Trading

1
Market sizes regional, $millions
Domestic Market Capitalisation Europe - Middle East - Africa
(USD millions) Abu Dhabi Securities Exchange 137,617.5 124,532.6
Amman Stock Exchange 22,740.0 23,924.6
Exchange End 2018 End 2017 Athens Stock Exchange 38,370.8 48,346.2
Bahrain Bourse 21,862.7 21,723.5
Beirut Stock Exchange 9,675.2 11,491.8
Americas BME Spanish Exchanges 723,691.0 849,161.9
B3 SA Brasil Bolsa Balcao 916,824.4 815,165.2 Borsa Istanbul 149,263.6 162,886.8
Barbados Stock Exchange 3,541.6 3,350.9 Botswana Stock Exchange 4,034.1 4,583.5
Bermuda Stock Exchange 2,590.1 2,874.8 Bourse de Casablanca 61,080.8 65,754.4
Bolsa de Comercio de Buenos Aires 45,986.1 54,712.0 BRVM 8,453.3 12,485.7
Bolsa de Comercio de Santiago 250,739.6 261,259.2 Bucharest Stock Exchange 20,853.8 23,621.3
Bolsa de Valores de Colombia 103,848.4 111,293.8 Budapest Stock Exchange 28,934.6 31,553.8
Bolsa de Valores de Lima 93,385.4 95,227.2 Cyprus Stock Exchange 3,313.5 2,696.4
Bolsa de Valores de Panama 15,647.7 15,023.7 Deutsche Börse AG 1,755,172.8 2,161,242.1
Bolsa Mexicana de Valores 385,051.4 417,729.5 Dubai Financial Market 86,208.3 107,291.7
Bolsa Nacional de Valores 2,401.1 3,010.8 Euronext 3,730,398.3 4,196,901.7
Jamaica Stock Exchange 12,057.1 9,404.8 Iran Fara Bourse 26,912.2 14,954.7
Nasdaq - US 9,756,836.1 10,039,335.6 Irish Stock Exchange 110,154.4 140,012.3
NYSE 20,679,476.9 22,081,367.0 Johannesburg Stock Exchange 865,327.7 1,057,528.5
TMX Group 1,937,902.7 2,179,674.9 Kazakhstan Stock Exchange 37,005.3 39,489.8
34,206,288.6 36,089,429.5 Ljubljana Stock Exchange 7,266.5 6,318.4
LSE Group 3,637,996.0 4,455,429.5
Asia - Pacific Luxembourg Stock Exchange 49,482.6 65,564.4
Australian Securities Exchange 1,262,800.3 1,363,193.3 Malta Stock Exchange 5,050.6 4,940.4
BSE Limited 2,088,431.4 2,185,195.6 Moscow Exchange 576,116.3 517,049.1
Bursa Malaysia 398,018.7 444,445.6 Muscat Securities Market 18,782.4 21,304.4
Chittagong Stock Exchange 38.2 42.8 Namibian Stock Exchange 2,461.9 2,915.2
Colombo Stock Exchange 15,575.0 15,903.3 Nasdaq Nordic Exchanges 1,322,817.5 1,465,045.4
Dhaka Stock Exchange 39,761.9 43,935.1 Nigerian Stock Exchange 31,520.5 36,536.8
Hanoi Stock Exchange 8,308.4 9,845.0 Oslo Stock Exchange 267,382.2 271,781.5
Hochiminh Stock Exchange 124,344.6 113,041.4 Palestine Exchange 3,734.9 3,891.5
Hong Kong Exchanges and Clearing 3,819,215.4 4,341,403.9 Qatar Stock Exchange 163,047.4 130,729.4
Indonesia Stock Exchange 486,765.9 488,768.3 Saudi Stock Exchange (Tadawul) 496,353.2 451,174.2
Japan Exchange Group 5,296,811.1 6,372,337.3 SIX Swiss Exchange 1,441,160.5 1,672,955.7
Korea Exchange 1,413,716.5 1,697,377.1 Stock Exchange of Mauritius 9,847.5 9,523.8
National Stock Exchange of India 2,056,337.3 2,157,607.3 Tehran Stock Exchange 145,970.8 108,634.7
NZX Limited 86,132.6 87,174.5 Tel-Aviv Stock Exchange 187,466.4 213,550.7
Philippine Stock Exchange 258,155.7 276,209.4 The Egyptian Exchange 41,940.9 46,148.2
Shanghai Stock Exchange 3,919,420.3 4,818,288.9 Trop-X (Seychelles) Limited 283.7 NA
Shenzhen Stock Exchange 2,405,459.5 3,428,556.5 Tunis Stock Exchange 8,329.0 8,922.6
Singapore Exchange 687,257.2 771,835.9 Ukrainian Exchange 4,415.4 5,198.0
Taipei Exchange 92,477.8 108,524.4 Warsaw Stock Exchange 170,230.2 210,181.5
Taiwan Stock Exchange 959,219.7 1,041,453.9 Wiener Borse 116,802.0 150,646.7
The Stock Exchange of Thailand 500,741.0 552,263.3 Zagreb Stock Exchange 20,509.0 22,764.8
25,918,988.4 30,317,402.7 16,570,037.4 18,981,390.2
Source: World Federation of Exchanges Overview 76,695,314.4 85,388,222.4
2
Number of companies
Number of listed companies Europe - Middle East - Africa
2018 Abu Dhabi Securities Exchange 70 67 3
Exchange Domestic Foreign Amman Stock Exchange 195 195 0
Total
companies companies Athens Stock Exchange 187 183 4
Bahrain Bourse 44 43 1
Americas Beirut Stock Exchange 10 10 0
B3 SA Brasil Bolsa Balcao 339 334 5 BME Spanish Exchanges 3,007 2,980 27
Barbados Stock Exchange 20 16 4 Borsa Istanbul 378 377 1
Bermuda Stock Exchange 51 13 38 Botswana Stock Exchange 35 26 9
Bolsa de Comercio de Buenos Aires 99 93 6 Bourse de Casablanca 76 75 1
Bolsa de Comercio de Santiago 285 205 80 BRVM 45 45 0
Bolsa de Valores de Colombia 68 66 2 Bucharest Stock Exchange 87 85 2
Bolsa de Valores de Lima 223 209 14 Budapest Stock Exchange 42 42 0
Bolsa de Valores de Panama 31 30 1 Cyprus Stock Exchange 102 91 11
Bolsa Mexicana de Valores 145 140 5 Deutsche Börse AG 510 462 48
Bolsa Nacional de Valores 10 10 0 Dubai Financial Market 67 51 16
Jamaica Stock Exchange 76 76 0 Euronext 1,208 1,059 149
Nasdaq - US 3,058 2,622 436 Iran Fara Bourse 114 114 0
NYSE 2,285 1,775 510 Irish Stock Exchange 54 43 11
TMX Group 3,383 3,330 53 Johannesburg Stock Exchange 360 289 71
10,073 Kazakhstan Stock Exchange 110 97 13
Ljubljana Stock Exchange 31 31 0
Asia - Pacific LSE Group 2,479 2,061 418
Australian Securities Exchange 2,146 2,004 142 Luxembourg Stock Exchange 162 27 135
BSE Limited 5,233 5,232 1 Malta Stock Exchange 25 25 0
Bursa Malaysia 912 902 10 Moscow Exchange 225 221 4
Chittagong Stock Exchange 282 282 0 Muscat Securities Market 110 110 NA
Colombo Stock Exchange 297 297 NA Namibian Stock Exchange 44 10 34
Dhaka Stock Exchange 311 311 0 Nasdaq Nordic Exchanges 1,019 974 45
Hanoi Stock Exchange 376 376 0 Nigerian Stock Exchange 164 163 1
Hochiminh Stock Exchange 373 373 0 Oslo Stock Exchange 237 237 0
Hong Kong Exchanges and Clearing 2,315 2,161 154 Palestine Exchange 48 48 0
Indonesia Stock Exchange 619 619 0 Qatar Stock Exchange 46 46 NA
Japan Exchange Group 3,657 3,652 5 Saudi Stock Exchange (Tadawul) 200 200 NA
Korea Exchange 2,207 2,186 21 SIX Swiss Exchange 270 236 34
National Stock Exchange of India 1,923 1,922 1 Stock Exchange of Mauritius 103 99 4
NZX Limited 137 131 6 Tehran Stock Exchange 323 323 0
Philippine Stock Exchange 267 264 3 Tel-Aviv Stock Exchange 449 421 28
Shanghai Stock Exchange 1,450 1,450 NA The Egyptian Exchange 250 249 1
Shenzhen Stock Exchange 2,134 2,134 NA Tunis Stock Exchange 82 82 0
Singapore Exchange 741 482 259 Ukrainian Exchange 80 78 2
Taipei Exchange 766 732 34 Warsaw Stock Exchange 852 823 29
Taiwan Stock Exchange 945 855 90 Zagreb Stock Exchange 127 127 0
The Stock Exchange of Thailand 704 704 NA 14,027
27,795
51,895
Overview 3
Value of share trading
Value of share trading. Electronic order book
(USD millions) Europe - Middle East - Africa
2018 Amman Stock Exchange 2,365.3 2,365.3 0.0
Exchange Domestic Foreign Athens Stock Exchange 12,715.1 12,254.7 460.4
Total
companies companies Bahrain Bourse 969.1 969.1 NA
Cboe Europe 2,812,273.2 0.0 2,812,273.2
Americas Beirut Stock Exchange 377.8 377.8 0.0
B3 SA Brasil Bolsa Balcao 814,126.8 811,250.2 2,876.7 BME Spanish Exchanges 647,383.8 643,067.1 4,316.6
Barbados Stock Exchange 11.4 11.2 0.2 Borsa Istanbul 403,214.2 403,093.3 120.9
Cboe Global Markets 16,036,009.8 16,036,009.8 0.0 Botswana Stock Exchange 177.1 158.4 18.7
Bermuda Stock Exchange 49.7 49.2 0.5 Bourse de Casablanca 3,963.5 3,962.7 0.9
Bolsa de Comercio de Buenos Aires 6,778.7 5,870.9 907.7 BRVM 475.9 475.9 0.0
Bolsa de Comercio de Santiago 46,970.0 46,895.6 74.4 Bucharest Stock Exchange 2,857.0 2,844.6 12.4
Bolsa de Valores de Colombia 14,353.6 14,317.4 36.2 Budapest Stock Exchange 10,216.2 10,216.2 0.0
Bolsa de Valores de Lima 3,376.6 2,003.8 1,372.8 Cyprus Stock Exchange 57.5 57.5 0.0
Bolsa de Valores de Panama 319.1 319.1 0.0 Deutsche Börse AG 1,815,087.8 1,666,358.0 148,729.7
Bolsa Mexicana de Valores 115,263.8 96,841.5 18,422.4 Dubai Financial Market 15,642.3 13,105.9 2,536.3
Bolsa Nacional de Valores 52.3 48.5 3.8 Euronext 2,200,719.9 2,200,560.6 159.3
Jamaica Stock Exchange 566.0 557.1 8.9 Iran Fara Bourse 8,845.7 8,845.7 0.0
Nasdaq - US 16,789,810.0 14,985,300.0 1,804,510.0 Irish Stock Exchange 33,118.1 33,080.0 38.0
NYSE 19,340,880.0 18,041,900.0 1,298,980.0 Johannesburg Stock Exchange 392,535.9 319,729.5 72,806.4
TMX Group 1,447,590.5 1,440,684.8 6,905.7 Kazakhstan Stock Exchange 1,534.2 1,405.8 128.4
54,616,158.2 Ljubljana Stock Exchange 386.7 386.7 0.0
LSE Group 2,541,532.0 2,343,350.0 198,182.0
Asia - Pacific Luxembourg Stock Exchange 96.3 81.9 14.3
Australian Securities Exchange 860,757.5 818,169.0 42,588.6 Malta Stock Exchange 102.2 102.2 0.0
BSE Limited 115,717.0 115,717.0 NA Moscow Exchange 166,525.9 162,481.5 4,044.5
Bursa Malaysia 136,760.8 136,514.7 246.0 Muscat Securities Market 1,916.2 1,916.2 NA
Chittagong Stock Exchange 1,039.6 1,039.6 0.0 Namibian Stock Exchange 902.0 66.9 835.1
Colombo Stock Exchange 671.9 671.9 NA Nasdaq Nordic Exchanges 847,989.7 813,979.6 34,010.1
Dhaka Stock Exchange 15,933.3 15,030.6 902.7 Nigerian Stock Exchange 2,598.0 2,581.8 16.2
Hanoi Stock Exchange 7,722.4 7,722.4 0.0 Oslo Stock Exchange 145,885.2 126,610.2 19,274.9
Hochiminh Stock Exchange 45,894.7 45,894.7 0.0 Palestine Exchange 353.5 353.5 0.0
Hong Kong Exchanges and Clearing 2,340,132.1 2,264,866.1 75,266.0 Qatar Stock Exchange 18,946.8 18,946.8 NA
Indonesia Stock Exchange 106,002.5 106,002.5 0.0 Saudi Stock Market (Tadawul) 229,668.1 229,668.1 NA
Japan Exchange Group 6,290,598.6 6,288,593.1 2,005.5 SIX Swiss Exchange 964,623.8 945,715.5 18,908.3
Korea Exchange 2,508,491.1 2,488,255.2 20,235.9 Stock Exchange of Mauritius 462.6 460.0 2.6
National Stock Exchange of India 1,163,820.3 1,163,793.9 26.4 Tehran Stock Exchange 27,846.8 27,846.8 0.0
NZX Limited 12,672.2 12,518.7 153.4 Tel-Aviv Stock Exchange 64,952.0 64,952.0 NA
The Philippine Stock Exchange 29,127.6 29,106.6 21.0 The Egyptian Exchange 14,489.4 14,488.5 0.8
Shanghai Stock Exchange 6,037,193.3 6,037,193.3 NA Tunis Stock Exchange 938.6 938.6 0.0
Shenzhen Stock Exchange 7,498,573.2 7,498,573.2 NA Ukrainian Exchange 12.1 12.1 0.0
Singapore Exchange 221,840.3 221,840.3 NA Warsaw Stock Exchange 56,843.0 56,362.9 480.1
Taipei Exchange 269,326.3 258,747.7 10,578.5 Zagreb Stock Exchange 254.3 254.3 0.0
Taiwan Stock Exchange 967,279.8 903,912.0 63,367.8 13,451,854.7
Stock Exchange of Thailand 388,004.6 388,004.6 NA
29,017,558.9 97,085,571.8
Overview 4
Trading

Trading process 5
Trading …
Traditionally, a buy-side initiated trade is placed as an order
with a broker, who then communicates it to a trader/dealer.
In turn, the dealer would trade against own inventory or
work the order on an exchange (pathway A)

Trading process 6
DMA
Direct market access is where the broker allows clients to
access their order routing infrastructure (pathway B)

Allows buy-side to issue electronic orders directly to

exchange, effectively giving them the same level of control
as the sell-side

Sponsored access takes this to the next level, for clients

whose high-frequency trading needs ultra-low latency
(pathway E)

Trading process 7
Algorithmic trading
Algorithmic trading is a computerized system responsible for
executing orders, rather than being worked by a trader
• Initially such algorithms were used by busy sell-side traders
(pathway C)
• Now clients use their own algorithms (pathway D)

Trading process 8
ECNs
Generally based on central limit order books with continuous
auctions

Came about due to a 1997 SEC ruling that private inter-

dealer prices should also be available to the public

ECN resembles an exchange but operates like an electronic

broker
• ECN must be registered as a broker/dealer or as a self-regulated
securities exchange

Trading process 9
MTFs
Multilateral trading facility are European counterparts of
ECNs
• An MTF must be registered with the relevant national regulator
before operations can commence

Chi-X is the major MTF in Europe

Trading process 10
ATS/Dark pools
Alternative trading systems provide opaque order-driven
trading platforms that aggregate pools of liquidity

Anonymously match buy and sell orders of a pool of

participants, generally institutional investors and broker-
dealers, at pre-specified times and at prices determined in
the primary market for the security

Trading process 11
Dark pools …
Advantages
• Confidential
• Low transaction costs
▪ Important for managing large blocks

Disadvantages
• No trading immediacy
• Darkness is “pre-trade” only
▪ Trades have to be ultimately reported
• There is no mechanism for price determination
▪ Prices for all trades are driven by best bid/offer
▪ Dark pools cannot exist without visible markets

Trading process 12
Market structure

Trading process 13
Price formation
Usually done through some form of fundamental valuation
analysis (discounted cashflow, multiples, etc.)

In a frictionless world, “excess buying” does not lead to

higher prices

Price formation 14
Price formation …
Market microstructure focuses of one particular aspect of this
process in the real world (with intermediaries), namely the
determination of the bid-ask spread

Price formation 15
Price
Bid quote is the highest price that someone is publicly willing
to pay

Ask or offer quote is the lowest price at which someone is

publicly willing to sell
• Depending on the market convention the bid and ask might be
indicative or firm commitments

Price formation 16
Spreads
The difference between the ask and bid quotes is the spread
• the spread is the cost incurred by someone who bought and
immediately reversed
• Alternatively, if the bid and ask quote were posted by a single
agent, the spread could represent the realized profit

Spreads are determined based on two factors

• Transaction cost component (inventory based models)
• Adverse selection component

Price formation 17
Spreads ...
Transaction cost component
 Assuming all traders know the asset value with certainty,
prices would bounce between bid and ask prices

 Spread is equal to the cost of doing business

• Normal business costs (office, technology etc.)
• Costs of maintaining an inventory (desired position is zero)
▪ When the inventory is too low, raise bid to encourage sellers (or increase the
bid size)
▪ When the inventory is too high, lower ask to encourage buyers (or increase the
ask size)

Price formation 18
Spreads …
Adverse selection component
 Some traders are better informed than others
• Ask price is set higher than the fundamental value to reflect the
fact that the next trade is an informed buyer
• Bid price is set lower than the fundamental value to reflect the fact
that the next trade is an informed seller

 Spread allows dealers to recoup from uninformed traders

what they lose to informed traders

Price formation 19
Types of orders
Instructions to the brokers on how to complete the order

 Market
• Executed immediately at current market prices

 Limit
• Specify prices at which willing to buy/sell

Price formation 20
Market order
Instruction to trade a given quantity at the best possible
price
• No specific price conditions
• Focus is on completing the order
Market orders demand liquidity
• Buy order will execute at the offer/ask price (101)
• Sell order will execute at the bid price (100)
• Immediate cost is half the bid-ask spread (0.5)

Price formation 21
Market order …
For orders larger than the current BBO size, market orders
“walk the book”
• Eg. A buy order for 2,000 may be crossed with S1 and S2

• If the order still can’t be completed, some venues (LSE) will cancel
it, while some (Euronext) will leave the residual on the order book

Price formation 22
Market order …
Risk is the execution price
• If suddenly S2 is cancelled, then our order will cross against S1 and
S3 raising the average execution price to 102.5

Sometimes market orders can achieve better prices than

expected
• Market order executes against a hidden order

Price formation 23
Limit order
Instruction to buy/sell a given quantity at a specified price or
better
• Buy limit order must execute below this price
• Sell limit order must execute above this price

If there are no orders that match an acceptable price, limit

order is left in the book till it expires or is canceled

Limit orders 24
Limit order book

Limit orders 25
Limit order …
Buy limit order for 1,000 shares at a price of 100 or better

Order cannot currently execute

Our order is left as B4, after B1 but before B2

Limit orders 26
Limit order …
Limit order sacrifices execution to ensure price
Compare limit order to buy 2,000 shares at a price of 101
versus a market order

Limit orders 27
Limit order …
 Limit orders provide liquidity
 Since traders can choose whether they want to trade with a
limit order, standing limit orders are options to trade (but
not option contracts)
• Sell limit orders are call options
• Buy limit orders are put options
 These options are freely granted to the public
• Option value of a limit order is the value of the order to other
traders
▪ Depends on limit price, how long the order will stand, and price volatility

Limit orders 28
Limit order markets
 All traders participate equally
 Traders publicly post their orders and the transaction price
is the result of the equilibrium of supply and demand
 All buy and sell orders are entered in a central order book
and a new order is immediately matched with the book of
limit orders previously submitted
• Limit order book is publicly visible
• Execution of market orders at bid/ask is not guaranteed
 Majority of the worldwide markets today are limit order
markets

Limit orders 29
Priority within the book
 Price
• A buy order with a relatively high price is said to be (relatively)
aggressive. (“The buyer is willing to pay more”)
• A sell order with a relatively low price is aggressive. (“The seller is
willing to accept less”)
• More aggressive limit orders have priority over less aggressive
orders
 Time
• An order that arrives earlier has priority over an order that arrives
later
 Other
• Visibility
• Type of trader
Limit orders 30
Hidden orders
A trader who submits a limit order can decide whether or not
it is to be displayed (the default) or hidden

A hidden order is held in the book and is available to be

executed

We can only see it when and if it is executed

• A hidden order is a form of dark liquidity

For orders at the same price, displayed orders have priority

over hidden orders
Limit orders 31
Spreads in limit order markets
Visible information in limit order book affects price formation
(spread)
• Market orders demand liquidity but pay bid/ask
• Limit orders provide liquidity but risk non-execution

Determinants of spreads
• Information asymmetry ↑
• Volatility ↑
• Limit order management costs ↑
• Value of trader time ↑

Limit orders 32
Margin trading
Using only a portion of the proceeds for an investment;
Borrow remaining component

Margin trades 33
Stock margin trading
Maximum margin is currently 50%; you can borrow up to
50% of the stock value

Maintenance margin: minimum amount equity in trading can

be before additional funds must be put into the account

Margin call: notification from broker you must put up

additional funds

Margin trades 34
Margin trading – initial conditions
GOOG $720
50% Initial Margin
30% Maintenance Margin
100 Shares Purchased

Initial Position
Stock $72,000 Borrowed $36,000
Equity $36,000

Margin trades 35
Margin trading – maintenance margin
Stock price falls to $500 per share

New Position
Stock $50,000 Borrowed $36,000
Equity $14,000

Margin% = $14,000/$50,000 = 28%

Margin trades 36
Margin trading – margin call
How far can the stock price fall before a margin call?

Equity / Investment = Margin

(100P – $36,000) / 100P = 30%

Solving, we get
P = 360/0.7 = $514.3

Margin trades 37
Margin trading – cover margin call
Newer position (raise cash)
Stock $50,000 Borrowed $36,000
Cash $1,000 Equity $15,000
Margin% = 15,000/50,000 = 30%

OR

Newer position (sell stock)

Stock $45,000 Borrowed $31,000
Equity $14,000
Margin% = 14,000/45,000 = 31%
Margin trades 38
Short sales
Purpose
• To profit from a decline in the price of a stock or security

Mechanics
• Borrow stock through a dealer
• Sell it and deposit proceeds and margin in an account
• Closing out the position: buy the stock and return to the party
from which is was borrowed

Margin trades 39
Short sale mechanics
Four guys: Amit, X, Y, and Z. One share currently trading at
$50 but falls to $40

Original Amit borrows Amit sells to Y Amit buys Amit returns

position from X at $50 from Z at $40 to X
Amit 0 1 $50 1, $10 $10
X 1 0 0 0 1
Y 0 0 1 1 1
Z 1 1 1 0 0

Amit makes a profit of $10. X (lender) retains her position

Margin trades 40
Short sale – initial conditions
FB 1,000 Shares
50% Initial Margin
30% Maintenance Margin
$120 Initial Price

Cash $120,000 Stock owed $120,000

T-bills $60,000 Equity $60,000

Margin trades 41
Short sale – maintenance margin
Stock Price Rises to $150

Cash $120,000 Stock owed $150,000

T-bills $60,000 Equity $30,000

Margin = (30,000/150,000) = 20%

Margin trades 42
Short sale – cover margin call
Add collateral (T-bills)
Cash $120,000 Stock owed $150,000
T-bills $80,000 Equity $50,000
Margin = (50,000/150,000) = 33.3%

OR

Buy stock
Cash $70,000 Stock owed $100,000
T-bills $60,000 Equity $30,000
Margin = (30,000/100,000) = 30%
Margin trades 43
Short sale – margin call
How much can the stock price rise before a margin call?

($180,000* − 1,000P) / (1,000P) = 30%

P = $138.5

* Initial margin plus sale proceeds

Margin trades 44
Other details
You pay interest on margin loan

You receive interest on short sale proceeds but you pay the
stock lender
• Net is called short sale rebate
• In exceptional circumstances, stock can go special and have
negative rebate

On borrowed stocks
• You have to pay the dividend (manufactured dividend) to the lender
• Who owns the voting rights?

Margin trades 45
Trading algorithm
Defines the steps required to execute an order in a specific
way
1. How should we slice the order?
2. How should each slice be managed?

Example: Order to buy 6,000 shares of asset ABC might have

an algorithm such as:
• Buy 1,000 shares every 10 minutes (and then sleep for 10 minutes)
• Order will get executed in one hour

Trading algorithms 46
TWAP
Time weighted average price benchmark is the average price

Algorithms that attempt to meet this benchmark are based

on a uniform time-based schedule
• Unaffected by other factors such as market price or volume

Example: Trade 10,000 shares of ABC

• Buy 500 every 15 minutes (takes 5 hours)
• Buy 1,000 every 15 minutes (takes 2.5 hours)

Trading algorithms 47
TWAP …

Trading algorithms 48
TWAP …
Trading leads to signaling risk
• Only thing other participants do not know is the total size of the
order

Can have poor execution quality

• Prices could become unfavorable
• Liquidity drops

Trading algorithms 49
VWAP
Volume weighted average price benchmark for a given time
span is the total traded value divided by total traded quantity
• Fair reflection of the market conditions throughout the day

=VWAP ∑ v p
= ∑
n n n
f n pn
∑v n n
n

Large trades have more impact than small ones

Trading algorithms 50
VWAP …
In contrast to TWAP, we will have to trade in the correct
proportions
• These proportions are not known beforehand

Use historical volume profiles to estimate fn

Example: Buy 10,000 ABC

• Trading algorithm needs to place sufficient orders in each interval
to keep up with the target execution profile
• Not affected by actual market volume or price changes

Trading algorithms 51
VWAP …

Trading algorithms 52
VWAP …
Vulnerable to sudden shits in trading volume or liquidity

Some versions allow monitoring market conditions

• Makes them hybrid between static VWAP and dynamic volume
participation approach

Trading algorithms 53
Trading costs
Explicit costs
• Commissions, stamp duties, taxes

Implicit costs
• Caused by how trades move prices
• Dependent on order size, market liquidity for the security and the
speed of execution desired by the investor

Opportunity costs
• Loss (or gain) incurred as the result of delay in completion of, or
failure to complete in full, a transaction following an initial decision
to trade
Trading algorithms 54
Iceberg of trading costs

Direct Costs Commission

3-4 ¢ (9 bp)

Impact
Execution Shortfall
5 ¢ (15 bp)

Delay
Pre-trade Costs (PC)
10 ¢ (30 bp)
Missed Trades
4 ¢ (10 bp)

Source: Plexus Group Inc., 2007

Trading algorithms 55
High frequency trading
Generally refers to computer-driven trading strategies that
process information and react to market events very quickly
• Human reaction time: 200 millisecond
• Electronic message transmission, NY to Chicago, round trip: about
10 millisecond

Trading algorithms 56
An example

Trading algorithms 57
Need for speed

58
Flash crash of May 6th, 2010
Markets are more liquid because of HFTs
• But, not required by fiat to supply liquidity
• Because risk capital is finite, liquidity can dry up just when the
demand is high
▪ Even worse, suppliers can become demanders

Trading algorithms 59