Trading Costs and Electronic Markets Flashcards
Explicit costs
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
Implicit costs
indirect costs caused by the market impact of trading. Impacted by:
1) Bid-ask spread
2) Market impact
3) Delay costs
4) Opportunity costs
Bid-ask spread
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).
Market impact
(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
Delay costs
(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
Opportunity costs
(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.
Dealers
provide liquidity to other traders when they allow traders to buy and sell when those traders want to trade.
Market makers
Bid
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
Ask
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.
Inside spread (market spread)
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.
Limit order book
The book or list of limit orders to buy and sell that pertains to a security.
Midquote price
The average, or midpoint, of the prevailing bid and ask prices.
e.g. (100.49 + 98.85)/2 = 99.67
Three types of price benchmarks (transaction costs estimation methods)
effective spread
implementation shortfall
VWAP
Effective spread
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 }
Price improvement
When trade execution prices are better than quoted prices.
Implementation shortfall
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
VWAP Transaction Cost Estimates
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
Market fragmentation
Trading the same instrument in multiple venues
Alternative trading systems (ATSs), also known as electronic communication networks (ECNs) or multilateral trading facilities (MTFs)
function like exchanges but do not exercise regulatory authority over their subscribers except concerning the conduct of their trading in their trading systems.
High-frequency traders (HFTs)
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
Low-latency traders
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)
Electronic news traders
subscribe to high-speed electronic news feeds that report news releases made by corporations, governments, and other aggregators of information.
electronic order management systems (OMSs)
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.
collocation
placing servers in the rooms where the exchange servers operate
