**6. Transaction Costs** Flashcards
Direct T-costs
Brokerage commissions, spreads, margin interest, etc.I
Indirect T-costs
Price impact, price slippage, execution risk, price improvement, etc.
Market order to buy
Instructs the broker to buy at the best price available - executed at the lowest ask price
Market order to sell
Instructs the broker to sell at the best price available @ highest bid price
Limit order to buy
instructs the broker to buy at the limit price or below
Limit order to sell
instructs the broker to sell at the limit price or above
Submitter of a limit order is a
market marker
Submitter of a market order is a
price taker
Brokers execute customers order by ____
sending limit and market orders to centralised limit order book (CLOB)
NYSE is a ____ market, limit orders are quoted against the spread quoted by _____
Specialised market, the designated market maker (DMM)
Drawbacks on limit orders
Once the price hits the limit, the order will be executed
Buy limit orders will be executed on ___ news
Bad (price going down)
Sell limit orders will be executed on ___ news
Good (price going up)
Marketable limit orders can be executed ___
immediately
marketable limit order to buy is an order to…
buy at or above the current best ask price
marketable limit order to sell is an order to…
sell at or below the current best bid price
Bid
Price people want to buy (highest on top)
Ask
Price people want to sell (lowest on top)
Stop-loss orders
Placed with a broker to buy or sell a specific stock once the stock reaches or breaks through a specified stop price - designed to limit an investor’s loss on a position
Stop-limit orders
Triggers submission of a limit order
Stop price - price that activates the limit order and is based on the last trade price
Limit price - price constraint required to execute the order once triggered
Is there a guarantee with a stop-limit order?
No - as both stop and limit price required
Trailing stop order
sets the stop price at a fixed amount below the market price with an attached trailing amount (e.g. 10%)
Price priority, time priority and quantity priority
Gives precedence to buyers with highest bid price and sellers with lowest ask price
If there are multiple orders at the same price, then order with an earlier time trades first
Orders at same price will get partial execution in proportion to the size of their order
NASDAQ gives precedence to traders with
Highest quantity (for orders at the same price)
NYSE uses … allocation model
parity/priority
Parity Priority Model
Rewards the person who sets the best price as they offer deep liquidity - price setter will receive full allocation of their shares and remaining shares at same price from other buyers will be split equally
Bid Ask Spread Percentage
Ask - Bid/Bid
Fair Price
Middle price of bid ask spread
Part of the bid-ask spread is kept by the…
market maker who is handling the transaction
Why doesn’t all of the bid ask spread go to the market maker? (3)
- some traders might be able to trade at mid-spread prices
- Spreads can move in volatile markets
- market makers might have to give up some of the spread due to price improvements
Bid ask spread compensates the market makers for… (3)
- riskiness of holding inventory (29%)
- costs associated with processing orders (expenses etc.) (61%)
- adverse information cost (10%)
Bid-ask spread is low for…
less volatile stocks, stocks with high trading volume and stocks with higher prices than their peers
Relative bid-ask spread
Ask - bid/price
Low priced stocks have _____ spreads
large
DMM post prices at which they will ____
buy or sell a specific security
Bid-ask bounce effect
Prices of securities bounces back and forth between bid and ask prices as some traders are buying at ask prices from DMM and others are selling at bid price to DMM
Margin money
cash investors deposits to borrow a margin loan from broker to buy stock
How margin account works?
Deposit money into your account, place the order with the broker and the broker will lend you up to 50% of the value of the trade/stock, your trade/stocks will remain with the broker as collateral
Maintenance margin
Amount of equity an investor must maintain in the margin account - U.S. federal law requires that investors equity in the margin account should not fall below 25%
Margin call
Margin account falls below maintenance, investor receives a call to deposit additional money to return the account to maintenance - this is a courtesy not legal requirement
Price impact is part of ….
transaction costs
What is price impact?
When prices move against you while you are trading (up when buying and down when selling)
Why is there price impact? (2)
Markets are not completely liquid
Informational - large trades attract the attention of other traders due to this potentially being related to new information
Sunshine Trade
Trade involving a large block of stock that is publicised to the market before the order for the trade is made
Why do sunshine trades exist?
to reduce price impact by illiquidity
A stand in the market on NZX
Bid to buy (never to sell) a large block of stock during a pre-specified time window, to avoid price impact, can be on or off market
Bidders in large stands are required to bid on market for at least
1/5 of the target purchase
Price Slippage
Occurs when execution price of a trade is different from its requested price (e.g. orders could not be matched at preferred prices) - typically occurs in highly volatile fast moving markets
Negative slippage
Investor places order to buy at $X –> order executed at price more than $X -
Positive Slippage
Investor places order to sell at $X –> order executed at a price more than $X
Price improvement
Amount of savings a trader may receive on trade compared to the price quoted at the time the order was priced
Faster you order is executed, _____ likely to get a price improvement
less
Magnitude and frequency of price improvements are _____ for stocks with wide spreads, fewer trades and smaller trade sizes
Greater
Block trades
Large trading off-market order made by institutional investors of at last 10,000 shares or at a total market value of more than $200,000
In NZ a stand in the market is also a____
private order
Stands in the market in NZ take a long time to be ____
filled
Off-market trade in NZ is similar to
Block trade
When should you short sell?
When you expect the share price to go down
Short-sell process (4)
- borrow shares from broker
- sell shares
- buy back (typically at lower price)
- return shares to broker
How would you short sell for the purpose of hedging?
Write a short put option
Uptick rule
you cannot short sell a stock if the price has ticked down
