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FEC Financial Engineering Club. Agenda. Trading The Order Book and Order Types Market Participants. What is trading?. Economics : Multiple parties participating in the voluntary negotiation and then exchange of one’s goods and services for the desired goods and services of another.

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agenda
Agenda
  • Trading
  • The Order Book and Order Types
  • Market Participants
what is trading
What is trading?
  • Economics: Multiple parties participating in the voluntary negotiation and then exchange of one’s goods and services for the desired goods and services of another.
  • Finance: Purchasing and selling of securities.
  • As a career, trading involves selling and purchasing securities at a fast-pace for some purpose, generally to profit.
    • Heavy integration of technology for executing trades and gathering information
    • Filtering through information and risk management are key
the order book
The Order Book
  • How much would you pay for a bag of cash whose contents are unknown?
    • There is at least $1 in the bag and less than $10
the order book1
The order book

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

BUYERS

SELLERS

the order book2
The Order book

Price

  • A collection of buy and sell orders
    • Orders sitting in the book are called resting orders
    • The number of orders at each price level is referred to as the depth
  • The highest bid is referred to as the best bid
  • The highest ask is referred to as the best ask/offer
    • Their difference is the bid-ask spread
  • Here, the bid-ask spread is 522.22-522.17 = .05

Asks or sell orders

Best ask

Best bid

Bids or buy orders

order types
Order Types
  • Limit order: Buying a specified number of an asset only at a specified price or better
  • Example) AAPL is at 522. You put in a limit buy for 40 shares at 520. This means that your order is executed when AAPL is at 520 or lower, if there are sellers.
  • Liquidity: Limit orders sit and wait in the order book until an individual with the opposite position enters the market.
    • In this case, when an individual submits a trade to sell for 520 or less.
order types1
Order Types
  • Example) You want to put in a limit bid to buy 40 shares of AAPL at 522.14
  • How does this change the order book?
    • Current best-bid is 522.17
    • Best ask is 522.22

No sell orders at 522.14

+40

order types2
Order Types
  • Example) You want to put in a limit bid to buy 40 shares of AAPL at 522.14
  • How does this change the order book?
    • Current best-bid is 522.17
    • Best ask is 522.22
  • Here, we added liquidity by increasing the number of resting orders
order types3
Order Types
  • Example) NOW, suppose you want to put in a limit bid to buy 700 shares of AAPL at 522.22

675 sell orders at 522.22

+700

order types4
Order Types
  • Example) NOW, suppose you want to put in a limit bid to buy 40 shares of AAPL at 522.22
  • Here, we took and added liquidity
  • This is known as a marketable limit order
    • A limit order at a price that will execute immediately (best bid or ask)
order types5
Order Types
  • Market order: Buying a specified number of an asset at the best prevailing price on the opposite side of the order book
  • Example) AAPL is at 522. You put in a buy for 40 shares. Your order is executed immediately—that is, you buy 40 shares at the best ask.
  • Liquidity: Market orders always execute
order types6
Order Types
  • Example) You want to sell 20 shares of AAPL immediately. You submit a market sell.
  • How does this change the order book?
    • Current best-bid is 522.22
    • Best ask is 522.23

+20

order types7
Order Types
  • Example) You want to sell 20 shares of AAPL immediately. You submit a market sell.
  • Again, we took liquidity
order types8
Order Types
  • Example) Now, you want to sell an additional 20 shares of AAPL immediately. You submit a market sell.

Only 5 shares at best bid

+20

order types9
Order Types
  • Example) Now, you want to sell an additional 20 shares of AAPL immediately. You submit a market sell.

-5

-15

order types10
Order Types
  • Example) Now, you want to sell an additional 20 shares of AAPL immediately. You submit a market sell.
order types11
Order types
  • What are the pro’s of market orders?
    • Execute immediately
  • What are the con’s of market orders?
    • Unlimited price risk—potential to get bad fill prices
    • Cost of bid-ask spread
  • What are the pro’s of limit orders?
    • No price risk
    • They provide liquidity—can sometimes earn a rebate
  • What are the con’s of limit orders?
    • They may never execute
  • Conclusion: always use limit orders. Marketable limit orders capture (nearly) all the pro’s of market orders without the con’s
more complicated order types
More Complicated Order Types
  • Fill or kill (FOK): If the full quantity cannot be filled, don’t fill any.
  • Stop orders: Buy/sell once the price exceeds/falls below a specified price
  • Pegged orders: Buying/selling at a competitive offset to the best bid/ask
  • Combinations of orders: Iceberg orders, hidden orders
  • Cancelling orders: A feature that is currently being reconsidered
exchanges
Exchanges
  • Exchanges are organized venues where buyers and sellers meet and transact
    • Historically, physical venues
    • Now, collections of servers and computer infrastructure to maintain an order-book for one of many listed (traded) products
  • To trade on an exchange, one must become an exchange member, which costs a fee.
    • Traders providing liquidity (adding resting orders) often earn a rebate
    • Those taking liquidity (using marketable orders) often pay a fee
  • To be have a security listed on an exchange, the lister is required to maintain certain qualifications (in the case of a company) as well as pay listing and entry fees.
exchanges1
Exchanges

Exchange fees for CME

exchanges2
Exchanges
  • Exchange companies compete on fees, types of products listed, and order priority rules
    • Hire market makers (traders) to continuously provide liquidity
  • Oftentimes one holding company containing many exchanges and clearing corporations
  • CME Group—Chicago Mercantile Exchange Group
    • Several options and futures exchanges CME, NYMEX, CBOT, KCBOT
  • BATS Global
    • BATS BZX, BATS BYX exchanges
  • NYSE Euronext
    • NYSE, Euronext, NYSE Arca exchanges
exchanges3
Exchanges
  • One security can be listed on multiple exchanges
    • This creates market fragmentation issues

NASDAQ

BATS

What’s opportunities do we have here?

BUY on NASDAQ @ 522.21

Sell on BATS @ 522.22

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

market fragmentation issues
Market Fragmentation Issues
  • More importantly, institutional investors do not want to worry about trading on particular exchanges
    • Multiple exchanges institutional investing unnecessarily complicated
  • Competition amongst exchanges is good—cheaper fees
  • Market fragmentation is bad
  • Regulation NMS: Regulation passed in 2005/2006 (effective 2007) attempting to consolidate exchanges while promoting competition
features of regulation nms
Features of Regulation NMS
  • Sub-penny rule: Cheapest tick (increment) in a trade price is a penny
  • Access rule: Trading fees must be reasonable
  • Market-data rule: Each exchange must provide affordable data
  • Order protection rule: Marketable orders routed to best price
    • NBBO: National best bid and offer—best bids and best asks across all exchanges
    • Market orders routed to exchange with NBB or NBO
dark pools
Dark Pools
  • A trading venue where prices and trades are not publicized
  • Pro’s?
    • You have less market impact
    • People cannot benefit from knowledge conveyed in your orders
  • Con’s
    • Leeching from price discovery in “lit markets”
the trading ecosystem
The Trading Ecosystem

Arbitrage

Hedging

  • Three main types of trading:
    • Hedgers
    • Speculators
    • Arbitrageurs
  • Trading vs investing
    • Investing generally has longer holding periods
    • Investors intend to never sell their investments
    • Trading is generally the opposite

Speculators

hedgers
Hedgers
  • Traders who seek to mitigate risks in their business by trading
  • Example) You are a trader at BP. Your business has fixed costs of $2 million. Your portfolio is long 20,000 barrels of crude oil (currently $100/barrel). What is your position?

How can you hedge some of this downside risk?

Crude Price/Barrel

hedgers1
Hedgers

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

hedgers2
Hedgers

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

speculators
Speculators
  • Traders who speculate on asset prices via information and trade accordingly.
  • Example) You believe that AAPL will exceed earnings expectations this quarter due to product development. You buy shares of AAPL based on this sentiment and further research.
arbitrageurs
Arbitrageurs
  • Traders who trade on mispricings in asset prices.
    • Usually there is some model asserting a price different from the market
  • Example) Suppose , , and . It should hold that

=1

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

However =1.0248

How can we profit from this mispricing?

arbitrageurs1
Arbitrageurs
  • Start with $1,000,000.00 USD, buy GBP at

Now we have £ 600,000.00

  • Buy Euros at

Now we have € 732,000.00

  • Buy USD at

Now we have USD 1,024,800.00

agency trading
Agency Trading
  • Trading on behalf of another individual.
    • Large-scale brokerage firms have traders trade on behalf of clients
  • Example) A client calls TD Ameritrade to sell a large sum of bonds in their portfolio.

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

efficient market hypothesis
Efficient Market Hypothesis
  • Markets are informationally—efficient
    • To some degree, new information is already priced into assets; lucrative trading strategies have been used up
  • Weak form: Future prices cannot be predicted by analyzing the past (technical analysis). Some forms of fundamental analysis can produce excess returns.
  • Semi-strong Form: Share prices adjust very quickly to new information. Technical analysis and fundamental analysis cannot produce excess returns.
  • Strong Form: Share prices reflect all information, public and private. No one can earn excess returns
financial engineering in trading
Financial Engineering In trading
  • Pricing Models and asset dynamics
  • Execution strategies: How to split up your orders to receive the best fill price
  • Computing: Designing and programming high-performance systems with efficient software
next week
Next week
  • Trading in simulated markets
    • Introduction to the Rotman Interactive Trader
  • 7PM @ the Margolis Market Information Lab
    • Seats available to FEC via sign-up
thank you
Thank you!
  • Facebook: http://www.facebook.com/UIUCFEC
  • LinkedIn: http://www.linkedin.com/financialengineeringclub
  • Email: uiuc.fec@gmail.com

President

Greg Pastorek

gfpastorek@gmail.com

  • Internal Vice President

Matthew Reardon

mreardon5@gmail.com