TRADING COSTS AND ELECTRONIC MARKETS

Question 1

Describe whats the meaning of Inside Spread

Answer 1

Inside spread = difference between the best ask and the best bid

Question 2

Identify the different types of benchmark to evaluate implicit cost of a trade.

Answer 2

Effective spread, VWAP and implementation shortfall

Question 3

How do we calculate the effective spread

Answer 3

Effective spread transaction cost = side * (transaction price - mid quote)

Effective spread= Effective spread transaction cost * 2

Question 4

Identify the limitation of the effective spread benchmark

Answer 4

• Doesnt take into account market impact cost when a bid trade is split into smaller trades
• doesnt take into account slippage cost
• Effective spread doesnt take into account opportunity cost

Question 5

Identify the factors that drive the development of electronic trading systems

Answer 5

Remember CACAF

Cost : they are cheaper

Accuracy : perform exactly how they are programmed to perform

Continious market : dont need to take break

Audit trails : generate and maintain record

Fraud prevention : keep hidden orders hidden

Question 6

Explain market fragmentation and how we can overcome the challenges behind it

Answer 6

Market Fragmentation : When security trades on multiple market and doesnt have the same liquidity

How to overcome it :

1. Smart orders routers : try to find the markets with the best prices and sizes
2. Liquidity aggregation algorithms : Creates a super book that shows the different liquidity in all markets.

Question 7

Identify types of electronic traders

Answer 7

BAND F Q

1. Electronic new traders : trade on news. trade fast.
2. Electronic dealers : They offers bids and ask to profit from spread.

3, Electronic arbitrageurs : trades in multiple markets to profit from price discrepancies (they do long/short portfolio to minimize risk)

4. Electronic front runners : Use artificial intelligence to search for large trade and then will act before the large trade settle to profit from the market impact cost of the large trade.
5. Electronic quote matchers : they profit from standing order on the market to reduce their risk
6. Buy-side trader : execute trade on behalf of their portfolio managers.

Question 8

Explain how traders can minimize latency associated with communication speed

Answer 8

1. Invest in latest and fastest communication technology
2. Be as close as possible to the exchange

Question 9

Explain how traders can minimize latency associated with computation speed

Answer 9

1. Using the best hardware

Question 10

Explain what are discretionary orders

Answer 10

Limits orders that have a +/- amount specified to the exchange. If an order is at 19.03, it may get uncovered if a limit order is being placed at 19.01

Question 11

Identify the impact on how electronic trading has changed the way traders devise their trading strategies.

Answer 11

FLEMH

1. Flickering quotes : Place an exposed limit order to cancel it almost immediately. Used by traders not wanting other traders to profit from standing limit order (electronic quote matchers)
2. leapfrog : Dealers that wants to have the best bid or ask.
3. Electronic arbitrage : take liquidity on both side or just one side.
4. Machine learning :
5. Hidden orders : Limit orders that are hidden from the market, except the exchange.

Question 12

Describe the different risks associated with electronic tradings

Answer 12

FORMH

High frequency traders arms race : To be competitive, you need to buy the latest and fastest technology. increase cost.

Systematics risk :

Runaway algorithms : Produce a series of unintended orders.

Fatfingers : Input errors

Overcharge orders : Demand liquidity significantly higher than what is available in the market.

Malevolent orders : Orders to manipulate the markets.

Question 13

Describe abusing practices that real time surveillance of markets may detect.

Answer 13

Front Running : Try to seek for large trades orders and trade before it gets settle so he can profit from market impact cost. Not consider illegal if the information use to seek the large trade was not obtained improperly.

Market manipulation :

• Trading for market impact : Trades designed to change the price of the securities, to influence other trader perception of value.
• Rumormongering : Putting false information out there to affect traders value assessment.
• wash trading : Trade between commonly controlled account to create false impression of liquidity.
• Spoofing or layering : Fake limit order posted to create fake optimism or pessimism about the security.

Bluffing : Posting order to influence momentum traders perceived value.

Gunning the market : Forces other traders into bad trade. Rapid short selling of a stock to try to trigger stop-loss orders to repurchase the trade at the stop loss price.

Squeezing and cornering