5. Equity exchanges and trading Flashcards
What are the three main functions of equity exchanges?
- To act as a trading venue. Buyers can find sellers. Central venue saves investores time and trouble when trading.
- To allow price discovery. Easy to find current market sentiment and market value of asset (combination of buy and sell prices at exchange). Provision of price history records.
- To provide regulation and governance that must be followed. E.g., ensuring securities are not miscdescribed or missold.
These all overcome problems of asymmetric information and transaction costs.
What are sources of revenue for exchanges?
Listing fees, Execution fees, sale of pricing information, post-trade services
What is the virtuous cycle of liquidity?
For large well-known companies in major trading venues there are many traders willing to buy and sell. These equities are typically traded on order driven systems with larger numbers of buyers and sellers providing limit orders. This leads to low spreads between buying and selling prices and in turn encourages a greater volume of trading and the participation of more traders.
The opposite occurs for smaller less well-known companies.
What is a market maker?
A market maker is a trader who encourages trade and increases liquidity by always offering to buy and sell stocks for a certain price, and by offering a narrower bid-ask spread than other traders, and by often offering competitive ask prices (relatively low) and bid prices (relatively high). Although market makers make less profit per transaction due to their relatively narrow bid-ask spread, they earn high profits due to the much greater trading volume caused by the appeal of the narrow bid-ask spread.
Market makers always sell for more than they are willing to buy so that they can make some profit from buying a stock and then selling it. Market makers prices tend to be very similar (although usually slightly better) to other prices in order to make sure they still earn a decent profit and minimise losses when unwinding their position. This profit is their bid-ask spread and is the transaction cost for traders wanting to buy or sell stock immediately through the market maker.
What is a quote driven system?
A market that is supported by a market maker who continuously quotes bid and ask prices. A market maker will make a firm quotation (I will buy at X and sell at Y for quantities up to Z) or indicative quotation (I will buy at X and sell at Y but do not guarantee a quantity). Securities that are more liquid will have more market makers.
What is going short in trading?
Selling securities you do not currently own by borrowing them, with the intention of buying them back later at a lower price to return to the lender. A common activity of market makers.
What is a order driven system?
A market where instead of having a market maker, there are arrangements for both buyers and sellers to place orders on the system, indicating the price and the quantity at which they are willing to trade. Then there is a process of matching trades. Order driven systems work in two different modes: Auction and continuous mode.
What are the types of orders in order driven systems?
Limit order: States a maximum buying price or minimum selling price.
Market/best price order: Buy or sell at best market price available currently.
What is a limit order book?
A system containing the limit orders left at the end of the auction mode (all best price and limit orders within best prices have been executed). Trading continues for the rest of the trading day using the limit order book (continuous mode). The limit order book creates an equivalent of the bid-ask spread (quoted by market makers in quote driven systems), the difference between the lowest sell price (ask) and highest buy price (bid) which were matched at auction.
What mechanisms, apart from market makers, has the industry evolved for providing liqudity in equity markets?
Brokerage: Break down orders into smaller manageable size and routing them where they can be best executed.
Investment bank desks: By providing execution of large deals through directly matching buyers with sellers (‘crossing’ of orders).
Interdealer or wholesale brokers: Act as intermediaries between institutions that may have excess or insufficient inventories. Because (unlike the exchanges) they offer anonymous trading, they allow inventory to be adjusted without impacting so much on market price.
What is algorithmic trading?
Using a computer to make decisions about the execution of an order, breaking it up into sub-orders and deciding the subsequent timing of trades in order to minimise price impact.
What is high frequency trading?
Using computers to take advantage of very short-term profit opportunities in the form of small price differences for the trade of the same equity or very short-term predictable movements in market prices. These opportunities often arise because of price differences between different trading venues.
What are quantitative trading strategies?
Using computer models to formulate and then execute strategies for trading. Quantitative trading strategies operate over a longer investment horizon than HFT, seeking to hold and profit from positions over a period of days, weeks or even months. A number of active investment funds and hedge funds use quantitative trading strategies.
What is a flash crash? Give an example.
An event where prices of the overall market or a particular stock decline rapidly then recover quickly.
The flash crash of May 6th 2010:
In a single day the S&P 500 fell from 1,164 to 1,065 and then recovered to 1,128.
The main causes were:
- A single large derivate transaction with instructions to execute as quickly as possible regardless of price impact (unusual for such a large transaction).
- A deluge of automated selling orders by HFT algorithsm responding to falling prices.
SEC recommended to put in limits on price movements in US stock markets to prevent a repeat occurence.
