Trading

Front 1

Market microstructure

Back 1

The market structures and processes that affect how the manager's interest in buying or selling an asset is translated into executed trades

Front 2

Principal trade

Back 2

A trade with a broker in which the broker commits capital to facilitate the prompt execution of the trader's order

Front 3

Markets should provide

Back 3

- liquidity

- transparency

- assurity of completion

Front 4

Quote-driven markets

Back 4

Rely on dealers to establish firm prices at which securities can be bought or sold.

Front 5

Inside bid / market bid

Back 5

Highest and best bid

Front 6

Inside ask / market ask

Back 6

Lowest ask

Front 7

Inside quote / market quote

Back 7

Using the inside bid and inside ask

Front 8

Effective spread (buy order formula)

Back 8

= 2 × (execution price - midquote)

Front 9

Electronic crossing network

Back 9

Orders are batched together and crossed (matched) at fixed points in time during the day at avg bid and ask quotes

Front 10

Auction markets

Back 10

Trader orders compete for execution

Front 11

Automated auctions

Back 11

Computerized auction markets

Provide price discovery

Front 12

Use Brokered markets when:

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Investors use brokers to locate counterparty to a trade.

When:

1. Large block to sell

2. Want to remain anonymous

3. Market for the security is small or illiquid

Front 13

Hybrid market

Back 13

Combination of quote-driven, order-driven, and brokered markets

Front 14

Relationship between trader and broker

Back 14

Principal and agent

Broker acts as trader's agent, locates necessary liquidity and best price.

Broker may also provide record keeping, financing, cash management, and other services

Front 15

Relationship between trader and dealer

Back 15

Opposing interests

Dealers want to maximize trade spreads while traders want to minimize

Trader profits at dealer's expense when have extra info (adverse selection risk)

Front 16

Market liquidity

Back 16

small bid-ask spread

mkt Dept

resilience = stay close to intrinsic value

Front 17

Transparent market

Back 17

Can without significant expense or delay obtain both pre-trade info and post-trade info.

If not = lose faith, decreasing trading activity

Front 18

Market's assurity of completion

Back 18

Can be confident that counterparty will uphold their side of trade agreement

Front 19

Explicit costs

Back 19

Readily discernible and include commissions, taxes, etc

Front 20

Implicit costs

Back 20

Bid-ask spread,

market or price impact costs

Opportunity costs

Delay costs (eg. Shipping)

Front 21

Implementation shortfall

Back 21

Difference between actual portfolio return and paper portfolio return.

For purchase:

- increase in price = cost

- decrease in price is account benefit (a negative cost)

Front 22

Decision price (DP)

Back 22

Mkt price when order is initiated

Front 23

Revised benchmark price (BP*)

Back 23

Mkt price of security if order not completed in timely manner as defined by user

Front 24

Missed trade equation

Back 24

Front 25

Explicit costs

Back 25

Commission or fees.

= Cost per share × # shares executed

Front 26

Delay

Back 26

Front 27

Market impact

Back 27

Front 28

Advantages of VWAP

Back 28

1. Easily understood

2. Computationally simple

3. Can be applied quickly to enhance trading decisions

4. Most appropriate for comparing small trades in nontrending mkts

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Disadvantages of VWAP

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1. Not informative for trades that dominate trading volume

2. Can be gamed by traders

3. Doesn't evaluate delayed or unfilled orders

4. Doesn't account for mkt movements or trade volume

Front 30

Advantages of Implementation Shortfall

Back 30

1. PM can see the cost of implementing their ideas

2. Demonstrates the trade-off b/w quick execution and mkt impact

3. Decomposes and identifies costs

4. Can be used in an optimizer to minimize trading costs and max performance

5. Not subject to gaming

Front 31

Disadvantages of Implementation Shortfall

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1. May be unfamiliar to traders

2. Requires considerable data and analysis

Front 32

Use of Econometric models

Back 32

Used to forecast transaction costs

Front 33

Mkt microstructure theory has shown that trading costs are nonlinearly related to:

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1. Security liquidity: trading volume, mkt cap, spread, price

2. Size of the trade relative to liquidity

3. Trading style: more aggressive = higher costs

4. Momentum : trades that require liquidy

5. Risk

Front 34

Usefulness of econometric models

Back 34

1. Trading effectiveness can be assessed by comparing actual trading costs to forecasted trading costs from the model.

2. Can assist PM in determining the size of the trade

Front 35

Information-motivated traders

Back 35

Trade based on time-sensitive info.

Prefer mkt orders bc trades must take place quickly

Trades demand liquidity, willing to beat higher trading costs

Front 36

Value-motivated traders

Back 36

Use investment research to uncover misvalued securities.

Will use limit orders.

Main objective = price, not speed

Front 37

Liquidity-motivated traders

Back 37

Transact to convert securities to cash or reallocate portfolio from cash.

Utilize mkt orders and trades on crossing networks and electronic communication networks (ECNs)

Prefer to execute orders within the day

Front 38

Passive traders

Back 38

Trade for index funds and other passive investors

Favor limit orders and trade on crossing networks.

Allows for low commissions, low mkt impact, price certainty, possible elimination of bid-ask spread.

Front 39

Liquidity-at-any-cost trading focus

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Must transact large block of shares quickly.

Must be ready to pay higher price for trading in the form of mkt impact, commissions, or both

Front 40

Costs-are-not-important trading focus

Back 40

Believe exchange mkts will operate fairly and efficiently such that execution price they transact is at best execution.

Must use market orders

Front 41

Need-trustworthy-agent trading focus

Back 41

Employ broker to skillfully execute large trade in a security, which may be thinly traded.

Weakness: commissions may be high and trader may reveal his trade intentions to the broker.

Front 42

Advertise-to-draw-liquidity trading focus

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Trade is publicized in advance to draw counterparties to the trade.

Weakness: another trader may front run the trade, buying in advance of a buy order

Front 43

Low-cost-whatever-the-liquidity trading focus

Back 43

Place limit order outside current bid-ask quotes in order to minimize trading costs.

Passive and value-motivated traders will offer pursue this strategy.

Front 44

Algorithmic trading

Back 44

The use of automated, quantitative systems that utilize trading rules, benchmarks, and contraintes to execute orders with minimal risk and costs.

Strategies classified into logical participation strategies, opportunities strategies and specialized strategies

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Types of algorithmic trading strategies

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1. Logical participation strategies (simple logical and implementation shortfall strategies)

2. Opportunistic strategies

3. Specialized strategies

Front 46

Simple logical participation strategies

Back 46

Seek to trade with mkt flow so as to not become overly noticeable to the mkt and to minimize mkt impact.

Front 47

Implementation shortfall strategies

Back 47

(or arrival price strategies)

Minimize trading costs as defined by the implementation shortfall measure or total execution costs.

Front 48

Opportunistic participation strategies

Back 48

Trade passively over time but increase trading when liquidity is present

Front 49

Specialized strategies

Back 49

Include passive strategies and other miscellaneous strategies

Front 50

VWAP strategy

Back 50

Seek to match or do better than day's VWAP

Front 51

Time-weighted average price strategy (TWAP)

Back 51

Spreads the trade out evenly over the whole day as to equal a TWAP benchmark.

Used for thinly traded stock with volatile, unpredictable intraday trading volune

Front 52

Best execution vs prudence

Back 52

Prudence = selecting security most appropriate for an investor

Best execution = best means to buy/sell those securities

Both attempt to improve portfolio performance and meet fiduciary responsibilities

Front 53

Characteristics of best execution

Back 53

1. Depends on VA of trade vs cost

2. Best execution and VA cannot be known ex ante

3. Best execution and cost can only be calculated ex post.

4. Relationships and practices = integral to best execution. Best execution is ongoing and requires diligence and dedication to the process.

Front 54

Trade management guidelines

Back 54

1. Processes (have policies, procedures that have intent of maximizing portfolio value using best execution)

2. Disclosures (firm should provide disclosure to their clients &potential clients regarding (a) general info on trading techniques, mkts, brokers (b) conflict of interest related to trading)

3. Record keeping (firm should maintain documentation supporting (a) firm's compliance (b) disclosures made to its clients