The Soton Quants 3-part Trading Series begins with electronic markets.
Learn the effects of market microstructure on high-frequency trading and large trades.
4. Trading theory
series
Overview
● High level introductions
● Quant trading topics
● Part 1: Electronic markets
● Part 2: Portfolio optimisation
● Part 3: Trading costs
6. A market matches buyers and sellers
Markets to trade assets come in many forms
● Southampton Free & For Sale facebook page
● Shouting across the trading floor or down the phone
● London Stock Exchange
A good market provides
● A fair price
● Low cost
● Liquidity
● Transparency?
8. Stock exchanges become more automated
1971
NASDAQ opens
Electronic quote
system
1976
NYSE DOT
Broker sends
electronic orders
to floor
1987
NASDAQ SOES
Investors send
electronic orders
2001
NYSE Direct+
Automated
electronic
trading system
9. Know the market to trade successfully
● Trading algo success depends on market structure
● Understand impact of liquidity
● Understand impact of spreads
● Understand impact of trading costs
These are especially relevant to:
● Very large trades
● High frequency trading (HFT)
12. Asset types and participants
● Ordinary shares
● Corporate bonds
● Government bonds
● FX
● Commodities
● Real estate
● Derivatives: futures/options
● Swaps
● Mutual funds
● ETFs
● Companies (IPOs)
● Shareholders
● Company directors
● Mutual funds
● ETFs
● Hedge funds
● Prop traders
● Day traders
● Retail investors
● Market makers
13. Different motivations to participate
Fundamental: not driven by the market, long term
● Hedging (manufacturers, production, etc.)
● Futures / options as insurance
● Government intervention (QE, currency, buy/sell assets)
Proprietary: acts on current market information
● Hedge funds
● Day traders
● “Prop shops”
Market makers: facilitate a market in order to make money
15. Visualising the state of the LOB
£79.51£79.52
£79.53
£79.54
£79.55£79.56
£79.57
£79.58
£79.59£79.60
£79.61
£79.62
£79.63£79.64
£79.65
£79.66
BIDS ASKS
16. Visualising the state of the LOB
£79.51£79.52
£79.53
£79.54
£79.55£79.56
£79.57
£79.58
£79.59£79.60
£79.61
£79.62
£79.63£79.64
£79.65
£79.66
Bid price
Mid-price
Ask price
17. New LOs arrive and are matched
£79.51£79.52
£79.53
£79.54
£79.55£79.56
£79.57
£79.58
£79.59£79.60
£79.61
£79.62
£79.63£79.64
£79.65
£79.66
18. New LOs arrive and are matched
£79.51£79.52
£79.53
£79.54
£79.55£79.56
£79.57
£79.58
£79.59£79.60
£79.61
£79.62
£79.63£79.64
£79.65
£79.66
19. New LOs arrive and are matched
£79.51£79.52
£79.53
£79.54
£79.55£79.56
£79.57
£79.58
£79.59£79.60
£79.61
£79.62
£79.63£79.64
£79.65
£79.66
20. New LOs arrive and are matched
£79.51£79.52
£79.53
£79.54
£79.55£79.56
£79.57
£79.58
£79.59£79.60
£79.61
£79.62
£79.63£79.64
£79.65
£79.66
Matched
21. Visualising the state of the LOB
● Best bid and ask price define the spread
● Liquid = small spread
● Price is discrete (tick)
● Tick price is smallest spread
● Limit orders are posted to book
● Limit orders are matched
● Buys always higher than asks
25. Matching via price-time priority
● Best price (highest for bid, lowest for ask) has priority
● Earlier orders have priority
● Market orders before limit orders
● Many other possible matching systems
○ E.g. auctions
29. Order types
● Limit orders
○ Passive
○ Liquidity providing
○ Guaranteed price - undetermined time
● Market orders
○ Aggressive
○ Liquidity taking
○ Immediately matched - undetermined price
○ Effective price
● Many more order types
● Orders may be rerouted
○ Regulation
● Fees charged for different orders (distorts market prices)
30. Market technology
● Book can be lit or dark
● Getting a direct feed:
○ Speed critical
○ Length of cable critical (firm location)
○ Large cost for direct feed $$$
○ Larger cost for colocation $$$$$$$
● A technology race for participants
33. Visualising betting strategies in LOB Data
K. Croxson & J. Reade. “Information and efficiency: goal
arrival in soccer betting”. The Economic Journal 124. (2007)
43. Market makers function
● Provides liquidity
● Takes on the risk of price movements
● Profits from offering a spread
● Averse to holding assets
● Large institutions
● HFT often used
44. Grossman-Miller Model solution
An agent wants to sell ‘X’ shares - what price do ‘N’ MM’s offer for their risk?
● MM will only buy assuming a subsequent sell
● MM will ask for a premium to compensate risk of price movements
● Agent is price sensitive -> won’t sell all shares above fair price
45. Grossman-Miller Model solution
An agent wants to sell ‘X’ shares - what price do ‘N’ MM’s offer for their risk?
● MM will only buy assuming a subsequent sell
● MM will ask for a premium to compensate risk of price movements
● Agent is price sensitive -> won’t sell all shares above fair price
In equilibrium:
46. Is HFT good?
Does it damage markets?
Does it improve efficiency?
Many more open questions...
47. That’s all!
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In 2 weeks:
Part 2 - Portfolio optimisation
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