41 (PM) - Trading Costs & Electronic Markets

Question 1

What are the two types of execution costs?

Answer 1

1. Explicit trading costs
2. Implicit costs

Question 2

What are examples of explicit trading costs?

What are examples of implicit costs?

Answer 2

Explicit: Brokerage, taxes, and fees.

Implicit: Costs that are harder to measure. Include bid-ask spread, market impact (i.e. price impact), delay cost (i.e. slippage), and opportunity cost.

Question 3

Best bid (aka inside bid)

Answer 3

Highest-posted bid price

Question 4

What do dealers do?

Answer 4

Dealers make the market by offering to buy for, and sell from, their own inventory.

Question 5

Best ask (aka inside ask)

Answer 5

Lowest ask price

Question 6

Inside spread

Answer 6

The difference between the best ask price and the best bid price.

Question 7

Midquote price

Answer 7

The average of the bid and ask price quoted by a single dealer.

Question 8

Limit order book

Answer 8

A book that shows the available posted bid and ask prices/offers with corresponding quantities that the dealer is willing to purchase or sell.

Question 9

Standing limit order

Answer 9

Traders posting a quote to provide liquidity to the market and trade at their posted prices, but at the risk of failure to complete the trade.

Question 10

What impact will price movement have on an effective spread?

Answer 10

If the trade occurs at a better price, the effective spread will be lower than the quoted spread.

Question 11

Volume-weighted average price (VWAP) (aka interval VWAP)

Answer 11

The weighted average price at which all the trades were executed during the time interval between the order being placed and being executed.

Question 12

Implementation shortfall

What does implementation shortfall address?

Answer 12

The difference in value between a hypothetical paper portfolio and the actual value of a portfolio.

Addresses the shortfalls of VWAP by measuring the total cost of trading by capturing all three implicit costs (i.e. price impact, slippage, and opportunity costs).

Question 13

What does a paper portfolio take into account?

Answer 13

In a paper portfolio, trades are fully executed at no cost, and at the prevailing price when the order is placed, which is generally the mid-quote price at that time.

Question 14

What are the major factors that have driven the development of electronic trading systems?

Answer 14

1. Lower cost
2. Higher accuracy
3. Provides audit trails
4. Better fraud prevention
   5.Continuos market during trading hours

Question 15

What have electronic trading systems generally provided to markets?

Answer 15

Lower trading costs and improved execution efficiency.

Question 16

When does market fragmentation occur?

Answer 16

When a security trades in multiple markets. There may also be significant liquidity differences between these electronic markets.

Question 17

What are two trading algorithms that seek to overcome the challenges of market fragmentation?

Answer 17

1. Liquidity Aggregation Algorithms - Create a “super book” displaying liquidity across all markets.
2. Smart Order Routing Algorithms - Send orders to the markets with the best prices and sizes.

Question 18

Latency

Answer 18

The time lapse between the occurrence of an event and the execution of a trade based on that event.

Question 19

Who do electronic trading systems give a competitive advantage to?

Answer 19

High-frequency traders - Traders who make quick round-trip trades thousands of times during the day.

Low-latency traders - Traders who rely on speed in receiving news and trading on it. Seek to benefit from enhanced communication and computation speed. Gain competitive advantages by “jumping the queue” in order taking, market making, and order concealing. Seek to benefit from enhanced communication and computation speed.

Question 20

Who are the major electronic traders?

Answer 20

1. Electronic news traders - Analyze high-speed news feeds and submit market orders based on the analysis.
2. Electronic dealers - Post bid and offer prices to profit from the spread.
3. Electronic arbitrageurs - Trade in multiple markets seeking to exploit price discrepancies.
4. Electronic front runners - Use AI to sniff out large trades (or many small trades) on the same side and then use low latency to trade ahead of them.
5. Electronic quote matchers - Provide standing limit orders that provide valuable information to other traders. They disclose the intent of the trader posting the order to buy or sell the specified quantity.
6. Buy-side traders 0 Traders that execute orders on behalf of portfolio managers and use electronic order management systems to trad orders.

Question 21

What do electronic front runners typically trade on?

Answer 21

Patterns and events, not insider information.

Question 22

What are buy-side electronic brokers?

Answer 22

Brokers than buy-side traders sue for trade execution. These brokers also offer advanced order-processing algorithms and tactics in addition to standard market and limit order processing.

Question 23

What are the two major risks of using electronic trading systems?

Answer 23

1. High-frequency traders (HFT) arms race - State-of-the-art technology to support HFT trading of firms can lead to disadvantages for smaller investors and traders.
2. Systemic risk - The cots of bad trades being borne by parties other than the party responsible for the trade.

Question 24

What can lead to systemic risk when using electronic trading systems?

Answer 24

1. Runaway algorithms - Produce a series of unintended orders causing extreme volatility.
2. Fat finger errors - Input errors that can lead to extreme volatility.
3. Overcharge orders - Orders that can demand liquidity significantly higher than what is available in the market.
4. Malevolent order - Order created to manipulate a market.

Question 25

What are the two major abusive trading practices?

Answer 25

1. Front running - Low-latency trading ahead of known large trades, benefiting from price subsequent price movement of such large trades.
2. Market manipulation - Activity that is intended to produce false data, including price and volume data. Manipulative traders seek to deceive other traders causing them to act on misleading information to the advantage of the manipulators.

Question 26

What are the key examples of market manipulation?

Answer 26

1. Trading for market impact - Trades designed to change the price, sometimes at a large cost.
2. Rumormongering - Dissemination of fake information to affect the target trader’s value assessments.
3. Wash trading - Trading between commonly controlled accounts creates an impression of false liquidity.
4. Spoofing or layering - Fake limit orders are posted to create fake optimism/pessimism for security.
5. Bluffing - Preying on momentum traders.
6. Gunning the market - Forces traders into bad trades.
7. Squeezing and cornering - Obtaining control over resources needed to settle contracts and then withdrawing those resources, triggering defaults.

Question 27

What does real-time surveillance seek to do?

Answer 27

Seeks to detect market abuses and potential crises as they unfold, allowing for a faster response.

Question 28

Advanced order types

Answer 28

Limit orders with a dynamic limit price that varies with a benchmark.

Question 29

Trading tactics

Answer 29

Plans calling for the submission of multiple orders.

Question 30

Discretionary orders (trading tactic)

Answer 30

Orders that have a +/- discretion amount specified to the exchange.

Question 31

Immediate or cancel (IOC) orders (trading tactic)

Answer 31

Orders that are canceled unless executed immediately.

Question 32

Dark pools

Answer 32

Trading venues that hide their liquidity and restrict trading to a select clientele.

Question 33

Midspread orders (trading tactic)

Answer 33

Limit orders pegged ti the midpoint of the quoted bid-ask spreads.

Question 34

Trading algorithms (aka algos)

Answer 34

Programmed execution strategies using multiple orders, sequencing of orders, and trading tactics to achieve specific goals.

Question 35

Electronic trading systems enable what?

Answer 35

1. Hidden orders - Limit orders that are hidden from the market except for the exchange receiving them.
2. Leapfrogging - Beating the best bid or ask price.
3. Flickering quotes - Exposed limit orders that are submitted and canceled almost immediately.
4. Electronic arbitrage - Taking liquidity on both sides, offering liquidity only to one side, or offering liquidity on both sides.
5. Machine learning - Using statistical modeling techniques that allow the model to evolve based on new data.

Question 36

Electronic trading systems employ what?

Answer 36

1. Advanced order types
2. Trading tactics
3. Trading algorithms (aka algos)