Transcript Part - IV Types of Orders & Market Structures
Part - IV Types of Orders & Market Structures 1
Introduction to Orders
What is an order?
It is a trade instruction given to a broker or to an exchange.
Whenever a trader wishes to buy or sell a security he needs to place an order It should indicate: What he wishes to accomplish The terms and conditions subject to which he wants his instructions to be carried out.
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Introduction (Cont…)
In order to convey meaningful information to the person who is executing the trade, an order must contain certain basic information.
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Required Information
Firstly the trader needs to indicate as to whether he wishes to place a long or a short position.
For a long position a placed.
buy For a short position a sell be placed.
order needs to be order needs to 4
Required Information (Cont…)
The security that is sought to be bought or sold must be clearly identified.
For instance if we assume that the investor wishes to go long in IBM stock, he should: Place a buy order for IBM shares 5
Required Information (Cont…)
The number of shares that are sought to be bought or sold must be specified.
This is called the Order Size .
To continue with our example let us assume that the investor places a buy order for 200 shares of IBM.
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Required Information (Cont…)
The next critical issue is the price.
Is the trader prepared to accept the best price that is currently available in the market?
If not, if he wishes to buy What is the maximum price that he is willing to pay Else if he is seeking to sell What is the minimum price that he is prepared to accept 7
Required Information (Cont…)
Traders who are prepared to accept the best terms available in the market Place Market Orders Others who wish to place a ceiling or a floor Place Limit Orders The corresponding price ceiling or floor is called the Limit Price .
Let us assume that the investor places a limit buy order with a limit price of $ 595.
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Required Information (Cont…)
Finally the trader needs to specify how long he would like the order to remain valid for in the event of a delay in execution due to the unavailability of a suitable matching order on the other side of the market.
For instance a trader may specify that his order should be either executed on submission or canceled. 9
Required Information (Cont…)
Or he may be prepared to specify a period of time for which he is prepared to wait if a suitable match is not available.
Exchanges will not obviously permit orders to stay alive forever. They will specify a maximum validity period.
Orders which fail to get executed within this period will automatically stand canceled. 10
Required Information (Cont…)
Continuing with our example assume that our investor places a Day Order .
It means that if a suitable match is not found by the end of the day on which the order is entered, it should be canceled. The next issue is Is it acceptable to partially fill the order 11
Required Information (Cont…)
Take the case of the buy order for 200 shares What if a counterparty is found for only 100 shares?
Should the order be partially executed and the remaining order for 100 shares be kept in abeyance until another suitable match is found. If the investor does not wish this to happen he will place an All or None (AON) order.
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Introduction (Cont…)
Orders are the fundamental building blocks of trading strategies.
A proper order issued at the right time can: Make the difference between a profitable trade and a costly trade.
It can at times even make a difference between a trade and no trade.
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Why Orders?
Orders become essential because most investors do not personally arrange their trades.
Thus, in order to ensure that others execute their trades as per their intent, they must specify all relevant information.
Thus it is desirable that they envisage all possible contingencies and prescribe suitable courses of action.
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Revocation
In the event that an investor wishes to modify the terms on which he wishes to trade, he has no option but to cancel his existing order and resubmit a fresh order.
The problem in practice is that by the time a fresh order is issued, market conditions may have changed adversely.
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Revocation (Cont…)
At times, to make matters worse, an existing order may get executed before the trader is able to have it canceled. Thus correct specification is critical.
Speed is the essence in order placement, execution, and cancellation.
Obviously computer based trading systems are superior to manual systems.
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Terminology
When a trader wants to indicate that he wishes to buy a security, he will make a bid .
When he wishes to convey that he is seeking to sell he will make an offer.
When a dealer wishes to trade on his own account he will quote either a bid or an offer.
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Terminology (Cont…)
Whereas if the dealer is trading on behalf of a client, he will convey the buy or sell order placed by the client to a broker or to an automated trading system.
Bids and offers include information not just about the price, but also about the quantity sought to be transacted.
This is known as the order size.
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Terminology (Cont…)
The price specified in a buy order is called: the bid or the bidding price .
The price specified in a sell order is called: the offer, offering, ask, or asking price.
The highest bid price in the market is called the best bid .
The lowest offer price in the market is called the best offer .
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Terminology (Cont…)
The best bid and offer are also known as the Market Bid and Market Offer respectively.
A Market Quotation , often called a Best Bid and Offer (BBO) reports the best bid and offer in the market at a point in time.
The best bid and offer available anywhere in the U.S. at a point in time is known as the National Best Bid and Offer (NBBO).
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Terminology (Cont…)
The difference between the best ask and the best bid is the bid-ask spread .
It is also known as the inside spread , since it is observed within the market.
In England the spread is often referred to as the touch .
Once an order is accepted the price at which the trade is executed is known as the Trade Price. 21
Terminology (Cont…)
An order may not be released for trading as soon as it is submitted.
In practice a broker may need to check whether a particular account is authorized to trade.
Once an order is accepted, but before it is executed, it is known as a Working Order .
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Order Driven Markets
Markets may be classified based on the execution system An execution system is a set of procedures for matching buyers and sellers.
We will first focus on what are called order driven markets.
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Order Driven Markets (Cont…)
What is an order driven market?
It is a market in which buyers and sellers can trade with each other without the intermediation of a dealer.
These markets have specified trading rules which stipulate as to how trades should be executed. 24
Order Driven Markets (Cont…)
There are two sets of rules.
The Order Precedence Rules how buy and sell orders should be arranged and matched.
state as to The Trade Pricing Rules determine the price at which a trade is to be executed.
are used to 25
Order Driven Markets (Cont…)
Most of these markets are Auction Markets.
In these markets the trading rules define the process by which buyers seek the lowest available prices and sellers seek the highest available prices. This is called the Price Discovery Process . 26
Order Driven Markets (Cont…)
Public traders are not the only traders on such markets.
Dealers can also trade.
There are in fact markets where they provide most of the liquidity.
In a pure order driven market however, a dealer is on par with any other public trader.
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Order Driven Markets (Cont…)
Many order driven markets conduct continuous two-sided auctions in which buyers and sellers can continuously attempt to arrange their trades at prices that vary through time.
Such auction markets can be of two types Open outcry systems Electronic rule based systems 28
Order Driven Markets (Cont…)
In an open outcry system also known as an Oral Auction exchange.
traders negotiate face to face on the floor of an The trading rules determine as to who can negotiate and when.
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Order Driven Markets (Cont…)
In an electronic rule based system the trading rules are coded into the order processing software.
There are still some outdated systems where incoming orders are matched manually by clerks. 30
Order Driven Markets (Cont…)
Since these markets employ clearly specified trading rules traders cannot choose with whom they will trade.
In practice, a trader may end up trading with someone with whom he does not have a credit relationship.
To prevent settlement failure, such exchanges employ elaborate procedures to ensure that all traders are creditworthy and trustworthy. 31
Market Orders
In the case of a market order there is no specified price limit.
The execution price for such orders is determined as follows. 32
Market Orders (Cont…)
A market buy order will be executed at the best available price from the standpoint of the trader.
What is the best available price for him?
It is obviously the lowest of the limit prices specified by all those traders who have placed unexecuted limit sell orders prior to the placement of the market order.
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Market Orders (Cont…)
Market sell orders too will get executed at the best available price from the standpoint of the trader.
This will obviously be the highest of the limit prices specified by the traders who have placed unexecuted limit buy orders prior to the incoming market sell order.
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Priority Rules
In order to ensure that market orders get executed at the best available prices, the unexecuted but valid limit orders at any point in time must be sorted according to Priority Rules.
There are two major rules The price priority rule The time priority rule and 35
Priority Rules (Cont…)
The primary priority rule is the Price Priority Rule.
According to this: A limit buy order with a higher limit price ranks higher than all other limit buy orders with lower limit prices.
A limit sell order with a lower limit price ranks higher than all other limit sell orders with higher limit prices. 36
Priority Rules (Cont…)
Thus an incoming market buy order is guaranteed to get executed at the lowest available price on the sell side of the market.
An incoming market sell orders is assured of getting executed at the highest available price on the buy side of the market.
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Priority Rules (Cont…)
The secondary priority rule is the Time Priority Rule.
How should two or more limit buy orders or limit sell orders with the same limit price be prioritized?
Obviously the order which comes in first is automatically accorded priority. 38
Limit Order Books
A Limit Order Book (LOB) at any point in time contains the details of those limit orders which are currently valid, but which have not been executed thus far due to the unavailability of a suitable match. In the earlier days this record was physically maintained in the form of a book of orders.
These days everything is in electronic form.
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Illustration
We will now give a detailed example to illustrate: How orders are arranged on the basis of the priority rules How matching between orders on the opposite sides of the market takes place 40
Illustration (Cont…)
Assume that today is 2 January and that shares of a company have just been listed for trading.
Also assume that in the first 30 minutes the following orders are placed.
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Table-1 Chronological Sequence of Orders
Time Trader
10:01 10:03 10:07 10:10 10:15 10:18 10:20 10:25 10:30 Arvind Beena Charu Dhiraj Ejaz Francis Gauri Harish Leena
Order Side
Buy Buy Sell Sell Buy Buy Sell Sell Buy
Order Size
100 200 200 500 200 400 500 200 500
Limit Price
600.00
600.20
600.10
600.25
600.00
Market 600.00
599.90
599.75
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Illustration (Cont…)
At 10:01 Arvind’s order will enter the system.
It is the very first order so it cannot be matched with an order on the other side.
Since it is a buy order it will go to the top of the buy side of the LOB.
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Table-2 Snapshot of the LOB at 10:01
Buyers
Trader Order Size Limit Price
Sellers
Limit Price Order Size Trader
Arvind 100 600.00
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Illustration (Cont…)
At 10:03 Beena’s order will enter the system. It too cannot be matched because there are no sell orders in the book at that point in time.
So the order will queue up on the buy side. The limit price specified by her which is 600.20 is higher than the price of 600.00 specified by Arvind. So she will get priority. 45
Table-3 Snapshot of the LOB at 10:03
Buyers
Trader Order Size
Beena 200
Limit Price
600.20
Limit Price
Sellers
Order Size Trader
Arvind 100 600.00
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Illustration (Cont…)
At 10:07 Charu’s sell order will enter the system.
It has a limit price of 600.10
It indicates that she is prepared to sell at this price or more.
The system will try and match it with the best buy order in the LOB This is Beena’s order with a limit price of 600.20. 47
Illustration (Cont…)
Obviously a trade is feasible.
Charu has sought to sell 200 shares Beena has sought to buy 200 shares So in the process of execution, both the orders will be completely filled. One question remains At what price will the trade be executed?
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Illustration (Cont…)
On the National Stock Exchange (NSE) an incoming or Passive Active order will get executed at the price of the existing or order with which it is matched. So in this case the trade will get executed at 600.20.
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Table-4 Snapshot of the LOB following the trade
Buyers Sellers
Trader Order Size Limit Price Limit Price Order Size Trader
Arvind 100 600.00
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Illustration (Cont…)
At 10:10 Dhiraj’s sell order will enter the system with a limit price of 600.25. The system will try and match it with the best order on the buy side which has a limit price of 600.00.
Obviously a trade is infeasible.
So Dhiraj’s order will take its place at the top of the sell side of the LOB.
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Table-5 Snapshot of the LOB at 10:10
Buyers Sellers
Trader Order Size Limit Price Limit Price Order Size Trader
Arvind 100 600.00 600.25 500 Dhiraj 52
Illustration (Cont…)
At 10:15 Ejaz’s buy order for 200 shares with a limit price of 600.00 will come in.
It cannot be matched with the best sell order.
In terms of the limit price it will have equal priority with Arvind’s order.
However since it came in later it will be accorded lower priority based on the time priority rule.
Hence it will be placed below Arvind’s order.
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Table-6 Snapshot of the LOB at 10:15
Buyers
Trader Order Size
Arvind 100 Sellers
Limit Price Limit Price
600.00 600.25
Order Size
500
Trader
Dhiraj Ejaz 200 600.00
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Illustration (Cont…)
At 10:18 Francis’ market buy order for 400 shares will come in.
This order is assured of execution if there happen to be one or more orders on the opposite side with a cumulative order size greater than or equal to the size of the incoming order.
In this case there is a sell order for 500 shares.
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Illustration (Cont…)
Thus the incoming order will be fully filled. The trade price will be the price of the passive order which 600.25. 56
Table-7 Snapshot of the LOB following the trade
Trader
Buyers
Order Size
Arvind 100
Limit Price
Sellers
Limit Price
600.00 600.25
Order Size
100
Trader
Dhiraj Ejaz 200 600.00
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Illustration (Cont…)
At 10:20 Gauri’s sell order for 500 shares with a limit price of 600.00 will enter. The system will try and match it with Arvind’s order.
A trade will result for 100 shares.
However 400 shares will remain to be filled on Gauri’s order. 58
Illustration (Cont…)
The system will try and match the remainder of the order with Ejaz’s order A trade will result for 200 shares.
However Gauri’s order will still not be fully filled.
For the balance 200 shares there is no possibility of a match.
So the unfilled portion will stay in the LOB.
It will go to the top of the sell side since Gauri’s limit price of 600.00 is less than the price of 600.25 specified by Dhiraj.
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Table-8 Snapshot of the LOB following the trade
Buyers Sellers
Trader Order Size Limit Price Limit Price
600.00
Order Size
200
Trader
Gauri 600.25
100 Dhiraj 60
Illustration (Cont…)
At 10:25 Harish’s sell order with a limit price of 599.90 will enter. Based on the price priority rule it will go to the top of the sell side of the LOB.
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Table-9 Snapshot of the LOB at 10:25
Trader
Buyers
Order Size Limit Price
Sellers
Limit Price
599.90
Order Size
200
Trader
Harish 600.00
600.25
200 100 Gauri Dhiraj 62
Illustration (Cont…)
At 10:30 Leena’s buy order with a limit price of 599.75 will enter.
The system will try and match it with the best sell order which has a limit price of 599.90.
Obviously a trade is infeasible.
The incoming order will therefore go to the top of the buy side of the LOB.
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Table-10 Snapshot of the LOB at 10:30
Buyers Sellers
Trader
Leena
Order Size
500
Limit Price Limit Price
599.75 599.90
600.00
600.25
Order Size
200 200 100
Trader
Harish Gauri Dhiraj 64
Question
What would happen if a market order were to enter the system and there were to be no limit orders on the opposite side. Every exchange will specify a solution for this eventuality. On the NSE if this kind of a situation were to occur during the course of a business day then The incoming order will become a limit order with a limit price equal to the last recorded trade price.
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Table-11 The LOB at a Particular Instant
Trader
Buyers
Order Size Limit Price Limit Price
599.90
Sellers
Order Size
200
Trader
Harish 600.00
600.25
200 100 Gauri Dhiraj 66
Question (Cont…)
Assume that the last recorded trade took place at a price of 599.80.
Assume that a market sell order for 500 shares placed by Raghu enters the system.
Obviously a suitable match cannot be found.
The incoming order will therefore be converted to a limit sell order with a limit price of 599.80.
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Table-12 Post Submission Snapshot of the LOB
Trader
Buyers
Order Size Limit Price
Sellers
Limit Price
599.80
599.90
600.00
600.25
Order Size
500 200 200 100
Trader
Raghu Harish Gauri Dhiraj 68
Question (Cont…)
A related question would be What if a market order were to enter the system at the start of a trading day and there were to be no limit orders on the other side.
The incoming order in such cases will be converted to a limit order with a limit price equal to the previous day’s closing price.
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Market Orders versus Limit Orders
Isn’t a limit order a more sensible alternative to placing a market order?
After all it gives the investor more control over the trade.
The answer is that while it is true that traders can control the execution price using limit orders, there is no guarantee that a suitable match for such orders can be found within a reasonable period of time.
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Market…(Cont…)
For instance assume that the last trade price was 600.20 and the order book at a point in time looks as follows.
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Table-13
Trader
Arvind Buyers
Order Size
100
Limit Price
600.00
Sellers
Limit Price
600.25
600.30
600.30
600.40
600.50
600.50
Order Size
500 300 1,700 1,500 1,000 1,000
Trader
Dhiraj Solomon Suniti Sunil Kumar Swamy 72
Market…(Cont…)
Assume that Ejaz places a buy order for 200 contracts with a limit price of 600.00.
It cannot be matched with an existing order.
So it will take its place in the queue behind Arvind’s order.
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Table-14 Snapshot of the LOB after Ejaz’s Order
Buyers
Trader Order Size
Arvind 100 Ejaz 200 Sellers
Limit Price Limit Price
600.00 600.25
600.00 600.30
600.30
600.40
600.50
600.50
Order Size
500 300 1,700 1,500 1,000 1,000
Trader
Dhiraj Solomon Suniti Sunil Kumar Swamy 74
Market…(Cont…)
Now assume that Simeran places a market buy order for 1,500 shares.
It will obviously get executed immediately.
500 shares will be bought at 600.25
1000 shares will be bought at 600.30
So the last reported trade price will be 600.30.
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Trader
Arvind Ejaz
Table-15 Snapshot of the LOB following the trade
Buyers
Order Size
100 Sellers
Limit Price Limit Price
600.00 600.30
Order Size
1,000 200 600.00 600.40
600.50
600.50
1,500 1,000 1,000
Trader
Suniti Sunil Kumar Swamy 76
Market…(Cont…)
Now assume that another market order is placed for 1500 shares by Rahul.
It too will get executed.
1000 shares will get traded at 600.30
And 100 shares at 600.40.
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Table-16 Snapshot of the LOB following the second trade
Trader
Arvind Buyers
Order Size
100 Sellers
Limit Price Limit Price
600.00 600.40
Order Size
1,000
Trader
Sunil Ejaz 200 600.00 600.50
1,000 Kumar 600.50
1,000 Swamy 78
Market…(Cont…)
Seeing the market price jump from 600.20 to 600.40 in a short span, other traders wishing to place buy orders may be induced to place limit orders with prices higher than that of the best order on the buy side.
Assume that Pooja places a buy order for 500 shares at 600.10
Followed by Ajay who places a buy order for 1,500 shares at 600.15.
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Table-17 The LOB at the End
Trader
Ajay Pooja Arvind Ejaz Buyers Sellers
Order Size
1,500 600.15 600.40 1,000 500 100
Limit Price Limit Price Order Size
600.10 600.50 1,000
Trader
Sunil Kumar 600.00 600.50 1,000 Swamy 200 600.00
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Market…(Cont…)
As can be seen Ejaz’s order has been pushed back in the queue. There is no way of telling when it will get executed There is no guarantee that it will get executed at all.
Had Ejaz placed a market order instead at the outset it would have been immediately executed at 600.25.
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Market…(Cont…)
Thus market orders are guaranteed to be executed if there are sufficient limit orders on the other side But the trader has no control over the execution price.
This is because the trade price will depend on the limit price of the matching limit order.
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Marketable Limit Orders
The odds of a limit order being executed on submission would depend on its limit price.
For buy orders, the higher the limit price the greater is the chance of early execution.
For sell orders, the lower the limit price the greater is the chance of early execution.
Limit buy orders with high prices and sell orders with low prices are said to be Aggressively Priced .
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Marketable…(Cont…)
In most cases: Limit buy orders will be placed at a price lower than the best available price in the market Which is the price of the best sell order in the LOB Limit sell orders will be placed at a price higher than the best available price in the market Which is the price of the best buy order in the LOB 84
Marketable…(Cont…)
Sometimes however a trader could price his limit order very aggressively.
A limit order is said to be marketable if it can be executed on submission.
We will illustrate it using an example.
Consider the following LOB.
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Table-18 Snapshot of an LOB
Trader
Anil Buyers
Order Size
500 Sellers
Limit Price Limit Price
600.00 600.25
Order Size
1300 Ashraf Mohan 1000 1500 599.90 600.40
599.75 600.50
1200 1500
Trader
Prasad Ahmed Kumar 86
Marketable…(Cont…)
A limit buy order with a limit price of 600.25 or more will get executed as soon as it enters the system.
A limit sell order with a limit price of 600.00 or less will be executed as soon as its enters the system.
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Marketable…(Cont…)
So the limit price for a marketable buy order: Must be greater than or equal to the best available offer The limit price for a marketable sell order must be less than or equal to the best bid.
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Marketable…(Cont…)
A marketable limit order seems fairly similar to a market order The question is: Why would anyone wish to place a marketable limit order instead of a market order?
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Rationale
Both market orders as well as marketable limit orders embody a desire for quick execution on the part of the trader.
But in the case of a market order he has no control over the execution price In the case of a marketable limit order he can specify a floor or a ceiling. 90
Rationale (Cont…)
When is this freedom to specify a floor or a ceiling likely to prove valuable?
It will be significant if circumstances were to preclude a marketable limit order from getting executed as planned.
Let us go back to Table-18.
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Table-18 Snapshot of an LOB
Trader
Anil Buyers
Order Size
500 Sellers
Limit Price Limit Price
600.00 600.25
Order Size
1300 Ashraf Mohan 1000 1500 599.90 600.40
599.75 600.50
1200 1500
Trader
Prasad Ahmed Kumar 92
Rationale (Cont…)
Assume that a trader named Ravi issues a limit buy order with a limit price of 600.30 for 300 shares.
His expectation at the time of placing the order is that: It will get matched with the best offer which is at 600.25
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Rationale (Cont…)
But it may so happen that another market order may enter the system before Ravi’s order.
Traders throughout the country (world) are monitoring the situation A split second’s delay in order entry can lead to another order (s) acquiring time priority.
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Rationale (Cont…)
Let us assume that a large market buy order for 3000 shares enters prior to Ravi’s order.
It will push the trade price up to 600.50.
Since Ravi has specified a limit of 600.30
His order will not be executed Instead it will go to the top of the LOB on the buy side 95
Rationale (Cont…)
If Ravi believes that the execution price is important although the speed of execution is a major factor He may prefer a marketable limit order to a market order In this case had he placed a market order it would have got executed at 600.50, an outcome that may not be satisfactory.
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Rationale (Cont…)
Thus marketable limit orders give the trader control over the execution price But there is execution uncertainty.
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Limit Orders as Options
A standing limit order is an offer of liquidity to other traders.
It gives them an option to trade at the limit price.
A limit sell order is a call option traders the right to buy.
A limit buy order is a put option other traders the right to sell.
that gives other that gives 98
Options (Cont…)
The specified limit prices are the exercise prices of the corresponding options.
However although a limit order represents an option, it is not an options contract in the conventional sense.
An options contract is an option to trade that is sold by a writer to a buyer in return for a price or premium.
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Options (Cont…)
Limit orders however are options given away for free.
In the sense that the traders who place such orders do not receive a premium.
Besides there is no exclusive owner of the option on the other side.
For any trader can exercise the option by placing a market order or a marketable limit order.
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Compensation for Traders Placing Limit Orders
A trader who places a limit order does not get an option premium even though the order represents an option.
So why should the trader offer an option for free?
The answer is that the trader hopes to trade at a better price.
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Compensation…(Cont…)
A buyer who has submitted a standing limit order Expects to buy at the bid price represented by his order Had he submitted a market order instead He would have to buy at the ask price Consider the following LOB 102
Table-19 Snapshot of the Petronet LOB
Buyers Sellers
Trader
Vivek Vikas Vinod Vijay Vinay
Order Size
500 1000 1500 1000 1500
Limit Price
20.85
20.80
20.75
20.70
20.65
Limit Price
20.95
21.05
21.15
21.20
21.15
Order Size
1300 1200 1500 2000 1000
Trader
Usha Uma Urmila Urvi Uttara 103
Compensation…(Cont…)
The trader who has placed the best bid expects to trade at 20.85.
Had he placed a market order instead He would have ended up buying at 20.95 104
Problems with Limit Orders
A trader placing a limit order will not always get what he is seeking.
Sometimes the market could move away from him The consequence will be that his order never gets traded 105
Problems…(Cont…)
If he still wants to trade he will have to chase the market Bidders will have too increase their bids Sellers will have to lower their offers Thus the price at which he ultimately trades may be worse than the price that he would have traded at had he used a market order at the outset.
106
Illustration
Take the case of the trader who has placed the best bid for Petronet at 20.85.
Assume that a market order for 3000 shares comes in and get executed.
The best ask will become 21.15.
Also assume that new limit buy orders come in at 20.90 and 21.00.
107
Illustration…(Cont…)
If after observing this our trader were to cancel his limit order and either place a fresh limit order at 21.00 or else place a market order which will then get executed at 21.15
The eventual price will be worse than 20.95
Which is the price he would have got had he used a market order at the outset.
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Risks
Traders who use limit orders face two kinds of risks.
The first pertains to execution uncertainty. When prices move away from their orders limit order traders will fail to trade For instance in the case of Petronet, if market buy orders keep entering The best offer will move up from 20.85
From the point of view of a trader who has placed a buy order at 20.65
The odds of execution will be reduced.
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Risks (Cont…)
The second risk is that a trader may end up trading and may subsequently regret it.
This will be the case if the price moves towards and through his limit price.
His order will obviously get executed.
But if the market continues to move sharply against him he could make significant losses.
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Risks (Cont…)
For instance, in the case of Petronet, assume that a market sell order for 4000 shares comes in It will cause a buy order for 1000 shares at 20.70 to get executed.
If the price were to keep declining The buyer may have to offload the shares subsequently at an even lower price 111
Risks (Cont…)
This is called ex-post regret .
This kind of regret is an occupational hazard for all traders and not just those who place limit orders.
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Stop-Loss Orders
What is a Stop-Loss order?
A stop or a stop loss order is an order placed by a trader who has a position in the market and would like to cut his losses and quit immediately if the conditions were to turn adverse.
Such a person may have no desire to close out his position at the time of placing his order.
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Stop-Loss Orders (Cont…)
Take the case of an investor who is long in a stock and expects the price to rise.
However if there were to be a sudden unanticipated decline in the market he may like to ensure that his loss does not exceed an acceptable level.
Let us assume that his threshold loss corresponds to a price of P * .
114
Stop-Loss Orders (Cont…)
In this case he can place a stop order with a trigger price of P * The stop instruction will prevent the order from getting activated until and unless the trigger is hit or breached.
Once the trigger is hit or breached the order will get triggered off and will become a market order.
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Table-20 LOB prior to the placement of a stop sell order
Trader
Aarti Anita
Aakanksha
Anamika Anushua Anjali Buyers
Order Size
1200 1000 500 800 500 1000
Limit Price
600.00
599.85
599.75
599.55
599.25
598.00
Limit Price
600.20
600.30
600.35
600.40
600.50
602.00
Seller
Order Size
500 1000 500 700 300 1000
Trader
Arvind Anurag Amitabh Arjun Ajay Avinash 116
Illustration (Cont…)
Assume that Vijay is currently long in 800 shares.
He has no intention of selling.
However if the market were to trade at 599.60 or below then he would like to exit the market immediately.
He can therefore place a stop sell order with a trigger price of 599.60.
117
Illustration (Cont…)
Assume that a market sell order for 4000 shares comes in.
It will ensure that Aarti’s, Anita’s, Aakanksha’s, Anamika’s, and Anushua’s orders are fully filled. The last trade price will be 599.25
This is less than Vijay’s trigger.
So his order will get activated and will get executed at 598.00.
118
Illustration (Cont…)
The trigger price in the case of a stop sell order will always be less than the best price that is available at the time of placing the order Which in Vijay’s case is 600.00 119
Stop Orders (Cont…)
Such orders can also be used by those who wish to buy in the event of adverse market conditions.
Assume that Rajiv has a short position in 800 shares.
He expects the market to fall.
However if the price were to rise and hit or cross 600.50, then he would like to offset his short position and exit the market.
120
Stop Orders (Cont…)
Assume that Rajiv places a stop buy order with a trigger of 600.50.
Assume that a market order for 3000 shares enters.
Arvind’s. Anurag’s, Amitabh’s, Arjun’s, and Ajay’s orders will be completely filled. The last trade price will be 600.50 which corresponds to Rajiv’s trigger. 121
Stop Orders (Cont…)
The stop buy order will get activated and will get executed at 602.00.
In the case of stop buy orders the trigger price will always be greater than the best price available in the market which is 600.20.
122
Stop-Limit Orders
Such an order also is an instruction to hold the order in abeyance until a specified trigger is hit or breached.
The difference is that in this case if the order is triggered off it will become a limit order.
Thus two threshold prices have to specified.
The first corresponds to the activation level order The second is the limit price for the limit for the limit order.
123
Stop-Limit Orders (Cont…)
Why do we need such orders?
Take Vijay’s case first.
His sell order got executed at 598.00 even though he had specified a trigger of 599.60.
He obviously had no control over the execution price Because the order became a market order on activation.
124
Stop-Limit Orders (Cont…)
If Vijay wanted to protect himself against such an eventuality he could have placed a stop limit order with a trigger price of 599.60 and a limit price of say 599.25.
In this case if the stop order is activated it will become a limit order at 599.25.
So Vijay is assured of a price of 599.25.
125
Stop-Limit Orders (Cont…)
Similarly when Rajiv placed a stop buy order it eventually got executed at 602.00 even though the specified trigger was 600.50. To protect himself he could have specified a stop-limit order with a trigger of 600.50 and a limit price of say 601.
In this case he will have to pay a maximum price of 601.
126
Market Impact
Large market orders are more difficult to fill than small ones and often result in large price moves. If there is a large buy order prices may move up substantially.
If there is a large sell order prices may move down substantially. 127
Market Impact (Cont…)
The movement in price due to a large order is called the Market Impact or the Price Impact of the order.
Take the case of the following LOB.
128
Table-20
Trader
Aarti Anita Aakanksha Anamika Anushua Anjali Buyers
Order Size
1200 1000 500 800 500 1000
Limit Price
600.00
599.85
599.75
599.55
599.25
598.00
Limit Price
600.20
600.30
600.35
600.40
600.50
602.00
Seller
Order Size
500 1000 500 700 300 1000
Trader
Arvind Anurag Amitabh Arjun Ajay Avinash 129
Illustration (Cont…)
A large market buy order for 4000 shares would get executed at prices ranging from 600.20 to 602.00.
A large market sell order for 5000 shares would get executed at prices ranging from 600.00 to 598.00
130
Lot Size
The usual unit of trading is referred to as a Round Lot . Normally traders trade in multiples of a round lot.
Anything less than a round lot is an odd lot.
The definition of a round lot depends on the instrument being traded and the market on which it trades.
131
Lot Size (Cont…)
On the American Stock Exchange, there is no no standard lot size, and a trade can be for any number of shares.
Most stock exchanges in the U.S. specify a round lot as constituting 100 shares.
In Japan a round lot is equivalent to 1000 shares .
132
Time Conditions
Traders specify validity instructions to indicate the period of validity of their orders.
They also specify expiration instructions to indicate as to when and how their orders become void.
In principle such instructions can be specified for any kind of an order.
133
Time Conditions (Cont…)
But these conditions are particularly important for standing limit orders and stop orders.
This is because such orders rarely trade on submission, and some may never trade.
Consequently there is a need to specify what is to be done with unfilled orders.
134
Open & Good Orders
An order that that has not yet been executed or canceled is an open order.
An order that is eligible for execution is a good order.
All good orders by definition are open orders.
But every open order need not be a good order.
135
Open & Good Orders (Cont…)
Consider an order placed on 1 July to buy a stock on or after 3 July.
On 1 July the order is an open order.
But is not a good order.
136
Day Orders
A day order is valid only for the duration of the day on which it is entered.
If it is not executed during the course of the day, then the system will automatically cancel it at the end of the day.
As of 1999 the Stock Exchange of Singapore has been permitting only `good today’ limit orders.
137
Day Orders (Cont…)
Every morning the Exchange opens with no outstanding orders carried over from the previous day.
138
Good Till Canceled Orders
Such orders will remain in the system until they are executed or canceled, whichever happens first.
So if they are not executed on the day on which they are entered, they will be carried over to the next day and so forth.
But obviously they cannot remain in the system indefinitely.
139
GTC Orders (Cont…)
The exchange will notify a maximum time period after which such orders will be automatically canceled. In order to ensure that traders do not forget such orders, many brokers provide their clients with a list of unfilled GTC orders at the end of every month.
140
GTC Orders (Cont…)
Some brokers cancel GTC orders after pre-specified time periods to avoid the cost of keeping track of stale orders.
In the U.S GTC orders expire semi annually unless canceled earlier.
That is, they have a maximum validity of six months.
141
Good Till Days Order
In the case of such orders, the investor has to specify the number of days for which the order can stay in the system unless it is executed.
The number of days that can be specified obviously cannot exceed the time limit set for Good Till Canceled orders.
142
GTD Orders (Cont…)
Special cases of such orders are Good this-week (GTW) orders and Good-this month (GTM) orders.
Not all brokers will accept such orders because it requires then to keep track of expiration dates.
143
Immediate or Cancel Orders
Such orders have to be executed as soon as they are released into the system or else they have to be canceled.
Sometimes only a partial match may be found.
If so, a part of the order will be executed and the unmatched portion will be immediately canceled.
They are also known as Fill or Kill (FOK) orders or as Good-on-sight orders.
144
Other Types of Orders
Good-after-orders become valid only after a pre-specified date.
are activated or Market-on-open only at the beginning of the trading session.
orders can be filled Market-on-close orders can be filled only at the close of the trading session.
145
Quantity Instructions
All-or-nothing or all-or-none (AON) orders must be either filled all at once or else remain unexecuted. There are also trades with a minimum or none instruction.
In such cases multiple trades can be used to fill an order.
146
Quantity (Cont…)
But each trade must be for a quantity that is greater than or equal to a specified minimum size.
Such orders are also known as Minimum Acceptable Quantity (MAQ) orders.
147
Tick Size
What is a tick?
It is the minimum price increment or variation observable in the market.
In other words, it is the smallest amount by which two prices can differ.
It is usually set by exchange regulations.
148
Tick Size (Cont…)
In the U.S. until 2000 the tick size was one-sixteenth of a dollar or 6.25 cents.
Subsequently the system has been decimalized and tick size is now 0.01 dollars or one cent.
The tick size on the Tokyo Stock Exchange is a function of the price.
149
Tick Size (Cont…)
P
Price
2000 Yen 2000 < P 3000 3000 < P 30000 < P 30000 50000 50000 < P 100000 100000 < P P 1000000 1000000
Tick Size
1 Yen 5 Yen 10 Yen 50 Yen 100 Yen 1000 Yen 10000 Yen 150
Tick Size (Cont…)
Traders classify prices by their relation to previous prices.
A price is said to be on an uptick if it is higher than the last observed price.
A price is said to be on a downtick if it is lower than the last observed price.
If a price is equal to the last observed price it is said to be on a zero tick.
151
Tick Size (Cont…)
Zero tick prices are further classified depending on the last different price observed.
A price is said to be on a zero downtick if the last different price observed was higher.
A price is said to be on a zero uptick if the last different price observed was lower.
152
Illustration
Previous to Last Price
72.00
Last Price Current Price
72.00
72.10
72.00
72.10
72.00
72.00
71.90
72.00
71.90
72.00
72.00
Term
Uptick Downtick Zero Downtick Zero Uptick 153
Oral Auctions
Many futures, options, and stock exchanges use continuous bilateral oral auctions to trade their contracts and securities.
The largest such market is the market for T-bond futures on the CBOT which attracts 500 floor traders.
In an oral auction traders meet face to face on the floor of the exchange.
154
Oral Auctions (Cont…)
Some will cry out their bids while others will call out offers.
Still others will listen for bids and offers that meet their requirements.
Most traders will do both – shout as well as listen.
155
Oral Auctions (Cont…)
Trades occur when a buyer accepts a seller’s offer or when a seller accepts a buyer’s bid.
In the first case the buyer will shout ` take it ’ to accept the offer.
In the second case the seller will call out ` sold ’ to accept the bid. 156
Oral Auctions (Cont…)
Buyers and sellers often take turns bidding and offering until they agree on a price and quantity to trade.
A trader who makes a bid or an offer to trade is a supplier of liquidity.
A trader who accepts a bid or an offer is an acceptor of liquidity. 157
Oral Auctions (Cont…)
The first rule of an oral auction is the open-outcry rule. That is, a trader must publicly express his bid or offer to enable others to react.
Any trader can accept a bid or ask called out by another trader, even though they may not be actively negotiating at that point of time.
158
Oral Auctions (Cont…)
The first person to accept a bid or an offer generally gets to trade.
The order precedence rules determine who can bid or offer, as well as whose bids or offers other traders can accept. The primary order precedence rule is always price priority.
159
Oral Auctions (Cont…)
The secondary order precedence rule would depend on the market concerned. Futures markets go by time preference. Stock markets use public order preference followed by time preference. 160
Price Priority
The rule gives precedence to traders who offer the best prices. Buyers can only accept the lowest offers and sellers can only accept the highest bid.
This rule is self-enforcing.
Because an honest trader will search for the best prices.
161
Price Priority (Cont…)
Most oral auctions will not allow a trader to bid below the best bid or offer above the best offer.
Such bids and offers only add to the noise and create confusion.
However a trader can improve the best bid by bidding higher.
A trader can similarly improve the best offer by offering at a lower price.
162
Time Priority
The time precedence rule gives precedence to the trader whose bid or offer improves the current best bid or offer.
When a trader is having time preference no trader can bid or offer at the best bid or offer that is currently available.
163
Time Priority (Cont…)
A trader will retain his time preference until another trader improves his quote or until another trader accepts his quote.
Once a bid or offer is accepted, anyone may bid or offer at the new price and all orders at that price have equal standing.
164
Priority
In an oral auction bids or offers are valid only for an instant.
In practice traders maintain their precedence by repeating their bids/offers as often as is necessary to show that they remain interested.
In a large active market, a trader may continuously repeat his bid/offer.
165
Time Priority (Cont…)
The time precedence rule encourages competition among traders.
Because if a trader is aggressive the only way that he can get ahead of someone who has time precedence is by improving the price.
And if he improves the price he automatically gets the right to trade first.
166
Time Priority (Cont…)
Unlike price priority time priority is not self enforcing. Most traders do not care whose bid or ask they are accepting as long as they get the best price.
Thus a person with time preference must defend it when someone improperly tries to quote at the same price.
167
Time Priority (Cont…)
In practice a trader whose priority is being challenged will yell out: ` That’s my bid’ or `That’s my offer’ or `That’s my market’ 168
Public Traders
Some equity exchanges prohibit members from trading ahead of a public trader who is willing to trade at the same price.
Why is this rule required?
An exchange member can easily acquire time preference at a new price before a public trader, because he sees price changes first and can quote faster than a public trader can submit orders.
169
Public Traders (Cont…)
Thus this priority rule permits a public trader to take precedence over a member even when the member has time preference.
The objective is to give public traders greater access to the market and weaken the information advantage possessed by the floor trader.
170
Trade Pricing Rule
This is used to determine the price at which a trade is accepted.
In an oral auction every trade takes place at the price proposed by the trader whose bid or offer is accepted.
171