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FEC Financial Engineering Club

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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FEC Financial Engineering Club

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  1. FECFinancial Engineering Club

  2. Agenda • Trading • The Order Book and Order Types • Market Participants

  3. 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

  4. Trading & Market Microstructure

  5. 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

  6. The order book If we put this bag up for auction, we might see the following: BUYERS SELLERS

  7. 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

  8. 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.

  9. 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

  10. 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

  11. 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

  12. 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)

  13. 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

  14. 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

  15. Order Types • Example) You want to sell 20 shares of AAPL immediately. You submit a market sell. • Again, we took liquidity

  16. 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

  17. Order Types • Example) Now, you want to sell an additional 20 shares of AAPL immediately. You submit a market sell. -5 -15

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

  19. 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

  20. 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

  21. Extreme Order Cancelling

  22. Market Participants

  23. 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.

  24. Exchanges Exchange fees for CME

  25. 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

  26. 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

  27. 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

  28. 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

  29. 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”

  30. 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

  31. 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

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

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

  34. 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.

  35. 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?

  36. 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

  37. 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.

  38. 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

  39. Efficient Markets

  40. 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

  41. Questions?

  42. 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

  43. 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

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