Trading Costs and Electronic Markets

Question 1

Explicit costs

Answer 1

direct costs of trading, such as broker commission costs, transaction taxes, stamp duties, and fees paid to exchanges. They are costs for which a trader could receive a receipt

Question 2

Implicit costs

Answer 2

indirect costs caused by the market impact of trading. Impacted by:
1) Bid-ask spread
2) Market impact
3) Delay costs
4) Opportunity costs

Question 3

Bid-ask spread

Answer 3

The ask price (the price at which a trader will sell a specified quantity of a security) minus the bid price (the price at which a trader will buy a specified quantity of a security).

Question 4

Market impact

Answer 4

(or price impact) is the effect of the trade on transaction prices. Traders who want to fill large orders often must move prices to encourage others to trade with them

Question 5

Delay costs

Answer 5

(also called slippage) arise from the inability to complete the desired trade immediately. Traders fail to profit when they fill their orders after prices move as they expect

Question 6

Opportunity costs

Answer 6

(or unrealized profit/loss) arise from the failure to execute a trade promptly. Traders fail to profit when their orders fail to trade and price move as they expect.

Question 7

Dealers

Answer 7

provide liquidity to other traders when they allow traders to buy and sell when those traders want to trade.

Market makers

Question 8

Bid

Answer 8

In a price quotation, the price at which the party making the quotation is willing to buy a specified quantity of an asset or security.

Best bid - The highest bid in the market a.k.a. inside bid

Question 9

Ask

Answer 9

The price at which a trader will sell a specified quantity of a security. Also called ask, offer price, or offer.

Best ask - The offer to sell with the lowest ask price a.k.a. best offer or inside ask.

Question 10

Inside spread (market spread)

Answer 10

The spread between the best bid price and the best ask price. Also called the market bid-ask spread, inside bid-ask spread, or market spread.

Question 11

Limit order book

Answer 11

The book or list of limit orders to buy and sell that pertains to a security.

Question 12

Midquote price

Answer 12

The average, or midpoint, of the prevailing bid and ask prices.

e.g. (100.49 + 98.85)/2 = 99.67

Question 13

Three types of price benchmarks (transaction costs estimation methods)

Answer 13

effective spread
implementation shortfall
VWAP

Question 14

Effective spread

Answer 14

Two times the difference between the execution price and the midpoint of the market quote at the time an order is entered.

Effective spread transaction cost estimate =
for buy orders, Trade size × { Trade price − [(Bid+Ask) / 2] }
for sell orders, Trade size × { [(Bid+Ask) / 2] −Trade price }

Question 15

Price improvement

Answer 15

When trade execution prices are better than quoted prices.

Question 16

Implementation shortfall

Answer 16

The difference between the return for a notional or paper portfolio, where all transactions are assumed to take place at the manager’s decision price, and the portfolio’s actual return, which reflects realized transactions, including all fees and costs.

The prevailing price—also called the decision price, the arrival price, or the strike price—is generally taken to be the midquote price at the time of the trade decision

Question 17

VWAP Transaction Cost Estimates

Answer 17

VWAP is the sum of the total dollar value of the benchmark trades divided by the total quantity of the trades

For buy orders, Trade size * [ Trade VWAP − VWAP benchmark ]
For sell orders, Trade size * [ VWAP ​benchmark − Trade VWAP ]

Analysts typically compute the VWAP using all trades that occurred from the start of the order until the order was completed, a measure that is often referred to as “interval VWAP

Question 18

Market fragmentation

Answer 18

Trading the same instrument in multiple venues

Question 19

Alternative trading systems (ATSs), also known as electronic communication networks (ECNs) or multilateral trading facilities (MTFs)

Answer 19

function like exchanges but do not exercise regulatory authority over their subscribers except concerning the conduct of their trading in their trading systems.

Question 20

High-frequency traders (HFTs)

Answer 20

generally complete round trips composed of a purchase followed by a sale (or a sale followed by a purchase) within a minute and often as quickly as a few milliseconds

Question 21

Low-latency traders

Answer 21

news traders who trade on electronic news feeds and certain parasitic traders.

Parasitic traders are speculators who base their predictions about future prices on information they obtain about orders that other traders intend, or will soon intend, to fill (includes frontrunners)

Question 22

Electronic news traders

Answer 22

subscribe to high-speed electronic news feeds that report news releases made by corporations, governments, and other aggregators of information.

Question 23

electronic order management systems (OMSs)

Answer 23

These systems keep track of the orders that their portfolio managers want to be filled, which orders have been sent out to be filled, and which fills have been obtained.

Question 24

collocation

Answer 24

placing servers in the rooms where the exchange servers operate

Question 25

Trading for market impact

Answer 25

involves trading to raise or lower prices deliberately

Question 26

Wash trading

Answer 26

consists of trades arranged among commonly controlled accounts to create the impression of market activity at a particular price.

Question 27

Spoofing (layering)

Answer 27

trading practice in which traders place exposed standing limit orders to convey an impression to other traders that the market is more liquid than it is or to suggest to other traders that the security is under- or overvalued

Question 28

Bluffing

Answer 28

Bluffing involves submitting orders and arranging trades to influence other traders’ perceptions of value

Question 29

Gunning the market

Answer 29

manipulator generally guns the market by selling quickly to push prices down with the hope of triggering stop-loss sell orders.

Question 30

Squeezing and cornering

Answer 30

In a squeeze or corner, the manipulator obtains control over resources necessary to settle trading contracts. The manipulator then unexpectedly withdraws those resources from the market, which causes traders to default on their contracts, some of which the manipulator may hold