdaq Stock Market
Dealer Association
London Stock Exchange
Exchange
eSpeed ( a government bond trading system)
Broker
Reuters 3000 ( a foreign exchange trading system)
Electronic Data Vendor
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Brokered Markets
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Brokered Markets
In such markets, brokers actively search to match buyers & sellers
In most cases the search for a counterparty will begin as soon as an order is received from a client
In some cases the broker himself may initiate the search
Such markets arise where the assets being traded are unique and not held in inventory by dealers Copyright Tarheel Consultancy Services
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Brokered markets examples
Large blocks of stocks & bonds are traded in such fashion – block trading is nothing but a brokered deal
Real estate transactions too involve brokers
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Hybrid Markets
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Hybrid Markets
They exhibit characteristics of more than one kind of structure
E.g. the NYSE is primarily order driven
However it requires the specialists to offer liquidity if no one else is willing.
Thus it does have elements of a quote driven system
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Hybrid Markets - NASDAQ
NASDAQ market is a hybrid
It is essentially quote driven but dealers are required to display & execute public limit orders
Block trades on both the NYSE & Nasdaq are examples of brokered trading
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