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Building COMMENTARY 78 Betler Perfortn.tnce OCTOBER
2OO3

THE SEARCH ENGINE
A client recently asked what kind of discipline their desk needs to develop in order to become one of the top desks. Underlying the question is whether trading is an art or a science. We acknowledge that there is art to determining changes in market sentiment. But good traders

also have a disciplined process for determining Strategy and Tactics when accessing liquidity.

Strategy is the determination of Urgency (aggressive market orders vs, limit orders) and Exposure (hiding vs. going fcr the ful! monty). Tactics are the types of Orders and the broker venues available once strategy has been determined. Broker selection comes from venue (commitments and relationships step in at this point) while prices are a function of Order tactic (arguing price at the last minute risks dimes to save pennies).

A recent Wall Street Journal article, carrying the heading "lt's time for the kiddies to get out of the pool," focused on how different professional traders deal with today's markets. The difference? Experience. More specifically, experience in accessing liquidity at an acceptable price. Internet search engines lead to lower costs for those who know how to use them. In essence, the wider the search, the better the potential outcome. But market Iiquidity is not as simple: prices do not stand sti'1, Search;ng for lower prices or more liquidity carries risks that prices may drift away before the trade is executed, or worse, may move away as a result of the search.

Trading Strategy
Strategy includes both Urgency, how quickly to trade, and Exposure, how to deal with size. The trader's #1 task is to determine how quickly to work an order given

the
Market Order
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and
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manager's the prevailing market trend

motive,

volume,
i^E^llllul-

and any anticiThe most expensive trades are often

Experienced traders often act as search engines. snooping through various market venues and players to seek liquidity. When volatility is low, all traders benefit from available time. When volatility spikes - as it did last October - good traders stand out in their ability to rapidly find liquidity at a reasonable price. Expert traders divide the search engine task in two: determining strategy, and determining the tactics, both venue and the right pace. Strategy is the big picture: think of this as the manager's motive for this order. Tactics are the tools used to implement the strategy.

mation.

those the
.

where
or

the trader

portfolio

manager "argued" with the market over the conflicts between price rationale and process discipline. While there are many variations, the primary tactical market instructions are either market or limit. Urgent, liquidity-demanding traders use market orders to absorb

whatever is available. As the chart above shows, they

are willing to pay the impact cost to trade quickly.
Liquidity providers will use more limit orders. Less time-

Trading Tactics
Buyside traders need to consider all three issues urgency, size and liquidity - when determining both trading tactics (what orders) and venue (to whom to expose orders). We begin by examining liquid orders.
Rather than discuss the merits of each type, we will focus instead on their applicability.

sensitive orders tend to favor limit order tactics, trading off speed for a hopefully better completion price, Of

course, an expert trader will vary the tactics as time elapses and prices move, although size can be an issue even when stocks are trendless.

While small or liquid orders need to consider only urgency, order exposure tactics become increasingly important as size grows and/or liquidity deteriorates. Traders in today's narrow spread/higher transparency markets are less willing to expose their orders. In
addition, brokers are far less willing to commit capital to

The graph of order types has two parameters: urgency and liquidity. For liquid orders, urgency is the primary

all but their very
best customers.
Basket/ Program

consideration. Small or urgent liquid orders can be traded as market orders through either dealers or via ECN's, while larger orders may have to 'absorb'the order books or rely on a broker for liquidity.
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Exposing orders at

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the wrong

time (e.9., mid-day) or to the wrong crowd (e.9., an indiscrete broker, too many brokers, to the

of both VWAP and Iimit orders allow
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Market

Fiil - Kitl MNH - Best Efforts

flexibility
markets

should change.
order will

Smart
ILLIQUID

management

algorithms
limits and

world) can lead to

front

ru nn ing,

Smart/Floating

allow both floating
Limit

+

Fixed

orders

chasing prices with

limit orders, and
high costs even
in

NOT URGENT

that change to market orders
when prices begin
to move adversely.

the absence

of

worthwhile decision information. Traders need to determine a strategy for exposing the order without roiling prices. For small cap stocks, reduced resiliency adds to the exposure problem. In contrast to trading in large cap stocks, repeated trades in a small cap stock leads to "stickier" price moves, even after the trader backs off. Therefore, even a 'non-exposing' strategy that takes advantage of available liquidity has to be
weighed for its possible price impact.

As order size grows, order types become more complex.

Urgent orders may require either broker

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 potential reward for correct calls in smaller cap stocks is also much greater (Note: the biggest rewards typically come from timely selling rather than buying). Exposure is not a significant issue for urgent orders; the desk's emphasis should be on finding liquidity within an acceptable horizon. Because of time constraints, searching

price is a secondary consideration. For that reason, it is important to know which ability

is limited and

brokers are best at providing liquidity at a fair price on a consistent basis.

\rVe often find that using broker capital

to initiate an order

s a trading mistake. Brokers often suggest this to 'get an

='t r the order, but the suggestion is not in the buyside's ::s: -:srest Capital is fine for finishing an order, but ,', -3- . s rsed to initiate it reduces the flexibilitv of where

losses to more knowledgeable traders. The trader and the manager must be 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 limit orders will expose only a modest number of shares with most going to the reserve book. The downside is that exchanges provide price, time, size priority - and reserve shares lose time priority to exposed
others arrivino at a later time.

to trade resiCua shares, and puts the desk into a
competing pos t on vrith the broker who needs to unwind

the initial trade at a minimal loss. Plexus finds that
costly as the initial trades and twice the expected
PAEG/L cost.
important. Traders are willing to accept the chance of adverse price moves to keep impact low, But as size grows, exposure creates its own price impact. Domestic brokers are less likely to frontrun stated client intentions than they once
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to either expose or hide their interest depending on market
Experienced traders will adjust their orders conditions. Today's markets are deepest at the open and the close, so larger portions can be hidden in the crowd. During thin mid-day periods, the experienced traders
hicje their orciers by using market orders to hit bicisioffers.

For lower urgency trades, price is more

were due

to

improved market monrtoring, but the

They will also use fill-or-kill orders to absorb available volume. They may split orders into small chunks and use either a single broker or multiple markets to capture liquidity without being too observable. The key is to be unpred ctable: orce the market figures you out. either you pay up or walK away.

problem has not completely gone away. Frontrunning appears much worse in non-US markets where shopping information in exchange for increased commission flow remains a problem. Another danger is revealing your intent to too many players, resulting in their moving their price targets away. After all, no one wants to be the first fill against a very large block trade
rokeia

Trading Venue
The other question is: Where do I trade? Note that we don't ask 'with whom?' The answer to that ouestion is determined by venue, just as price is determined by
order type. Liquidity
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. . . . .

Urgency
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Medium (if using broker) Medium Medium
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volumes over time ATS'S

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Med for Liqtidjty provtdlng Low for Liquidity-demanding

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LiquidNet Harborside

Med

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Low

I arno

Aomi..mnnvm;i ;" expose size only to counter party

-

High (small orOeis) 5-t-ow

Small---May trade in size with Corporations

Low - -- -

Limit traders want to maximize their exposure while market traders want to minimize theirs. Exposing orders ,.,,ill attract the other side, but also risks adverse selection

Traditional brokers are still the mainstay of the business, and remain the up-front providers of liquidity. But they are often the most exoensive route in terms of market

impact and commission. For small and less urgent orders, there are many alternative routes that offer lower costs. These routes do not ouarantee execution.
Technology has spawned alternatives to traditional brokerage and has increased the liquidity pool. But the
growth is in terms of breadth and speed more than depth.

approach to the trading process for the less experienced trader who needs a guide when markets become murky.

This broader view may also provide some grist for experienced traders who already function as effective search engines, but who are open to tinkering as
markets change.

Buyside traders have more places to search, but need help via automation to maximize their hits. When liquidity
is found, traders also need to develop skills (both manual

The process always starts with a

trade-by-trade

and automated) to mine the sources without tipping off competitors. Traditional brokers can multiply the trader's available search engines, but at the risk of exposure. As urgency rises, the tradeoff is often justified.
Our goal in this commentary is to introduce a systematic

understanding of the urgency and size issues. These determine the appropriate processes that the desk can use. Order tactics, in turn, determine the market venues that represent the best alternatives. At that point, the

on the desk's commitments, who is already trafficking in the name, and the desk's comfort with the specific broker (traditional or electronic).
soecific broker route deoends

Plexus News
Plexusis p/eased to announce that Marie Konstance has joined JPMIS as the head of Global Sales. We look forward to a wealth of fresh ideas emanating from Marie's extensive knowledge and experience.

Re/ease 2 0 or our lceBreaker'dritt-down',":;.;.;;:::r.;;.:r..;;.""";r";;"n* ,", reviewing daity tradins activity was made available last month. More detailed descriptions and instructions will be communicated very soon, or contact your consultant to get the latest information.

t,

Reprint any portion with credit given to:

lexu DIeXrrSCrfouIt
11150 W. Olympic Blvd., #900 Los Angeles, CA 90064

PH:

31 0.31

2.5505 FAX:

31 0.31

2.5506 www.plexusgroup.com

Plexus Group is a wholly owned subsidiary of JPMorgan lnvestor Servrces Company, a division of JPMoroan Chase.

A 2003 Plexus Group, lnc.

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