1. ©R. Schwartz Equity Markets: Trading and StructureSlide 1 Topic 6

2. ©R. Schwartz Equity Markets: Trading and StructureSlide 2 How Buyers & Sellers Meet Each Other

3. ©R. Schwartz Equity Markets: Trading and StructureSlide 3 ECONOMICS 101 PRICE SELL QUANTITY BUY Q* P* 0 The perfectly liquid, frictionless market solution The closest thing to it is a Call Auction

4. ©R. Schwartz Equity Markets: Trading and StructureSlide 4 The Big Problem Enabling Buyers and Sellers, Large and Small, to Find Each Other Two Dimensions Place Time

5. ©R. Schwartz Equity Markets: Trading and StructureSlide 5 10:50 10:55 11:00 Public Buyer Public Seller Limit Order Executes Places a Buy Limit Order Order Driven Market The limit order book brings buyer& seller together

6. ©R. Schwartz Equity Markets: Trading and StructureSlide 6 10:50 10:55 11:00 Public Buyer Public Seller Dealer Buys Dealer Sells Dealer Intermediation Dealer provision of immediacy brings buyer & seller together

7. ©R. Schwartz Equity Markets: Trading and StructureSlide 7 10:50 10:55 11:00 Public Buyer Public Seller A Call Auction A meeting point in time can bring multiple buyers & sellers together

8. ©R. Schwartz Equity Markets: Trading and StructureSlide 8 How a Call Auction Works

9. ©R. Schwartz Equity Markets: Trading and StructureSlide 9 The Electronic Call Auction Orders that could otherwise be matched and executed are held for a big, multilateral clearing Clearings are held at pre-determined points in time (i.e., once an hour) All crossing orders are executed at a single price – Buy orders at that price and higher execute – Sell orders at that price and lower execute

10. ©R. Schwartz Equity Markets: Trading and StructureSlide 10 O The Batching of Customer Orders O O O O 51 50 49 48 47 52 Question How should these limit orders be integrated to produce a good price? 1 2 3 4 5 6 No. Orders Price O Offer Bid

11. ©R. Schwartz Equity Markets: Trading and StructureSlide 11 Cumulate The Buy Orders (1) (3+1=4) (4+1+5) (5+1=6) 51 50 49 48 47 52 1 2 3 4 5 6 No. Orders Price (1+2=3) Individual buy order Cumulated buy orders at the price or better

12. ©R. Schwartz Equity Markets: Trading and StructureSlide 12 Cumulate The Sell Orders O (1) O(2) O (3) O (4) O (5) 51 50 49 48 47 52 1 2 3 4 5 6 Orders Price Individual sell order O Cumulative sell orders at the price or better

13. ©R. Schwartz Equity Markets: Trading and StructureSlide 13 Match Cumulated Buy & Sell Orders O O O O O CUMULATED SELL ORDERS CUMULATED BUY ORDERS 51 50 49 48 47 52 1 2 3 4 5 6 Orders Price 3 50 P* =

14. ©R. Schwartz Equity Markets: Trading and StructureSlide 14 Call Auction Limit Order Books Sparser Book Thicker Book

15. ©R. Schwartz Equity Markets: Trading and StructureSlide 15 When Calls Are Used Market Openings Market Closings (MOC & LOC orders) Nasdaqs Crosses (open and close) Intra-day At a predetermined time To reopen the market after a trading halt

16. ©R. Schwartz Equity Markets: Trading and StructureSlide 16 Calls Auctions And … Electronic technology The time clock – Jim Rosss piece in the text Who gets price improvement – Al Berkeleys piece in the text

17. ©R. Schwartz Equity Markets: Trading and StructureSlide 17 Benefits Focused liquidity – especially small & mid caps Control price volatility Fair Harder to manipulate Lower order handling costs A price discovery mechanism

18. ©R. Schwartz Equity Markets: Trading and StructureSlide 18 Problems Does not offer immediacy Bookbuilding

19. ©R. Schwartz Equity Markets: Trading and StructureSlide 19 Order Handling Differences Call vs Continuous Trading Market orders – infinitely aggressively priced limit orders Limit orders – can expect to be price improved Who provides liquidity to whom in a call?

20. ©R. Schwartz Equity Markets: Trading and StructureSlide 20 Types of Calls Price Scan Auction Sealed Bid Auction Crossing Network Open Limit Order Book Auction – TraderEx

21. ©R. Schwartz Equity Markets: Trading and StructureSlide 21 Optimal Order Placement

22. ©R. Schwartz Equity Markets: Trading and StructureSlide 22 How to Submit a Buy Order: Calls are the only game in town Your Reservation Price = $12 Limit PriceClearing Price Surplus $11.10 $11.20 $0.00 $11.10 $11.10 $0.90 $11.10 $11.00 $1.00 Limit PriceClearing Price Surplus $11.20 $11.30 $0.00 $11.20 $11.20 $0.80 $11.20 $11.10 $0.90 Why not $11.30 or higher?

23. ©R. Schwartz Equity Markets: Trading and StructureSlide 23 How to Submit a Buy Order: Calls are the only game in town Your Reservation Price = $12 Conclusion Limit Order Price = Reservation Price = $12 (Or one tick below)

24. ©R. Schwartz Equity Markets: Trading and StructureSlide 24 How To Submit A Buy Order To A Call That Is Followed By Continuous Trading Your Reservation Price = $12 Question: Would You Prefer To 1.Execute at $12.00 or not at all? 2 Execute at $11.90 in call or at $11.90 in continuous with 0.99 prob? 3. Execute at $11.90 in call or at $11.80 in continuous with 0.90 prob? 4. Execute at $11.90 in call or at $11.80 in continuous with 0.10 prob? 5. Execute at $11.90 in call or at $11.80 in continuous with 0.50 prob?

25. ©R. Schwartz Equity Markets: Trading and StructureSlide 25 How to Submit a Buy Order: Call Followed by Continuous (Answers to Questions 2 – 4) = $0.20 x 0.50 = $0.100 Expected Surplus at $11.80 =Surplus at $11.90 = $0.100 Q5 = $0.20 x 0.10 = $0.020 Expected Surplus at $11.80 >Surplus at $11.90 = $0.100 Q4 = $0.20 x 0.90 = $0.180 Expected Surplus at $11.80 <Surplus at $11.90 = $0.100 Q3 = $0.10 x 0.99 = $0.099 Expected Surplus at $11.90 >Surplus at $11.90 = $0.100 Q2 Continuous AuctionCall Auction

26. ©R. Schwartz Equity Markets: Trading and StructureSlide 26 How to Submit a Buy Order: Call Followed by Continuous 0.80$0.50$0.40$11.50$11.60 0.75$0.40$0.30$11.60$11.70 0.67$0.30$0.20 $11.70$11.80 0.50$0.20$0.10$11.80$11.90 NA$0.10$0.00$11.90$12.00 ContinuousCall Breakeven Probability of Executing in Continuous Surplus in Continuous Surplus in Call Price Finding the Optimal Price

27. ©R. Schwartz Equity Markets: Trading and StructureSlide 27 How to Submit a Buy Order: Continuous Followed by Call Your Reservation Price = $12 Your time frame is the trading day You place a day order that must be filled by 4:00 pm As the day progresses, all else equal, you are more apt to place a market order than a limit order There is a closing call Your limit order in the closing call would be one tick below your reservation price ($12)

28. ©R. Schwartz Equity Markets: Trading and StructureSlide 28 Continuous Followed by Call E(S) = [Pr x S Cont ] + [(1-Pr) x E(S Call )] S Cont = surplus if order executes in cont. market E(S Call ) = expected surplus from the call S Call = max(0, P R – P Call ) Because (1-Pr) x E(S Call ) >0, you are more apt to place a limit order in the continuous market when it is followed by a closing call Remember the gravitation pull effect S = your surplus from trading Pr = prob your limit order executes in cont. market

29. ©R. Schwartz Equity Markets: Trading and StructureSlide 29 A Call s Contribution to Market Quality

30. ©R. Schwartz Equity Markets: Trading and StructureSlide 30 Let s Focus on Volatility The opening spike: Price discovery The closing spike: End of day impatience to Get the job done What does this imply about market structure? A natural experiment: Nasdaqs closing/opening crosses (call auctions) introduced in March/October of 2004

31. ©R. Schwartz Equity Markets: Trading and StructureSlide 31 The Nasdaq Study* 52 large cap Nasdaq firms Time period: Feb 04 and Feb 05 We examined per day: 390 1-minute intervals (9:30-16:00) 30 10-second opening intervals (9:30-9:35) 30 10-second closing intervals (15:55-16:00) Volatility measured by high-low range for the interval * Market Structure and Intra-day Price Volatility: An Event Study on Nasdaqs Crosses Michael Pagano, Lin Peng, and Robert Schwartz

32. ©R. Schwartz Equity Markets: Trading and StructureSlide 32 Nasdaq Volatility Differences Between Feb 2004 and Feb 2005 One-minute Volatility w 60 bps Feb 2004 (Pre-Calls) 60 bps Feb 2005 (Post-Calls)

33. ©R. Schwartz Equity Markets: Trading and StructureSlide 33 Nasdaq Volatility Differences Between Feb 2004 And Feb 2005 10-Second Volatility 40 bps Feb 2004 (Pre-Calls) 5 Min After Opening 5 Min Before Close 40 bps Feb 2005 (Post-Calls) 5 Min After Opening 5 Min Before Close