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Money, Banking & Finance Lecture 4 The Theory and Practice of Equity Trading.

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Presentation on theme: "Money, Banking & Finance Lecture 4 The Theory and Practice of Equity Trading."— Presentation transcript:


2 Money, Banking & Finance Lecture 4 The Theory and Practice of Equity Trading

3 Aims Examine the process by which investment decisions are translated into the action of buying or selling shares. Understand how a trading environment operates and how the players interact. Appreciate how the actions of traders influence the market. Examine the Trader-Ex software for training of stock-market traders.

4 Trading and Investing Important distinction between Investing and Trading. Trading is about converting an investment decision at the least cost point. Trading is also about price discovery. The investment manager will have an idea of the equilibrium price but this could change in a dynamic and fast moving situation. Trading is also about finding price discrepancies and exploiting these for profit

5 Investment Decisions Time Taken by Fund Managers to make buy/sell decision % 54321Mean frequency < 1 hr hr – 1 day day – 1 wk wk – 1 m m Score 5 = very frequently (75 – 100% of the time); 1 = never Source: Schwartz R and Steil B (2002), Controlling Institutional Trading Costs: We have met the enemy and it is us, Journal of Portfolio Management, 23, 3,

6 Trading and Time Investment decisions are made in discrete time. Trading decisions are made in continuous time. Once a decision to invest has been activated to a trade, time takes on a different meaning. The trader wants to satisfy the instruction before the end of the trading day and show a good performance. Performance can be measured in terms of opportunity cost and/or actual cash surplus.

7 Bid-Ask Spread A bid order is an offer made by a trader to BUY a security. An ask order is the price a trader is willing to SELL a security. Sometimes called the OFFER price. A bid or an ask can stipulate the amount the trader will buy or sell and this is called a LIMIT ORDER. A market sell is a willingness to accept a bid order and a market buy is a willingness to accept an ask.

8 Order Arrival Orders to buy and sell will arrive during the market day. The Trader may be a short-term trader with orders to work for a client or working for a pension fund or hedge fund. Traders dont have the luxury of time. Their decision is to buy sell or wait To gauge the market – the balance of buy and sell orders At above equilibrium prices the arrival rate of sell orders are faster than the arrival rate of buy orders. Similarly at prices below some notional equilibrium, the arrival rate of buys are greater than sells.

9 Price Discovery Bid Ask SellsBuys P*

10 Informed Traders Informed Traders – agents who trade knowing that the current price level has diverged from the fundamental. Buy orders are sent to market if P* > P Sell orders are made when P* P (offer) or P* < P (bid). In the theoretical world of costless trading, complete markets, instantaneous information dissemination, price adjustments are instantaneous. In reality prices adjust rapidly with new news, but news could be changes in fundamentals, uncertainty, rumour or noise. The informed Trader will exploit information and act with a short lag to news about fundamentals.

11 P* and Best Bid and Offer Quotes

12 Liquidity Traders Idiosyncratic reasons for trade. Orders are two-sided. They can be market orders or limit orders and arrive randomly. Sometimes called noise traders. Liquidity traders differ in that they issue both market and limit orders but informed traders submit market orders only. Liquidity traders will not drive a price back to some previous level or reinforce a trend because informed traders drive the price to equilibrium.

13 Technical (Momentum) Traders These Traders are prevalent in the market. Market technician – using chartist analysis Algo trader – using a black-box device Arbitrageur – exploit price inefficiencies to profit. Market maker or Day Trader – profiting from the bid-ask spread or profiting from changing market conditions to buy low and sell high.

14 What Drives a Market? Trading Mechanism Order Book, Market Makers, Call Auction Informed Is p*>offer or p*

15 TraderEX Purpose 1)Make trading decisions 2)Understand price discovery 3)Evaluate trading rules for: –market participants –market quality –intermediaries and dealer roles 4) Compare alternative market systems 5) Have Fun

16 Computers Role Establish market background –Generate order flow –Update display and bid-ask quotes 2) Give participants orders to execute 3) Maintain transactions records for subsequent analysis on –Participants order placement decisions –Market quality (e.g., bid-ask spread)

17 Teaching Trading and Markets with TraderEx simulations (I) e.g., cardiff2 cardiff

18 Teaching Trading and Markets with TraderEx simulations (II)


20 Limit orders Market orders Buy orders Sell orders

21 Order book market Ask: 213 offered at Bid for 59

22 User has entered 2 limit orders to sell Entering a limit order

23 User is entering a market order to sell (44) units ahead of your 10 Click to cancel your limit order to sell 10 at 19.90

24 Sold! Mark-to-market P&L = -2.00

25 The Order Driven Market in TraderEx Days High Price Ask: 46 offered at Your limit orders to sell 40 units ahead of your 10 Ticker of trades

26 Can enter Chat messages

27 Performance measures 1) Average prices

28 Performance measures 2) P&L

29 Performance measures 3) VWAP

30 Market Structures 1.Order-driven: Buy-side trader with large order 2.Quote-driven: Market maker/ liquidity provider 3.Order book w/ Periodic call auction (3x day) 4.Order book w/ Dark liquidity pool

31 Order driven market Take/ Market Buy 5,000 shares of CAB Order to sell 5,000 shares of CAB executes at $48.10 Investment Managers Decision Buy-Side Trader (YOU) Order Book Market Add 250,000 shares to portfolios holding of CAB Trade Occurs

32 Performance Average Cost You purchased 140,000 shares at 3.5 cents below VWAP But 23.6 cents above the last price of the day. Your P&L position is -33

33 Buy side performance P&L per share = Mark-to-Market Price – Average Purchase Cost Good trading:* VWAP – Average Purchase Cost > 0 Good stock selection: Last Price – Price at time

34 Summary We have seen that investing is not the same as trading Investing is a strategic decision made by the portfolio manager. Trading involves meeting the instructions of the portfolio manager at the least cost or best price. The TraderEx software is a computer package that simulates trading in different market structures It also allows for interactive trading in real time.

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