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The Search Engine

The Search Engine

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Published by Wayne H Wagner

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Published by: Wayne H Wagner on May 05, 2009
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10/02/2010

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gforrlD
Building BetlerPerfortn.tnceCOMMENTARY
78
OCTOBER
2OO3
THE
SEARCH
ENGINE
A
client
recentlyasked
what
kind
of
discipline
their desk
needs
to develop
inorder
to
become
one of the
top
desks. Underlying
the
question
is
whether tradingis an art
or a
science.
We
acknowledge that there
is
art
to
determining changesin market
sentiment.
But
goodtraders
also
have
a
disciplined
processfor determining Strategyand
Tactics
when
accessing
liquidity.
Strategy
is the
determination
of
Urgency
(aggressive
marketorders
vs,
limit
orders)
and
Exposure(hiding
vs.
going
fcr
theful!
monty).
Tactics are
the types
of
Orders
and
thebroker
-
venues available once strategy
has
been
determined.
Broker selection comes
from
venue(commitments
and
relationships
step
inat
this
point)
while
pricesare
a
function of Ordertactic
(arguing
priceat
the
last
minute
risksdimes
to save
pennies).
Arecent
Wall
Street Journal article, carrying
the
heading
"lt's
timefor
the
kiddies
to
getout of
the
pool,"
focused
on
how differentprofessionaltraders
dealwith
today's
markets.
The
difference? Experience.
More specifically,
experience
in
accessing
liquidity
at an acceptable
price.
Internet search enginesleadtolowercostsfor those whoknow how to
use
them.
In
essence, thewider thesearch,
the
better
the
potential
outcome.
But market Iiquidity
is
notas
simple:prices
do
notstand
sti'1,
Search;ng
forlowerpricesormore liquiditycarriesrisks thatprices
may
drift away
before
the trade is
executed,
orworse,
maymove
away
as
a
resultof
the
search.
Experienced
traders often
act
as
search
engines.
snooping throughvarious
market
venues and
players
to
seek
liquidity.
When volatility
is
low,alltraders
benefitfrom available
time.
When volatility spikes
-
as
it
didlastOctober
-
goodtraders stand out
in
their ability
to
rapidly
find
liquidity
at a reasonable
price.
Expert traders divide
the
search engine
task
in
two:
determiningstrategy,
and
determining
thetactics,
both
.
venueand
the
right
pace.
Strategy
is
the
big
picture:
think
of
this as the
manager's motive
forthis
order.
Tactics are
the tools
used
to
implement
the
strategy.
Trading
Strategy
Strategyincludes
bothUrgency,
how
quicklyto
trade,
andExposure,
how
to
deal
with
size.
The
trader's
#1
task
is
to determinehowquicklyto work an order
given
MarketOrder
I
dULIU-
the
manager's
motive,
theprevailing
market
trend
and
volume,
and
anyantici-
--^r^li^E^-Pciigullllul-
mation.
Themost expensivetrades are
often
those
where
the
trader
or
the
portfolio
manager"argued"
with
the
market
over
the
conflicts
betweenpricerationale andprocess
discipline.
While
there are
many variations,
the
primary
tactical
market instructions are either
market
or
limit.
Urgent,
liquidity-demandingtraders
usemarket orders
to
absorb
 
whatever
is
available.
As the chart aboveshows, they
are
willing
to
pay
the
impact
cost
to
trade
quickly.Liquidity
providerswilluse
morelimit
orders.
Less time-
sensitive orders tendtofavorlimit order tactics, trading
off
speed
fora hopefullybetter completion
price,
Of
course,
an
expert trader
will varythe
tactics
as
timeelapses
andprices
move,
although
size
can
be
an
issue
even whenstocks are
trendless.
While small
or
liquidorders need
to
consider
only
urgency,
order
exposure
tactics
become
increasingly
important
as
sizegrowsand/or
liquidity
deteriorates.
Traders
in
today's
narrowspread/highertransparency
markets
are
lesswilling
to
expose
their
orders.
In
addition, brokers
are
far
less
willing to commit
capital to
all
but
their
verybest customers.
Exposing
orders
at
the
wrong
time
(e.9.,mid-day)
or
to
the
wrong
crowd
(e.9.,
an
indiscrete
broker,
too
many
brokers,
to
the
world)
can
lead
to
front
ru nn
ing,
chasing
priceswith
limit
orders,
and
highcosts even
in
the
absence
of
worthwhile decision
information.
Traders
need
to
determine
a
strategy
for
exposing
the
order
withoutroiling
prices.
For
smallcap stocks,reduced resiliencyadds to the exposure
problem.
In
contrast to trading
in
largecap
stocks,
repeated
trades
ina smallcap stock
leads
to
"stickier"pricemoves,even after
the
traderbacks
off.
Therefore,even
a
'non-exposing'
strategy
that takes
advantage
of
available liquidity
has
to
be
weighedfor
its
possible price
impact.
Trading
Tactics
Buysidetraders
need
to
consider
all
three
issues
-
urgency,
size and
liquidity
-
when
determining
both
trading tactics(whatorders)
and
venue
(to
whom
to
expose
orders).
We
begin
by
examiningliquid
orders.Ratherthan discuss the merits
of
each type, we will focusinsteadon
their
applicability.
Thegraph
of
order
types
has
two
parameters:
urgency
and
liquidity.
For
liquidorders, urgency
is
the
primary
consideration.
Small
or
urgent
liquid
orders
can
be
traded
as
market
orders through either
dealers
or
viaECN's,
while
larger
orders
may have
to
'absorb'theorder
books
or
rely
on
a
broker
for
liquidity.
Fnr locc
I
rrda ni^-A^.^.,^-i^+i^^^utuut), vdt tdLtuilJ
of
bothVWAP
and
Iimit
orders
allow
flexibility
should
markets
change.
Smart
ordermanagement
algorithms
will
allow both
floating
limits
and
orders
that
change
to
market
orders
when
prices
begin
to
move adversely.
As
ordersizegrows,order
types
become more complex.
Urgent
orders
may
require
eitherbroker
or
agency
capital
via
a
block
or
secondary
trade.
Obviously,
the
concession
will
be
a
function
of
both size and
market
capitalization; consistent
with
the
risks
of
providing
liquidity.
But
the
potentialreward
for
correct
calls
in
smaller
cap
stocks
is
also
muchgreater
(Note:
the
biggest
rewards
typically
come
from timely selling
rather
than
buying).
Exposure
is
not
a
significantissue
for
urgent orders;
thedesk'semphasis should
be onfinding
liquidity
within
an
acceptable
horizon.
Because
of
time
constraints,
searching
ability
is limited
and
price
is
a
secondary
consideration.
For
that
reason,
it
is
important
to
know
which
brokers are best
at
providingliquidity
ata
fair
price
on a consistent
basis.
Basket/Program
<--
Principalfl?,to"
oo""
+-
\/\^/AP
Market
________>
Agency Blockl
Seco
noa
ru
Fiil
-KitlMNH-
Best Efforts
ILLIQUID
Smart/Floating
Limit
+
FixedNOT
URGENT
 
\rVe
often findthatusing brokercapital
to
initiatean order
s a
trading
mistake.
Brokersoften suggestthis to'get
an
='t
r
theorder,
but
the suggestionis not
in
the
buyside's
::s:
-:srest
Capital
is finefor
finishing
an
order,
but
,',
-3-
.
s
rsed
to initiate
it
reducesthe flexibilitv
of
where
to
trade
resiCua
shares,
and
puts
the
desk into
a
competing
post
onvrith
the
broker
who
needs
to
unwind
the
initial
trade
at
a
minimal
loss.
Plexus
finds
that
-^^ir,.^r+-^)^^^a--.hoflrct rr:rlinn Lztr
ara
{^,,f+;m^-^-tr)ruudr
Lr
duuS dilu Lr-, -tuulLllllgs
ilS
costly
as the
initialtrades
andtwice
the
expected
PAEG/L
cost.
For
lower
urgency
trades,
price
is
more
important.Tradersare
willing
to accept
the
chanceof
adverse
price
moves
to keep
impact
low,
Butas sizegrows,exposure
creates
its
ownprice
impact.
Domesticbrokers
are
less
likely
to
frontrunstatedclient intentionsthan
they
once
were
due
to
improvedmarket
monrtoring,
but
the
problem
has not
completely
gone
away.
Frontrunningappears much
worse
in non-USmarketswhereshopping
information
in
exchange
for
increasedcommission
flow
remains
a
problem.
Another
danger
is
revealing
yourintentto
too many
players,resultingin
their
movingtheirprice
targets
away.
Afterall,
noone
wants
to
be
the
first
fillagainst a very large
blocktrade
losses
to
moreknowledgeable
traders.
Thetrader
and
the
manager
mustbe
confident
that
the
order
reflects
correct
fundamentals.
Exoosure
also
increases
the
risk
of
uncompleted
trading
when
it
establishes
a
floor
or
ceiling
for
others
to
use advantageously.For
these
reasons,
large limitorders
will
expose
only
a
modest number
of
shares
with
mostgoing
to
the
reserve
book.
The
downside
is
that
exchanges
provide
price,
time, size
priority
-
and
reserve
shares
lose
time
priority
to
exposedothers
arrivino
at
a
later time.
Experienced
traders
will
adjust
their
orders
to
either
expose
or
hidetheir
interest
depending
on
market
conditions.
Today'smarketsare deepest
at
the open
and
the
close,
so
largerportions
can
be
hidden
in
the
crowd.
During
thin
mid-dayperiods,
the
experienced
traders
hicje
their
orciers
by using marketorders to hit bicisioffers.
They willalso use
fill-or-killorders
to
absorb
available
volume.
Theymaysplit orders into smallchunks and
use
either
a
single broker
or
multiple markets
to
capture
liquidity withoutbeing too
observable.
Thekey is
to
be
unpred
ctable:
orce
the
market
figuresyouout.
either
you pay
upor
walK away.
Trading
Venue
The otherquestion
is:
Where
do
I
trade?
Note
that
we
don't
ask
'with
whom?'
Theanswer
to
thatouestion
is
determined
by
venue,
justas
price
is
determined
byorder
type.Urgency
Liquidityxposurerokeia
.
Fuli
ServlCe
.
Execution
.
Research
.
Service
L-liah-\larr,| ,,v,,/ LwYv
l-.l
in
h
High
)
Low
Ldgv
Medium(if
using
1
broker)MediumMedium
Med
)
Low
Med
)
LowMed
to
SmallMed
to
Small
.
Bloomberg/lnstinet
Fligj6llCmaltordeaa,\
>
Low
1
Srrlf-
butca'n trade
laige
i
.q^ml-t--aim;i
ii
-"i6;
volumesover timedanger is being
n
rori inla
h
lo
ATS'S
Low
Med
for
Liqtidjty
provtdlng
AnonymousLow
for
Liquidity-demanding
eet-me
Markets
.
LiquidNet
Med
)
Low
I arno Aomi..mnnvm;i ;"-
-
exposesize only tocounterparty
.
HarborsideHigh(smallorOeis)
5-t-ow
Small---- Low
-
--
-May
trade
insize withCorporations
Limittraders
want
to
maximize
their
exposure
whilemarkettraderswant
to
minimize
theirs.
Exposingorders
,.,,ill
attract the otherside,
but
also risks adverseselectionTraditionalbrokersare still
the
mainstayof
the
business,
and
remain
the
up-frontproviders
of liquidity.
But
they
are
often
the
mostexoensive
route in terms
of
market

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