Professional Documents
Culture Documents
Types of orders
Market order = instruction to trade at the best price currently available in the market. Advantage is
immediate execution (mostly) but price is uncertain.
Limit order = instruction to trade at best price available provided that it is no worse than the
specified limit price. Advantage is the possibility of price improvement. But:
− There is a risk of non-execution + cost of delay
− Prices/fundamentals may move against you - if you are slow in revising or cancelling your
order, smart traders will take advantage of the trading option you have given them (adverse
selection/picking-off risk)
Effective half-spread
The LOB at price points beyond the “Best Bid and Offer” (BBO) may not be readily observable. A
widely-used trading cost measure that uses prices actually obtained by investors is the effective half-
spread: Se =dt ( pt −m t ) where:
o pt : actual execution price of a market order
o mt : mid price just before execution ¿)
o dt : order direction indicator (dt = 1: buy order, dt = −1: sell order)
Realized Half-Spread
realized half-spread: Sr =d t ( pt −m t +∆ ) where:
o pt : execution price at time
o tmt+∆: mid price some time after the transaction
we have: Sr =d t ( pt −mt +∆ ) =d t ( pt −mt ) −d t ( mt +∆ −mt ) < Se Where d t ( pt −mt )
is Se and d t ( mt +∆ −m t ) is the price impact
Suppose that a stock’s fundamental value, as captured by the mid quote, follows a random walk:
mt =mt−1 +ϵ t where ϵ t is mean-zero “white noise”. ϵ t accounts for the arrival of new information
between time t −1 and t
As the expected value is zero, the expected return is zero, too E [m t −m t−1 ]=0