HOW TRADEREX WORKS

TraderEx is designed to be a learning tool. With it, you can learn about trading, and you can find out whether or not you are cut out to be a trader. You can also gain much insight into the dynamic behavior of a marketplace that is noted for its complexity, its intrigue, and its enormous importance to the broad economy: the marketplace where already issued equity shares are traded. And there is something else. You can have fun, for TraderEx is, all said and done, a game.

At the end of a simulation run you find out how well you have done. If you were given an order to work, did you get the job done? Did you buy at low prices and sell at high prices? Did you follow a prudent course or did you take excessive risk? What was your profit or loss? After finding out how well you have done, you sit back, smile, and then go back and trade some more. There is nothing to worry about, your bank account will not be affected by how much you have won or lost. You are only playing with simulated dollars.

TraderEx has played a major role in various courses that we teach in business school programs. The simulation has also been put to good use in seminars and training programs that we have conducted for industry participants including trading managers, regulatory officials, and stock exchange executives. We have run simulations in labs and classrooms with college undergraduates, with MBAs with PhDs, with new industry recruits, and with seasoned industry professionals. After a short introduction, we get them started. One step at a time, the greenhorns learn how to read the TraderEx screen, they find out how to enter orders and, before they know it, they are in the middle of a market trading. We show them the close correspondence between the TraderEx simulation and the real stock markets. The software is easy to use, but the beginners soon realize that successful outcomes are not a given, and that acquiring trading skills requires thought and effort. Seasoned professionals already know this.

A simulation run typically takes twenty minutes. In our training sessions, we introduce a simulation, talk about its parameters and market structure, and then turn the class loose. After a run, we discuss the results and then move on and launch another one. The participants learn by repetition. They generally begin the program quietly, focusing intently on their screens. With practice, they ease into it, they get more excited, and some of them start making noise. Exclamations of victory can be heard along with the cries of defeat. The words, “Hit me, hit me” are shouted out, along with “Come on, dude, where are you!” That is what we want. A simulation session is not just learning by talk and by lecture, it is learning by doing, and doing calls for engagement.

WHO THIS BOOK IS FOR

Investing is a traditional topic in financial economics. Trading, the implementation of an investment decision, is now receiving serious attention in academia. Trading is a solid topic for two business school subjects in addition to finance: computer information systems and economics. Students in computer information systems gain valuable experience with market concepts and the role of information technology in operating a market, providing a trading interface, and offering software functionality to trading participants.

Trading is particularly germane to economics. Microeconomics considers how economic agents interact in the marketplace to determine the pricing and distribution of goods, services, and assets. Equity shares are financial assets and the equity markets, as we have noted, are enormously important and exciting markets in which to study supply, demand, and pricing. Microeconomics strictly focuses on markets. And that is what TraderEx is—it is a market. TraderEx’s structure, the principles upon which it is based, and the insights that it provides are grounded in microeconomic theory, and its integral relationship to a microeconomics course naturally follows.

We do not treat markets in the abstract. We operate in the context of specific market structures and specific sets of trading rules. You will certainly find out that a market’s structure matters. TraderEx is built around four generic types of markets: a continuous order book market (participants post prices and trade against the posted prices), a call auction (orders are cumulated for simultaneous execution at a common clearing price), a dealer market (market makers post the prices that public participants can trade at), and a block trading facility (where large orders meet and transact against each other). Each of these markets represents a different economic environment, and each presents different decisions to make. You may not fully appreciate this in an economics theory course, but you will in the TraderEx Course: market structure matters.

OVERVIEW OF THE BOOK

The book is broken into two parts. The first part establishes a background on trading and markets from an economics perspective, and provides an overview of the simulation model and the TraderEx software. The second part gives you a sequences of exercises in which you will trade in different market environments created by the TraderEx software and its settings.

Here is a more detailed overview of Part One:

Chapter 1, Equity Market Trading: This chapter provides a broad overview of the equity markets, paying particular attention to trading costs and liquidity, two intimately related concepts. The four generic market structures that we have already noted are presented: the continuous order driven market, the call auction, the quote driven dealer market, and the negotiated block market. A crossing network, a facility that in a number of respects resembles the call auction, is also introduced. The concept of informational efficiency (or the lack thereof) is addressed, and the Efficient Markets Hypothesis (EMH) and random walk theory are included in the discussion.

We then turn to investor expectations. Expectations link the fundamental information that investors possess to security prices that are set in the marketplace. In discussing this link, we distinguish between the standard academic assumption that informed investors have homogeneous expectations, and the marketplace reality that informed investors have divergent expectations (very importantly, TraderEx allows for such divergency).

The chapter also sets forth the key players in the marketplace. Buy-side investors are distinguished from sell-side broker/dealer intermediaries. In turn, the buy-side participants are categorized as information traders, liquidity traders, and technical traders.

Chapter 2, Simulation as a Learning Tool: Chapter 2 explains what a simulation model requires to be an effective learning tool, and establishes the underlying economic structure of the TraderEx simulator. We distinguish between simulations based on historic (canned) data, and those run using computer-generated data. Canned data come from real markets and thus reflect reality, but constrain the exercises to what happened without regard to any impacts that your own orders can have. Our TraderEx computer generated simulation offers flexibility and control that would otherwise be unobtainable. To deliver its promise and to be engaging, the computer-driven trading model must have four properties that are next discussed: it must capture the pricing dynamics of a real-world marketplace, it must give you some basis for anticipating future price movements, it must let you replay a simulation with some parameter and/or market structure feature changed, and it must provide meaningful benchmarks against which your performance can be assessed.

TraderEx’s order flow is based on draws from various distributions, but underlying the statistical events are economic stories that pertain to the three types of traders that we introduce in Chapter 1: informed traders, liquidity traders, and technical traders. The chapter explains the economic models that support our statistical procedures.

Chapter 3, How to Use TraderEx: This chapter provides details about the TraderEx simulation software. After giving an overview of the simulation environment and specifying the requirements for running TraderEx, further detail is presented concerning the specific market structures that you will be trading in: the continuous order driven (order book) market, the quote driven dealer market, the order driven periodic call auction, a block trading facility, and a crossing network.

Chapter 4, Introduction to Trading Exercises: This chapter provides further information about markets and market participants so that you might have a good conceptual framework when undertaking the simulation exercises. Particular attention is paid, in turn, to the perspectives of buy-side participants and of sell-side market intermediaries. The TraderEx performance measures are then set forth and explained.

The material in Part One is also discussed in two related books: Equity Markets in Action (by Robert A. Schwartz and Reto Francioni) and The Equity Trader Course (by Robert A. Schwartz, Reto Francioni, and Bruce W. Weber). Both of these books provide further information on equity market structure, on the role and operations of exchanges, and on a spectrum of other topics including trading costs, public policy, and government regulatory intervention. If you are familiar with this material, you might wish to skim Chapters 1 and 2. Chapters 3 and 4 show you how to use the TraderEx software and introduce you to the trading exercises.

Part Two presents exercises along with additional discussion of the software and trading mechanisms that you will be operating within. The following is an overview of the five chapters containing hands-on trading exercises:

Chapter 5, Microeconomics Goes to Market: This chapter is the first of five that contain exercises that give you specific instructions for using the simulator. The eight exercises in this chapter are based on end-of-chapter material presented in the Wiley book, Micro Markets: A Market Structure Presentation of Microeconomic Theory (by Robert Schwartz). The first exercise gets you started with the simulator, and the seven that follow pertain to basic microeconomic formulations. They are:

1. Let’s Look at a Market

2. What Are Your Attitudes Toward Risk?

3. Call Market Trading

4. Trading Costs in Action

5. Dealer Costs and Inventory Control

6. Inter-Market Competition for a Stock Exchange

7. Finding an Equilibrium Value

8. Economic Effects of an Order Protection Rule

Chapter 6, The Order Book Market Structure: This chapter and the three that follow present exercises that target specific market structures. The exercises in this chapter first get you entering orders in a simple order book system that characterizes trading in an order driven market. After becoming familiar with the sizing and pricing of your orders, you will encounter the challenge of handling a really big order, of trading in an illiquid market, and of coping with heightened volatility. In the later simulation exercises you will, among other things, be given news releases, and you will be introduced to trading in a crossing network.

Chapter 7, The Call Auction Market Structure: The chapter first presents further information about call auction trading that includes an explanation of how your own orders can affect the clearing price that is set in a call. The exercises that follow first enable you to get comfortable interacting with the call auction, and then challenge you with working a large order when call and continuous trading are both available. You will also play the role of a proprietary trader who is presented with news releases. The last of these exercises is structured to emphasize different dimensions of your trading performance, and you will be able to assess and analyze your performance score.

Chapter 8, Dealer Markets—What Do The Trading Intermediaries Do? The chapter begins by giving you further information about the operations of a dealer market. The exercises then challenge you to manage your inventory position and risk by appropriate quote setting. You will also be exposed to the effect that preferencing has on your quote setting and inventory management. You will experience the challenge of market making in volatile markets, and in low liquidity markets. From the perspective of a market maker, you will also discover the value of having an alternative trading system available for use.

Chapter 9, Dark Pools—How Undisclosed Liquidity Works: The final set of simulation exercises places you in a hybrid environment that includes both the standard, transparent order book facility and a dark pool, block trading facility. After introducing you to the mechanics of the TraderEx dark pool, we face you with the challenge of working a large order in the hybrid marketplace. Additionally, we will periodically present you with news releases. Once again, we will call attention to the different dimensions of your trading performance, and you will be able to assess and analyze your performance score.

DOWNLOADING THE TRADEREX SOFTWARE

The TraderEx software can be downloaded at: www.wiley.com/go/traderex.

HOW TRADEREX WORKS WITH MICRO MARKETS

As noted, this TraderEx book has a companion, Robert A. Schwartz, Micro Markets: A Market Structure Presentation of Microeconomic Theory (John Wiley & Sons, 2010). Micro Markets is about how these markets operate from a microeconomics perspective, and it devotes particular attention to the equity markets. The end-of-chapter material in each of the eight chapters of Micro Markets includes a computer simulation exercise (these are the ones listed above) that can be undertaken with the software and additional instructions that we provide in the current book. These exercises, with some further detail added, are presented in Chapter 5 of this book.

Robert A. Schwartz
New York, NY

Gregory M. Sipress
New York, NY

Bruce W. Weber
London, England
April, 2010

Acknowledgments

We are most grateful for the constant support and encouragement that we have received throughout the production process from our friend and TraderEx partner, Bill Abrams. We also thank Pamela van Giessen and Emilie Herman, our editors at John Wiley & Sons, for their counsel, support, and advice. Gregory Sipress would like to thank his parents, Mannie and Carol, and his wife, Lisa, for their unwavering love and support. Finally, our wonderful children Emily, Lindsay, John, and Hayden kept us happy and smiling through the project.

PART ONE

An Overview of Equity Market Trading

CHAPTER 1

Equity Market Trading

Dealing rooms are no longer loud, boisterous places where intuition and personal contacts determine how traders buy and sell securities. Trading floors today are hushed, studious spaces, with individual traders scanning dozens of screens to monitor markets and track trading positions. As the decibel level has fallen, the complexity of trading decisions has increased.

Today, financial markets offer traders more functionality, features, and tools than ever before. Navigating the choices requires a thorough understanding of alternative market structures and a sharper insight into the drivers of trading performance. Gaining knowledge and understanding of the more sophisticated opportunities and difficult decisions is not easy.

This book and the simulation software that comes with it will do two things. First, it will sharpen your understanding of what equity trading is all about. Trading involves the conversion of an investment decision into a desired portfolio position. It is the last part of the asset management process, and it is a treacherous part where all of your best efforts in selecting an investment can be squandered due to excessive trading costs or delays. Investors want their trading to be completed at the least possible cost and in a timely fashion. Trading is also about finding pricing discrepancies in the market, and entering the appropriate buy and sell orders to realize profits from a market imperfection.

The book’s second objective is to detail how a micro market operates, for this knowledge can better your trading decision-making. A micro market is a market for a specific good, service, factor of production, or asset (in contrast to the macro market, which is all of a country’s micro markets in aggregate). In this book, we deal with one specific micro market: the secondary market where already issued equity shares are traded. This micro market specifies the institutions, rules, transparency level, and matching algorithms that determine how traders act and which orders trade.

Micro markets are at the heart of microeconomic theory. Microeconomics is about how households, firms, industries and asset managers interact in the marketplace to determine the pricing, production, and distribution of a society’s scarce resources and assets. But is microeconomic theory real-world? Much microeconomics, as traditionally presented, makes one big simplifying (and for us unacceptable) assumption: that a marketplace is a frictionless environment. The equity markets are far from frictionless, and we treat them as such. The interaction of orders, the setting of prices, and the determination of trading volumes are very much affected by various costs, blockages, uncertainties, and other impediments. This calls for analysis. Only when these marketplace realities are properly understood will a portfolio decision be properly formulated and implemented. In addition, as the trading world’s adoption of algorithmic trading increases, the technologists designing the software need to take account of market imperfections when structuring their systems.

Equities are a critically important financial asset for scores of investors and corporations, and they are essential to the vibrancy and growth of the macro economy. Corporate equities represent shares of ownership in public companies and, as such, equity financing is an essential source of the financial capital that firms must have to undertake their operations. According to the World Federation of Exchanges, the total market capitalization of all publicly traded companies in the world was $40 trillion in the fourth quarter 2008. On a national level, equities comprise a major part of the portfolios of both individual and institutional investors such as mutual funds and pension funds. And, in light of its dynamic properties, an equity market is a particularly intriguing micro market to study.

Trading is not investing, and traders are a very different breed of people than portfolio managers. Portfolio managers (PMs) focus on stock selection. They take careful account of the risk and return characteristics of different stocks and, with increasing attention, their liquidity. Traders implement the PMs’ decisions. Traders bring the orders they are given to the market, interact with other traders and, in the process, they focus out of necessity on liquidity (or the lack thereof).

A trader’s environment is very different from that of the PM. Once a decision has been made and passed on to the trading desk, time acquires a different meaning. The clock suddenly accelerates. Prices in the marketplace can move sharply in brief intervals of time. As they do, trading opportunities pop up and quickly vanish. Your own order handling can cause a price to move away from you. Poor order placement and imperfect order timing are costly. A hefty portion of the gains that an asset manager might otherwise have realized from a good investment decision can be eroded by a poor trading decision.

In Blink (Little Brown and Company, 2005), a fascinating book about how we can think quickly and intuitively without literally figuring out our answers, Malcolm Gladwell analyzes decision making from a perspective that is very germane for a trader. Perhaps you are at the trading desk of a mutual fund, a hedge fund, or a pension fund. You are an active, short-term trader, and you have orders to work. You see the numbers flicker on your screen. You follow the market as it becomes fast moving and then, sensing the situation, act on your snap judgment. Without having the luxury of time to figure it all out, you (or the trading algorithm that you have designed), buy the shares, sell the shares, or hold back. A trading day is replete with these blink experiences. Moreover, feedback and performance measures are presented almost immediately and your decisions and the outcomes are assessed. How well have you done (or not)? Obviously you cannot win them all, but with training, your blink experiences will work a whole lot better for you.

As a trader, you may take liquidity or supply it. Traders who are successful often choose to wait a bit before becoming aggressive. Al Berkeley of Pipeline has characterized the strong incentive not to display your trading intentions until the other side has revealed itself. “Pipeline’s order matching algorithm . . . price improves the first order that has been placed. It removes the perverse incentive to be passive and wait, and it solves the Prisoner’s Dilemma problem.” ¹ Successful traders often refer to the importance of consistency and not altering their decision-making approach when losses arise, and they remain steady on the plow. Quality decisions must be made under a spectrum of conditions, including when the market is under stress, as when stabilizing buy orders are cancelled, a rush of sell orders arrives, and the market turns one-sided. Daily openings and closings are also stressful times when volume is high, volatility accentuated, and the clock is ticking.

It takes much experience to think and to act instinctively. Professional traders become good traders only after gaining experience and learning what works. Think of the basketball player who, after having spent hundreds of hours shooting baskets for practice, makes a clutch shot on instinct just before the buzzer at the end of a championship game. And so it is with the equity trader. Only after many months of training will the good trader trade well on instinct. On this score, simulated trading can help. Our TraderEx software is designed to accelerate your learning process.

THE COSTS OF TRADING

Trading is costly because the marketplace is not a frictionless environment. Costs fall into two broad categories: explicit costs and execution costs (which, by their nature, are implicit). Explicit costs are visible and easily measured; they include, most prominently, commissions and taxes. Execution costs are not easily measured; they exist because, given the relative sparseness of counterpart orders on the market, a buy order may execute at a relatively high price, or a sell order may execute at a relatively low price. Along with reducing your returns, trading costs also cause investors to adjust their portfolios less frequently and, accordingly, to hold portfolios that they would not deem to be optimal in a perfectly liquid, frictionless environment.

To understand trading costs, one needs to know exactly how orders are handled and turned into transactions and transaction prices. We facilitate our discussion of order handling by defining the following:

• Quotation: A displayed price at which someone is willing to buy or to sell shares. A quote can be either firm or indicative. If firm, the participant setting the quote is obliged to honor it if a counterparty arrives. If indicative, the quoting participant is not obliged to.

• Bid Quotation: The price at which someone is willing to buy shares. The highest posted bid on the market is the “best bid” or the “inside bid.”

• Ask Quotation (offer price): The price at which someone is willing to sell shares. The lowest posted ask on the market is the best or “inside ask.”

• Limit Order: An individual participant’s priced order to buy or to sell a specific number of shares of a stock. The limit price on a buy limit order specifies the highest (maximum) price a buyer is willing to pay, and the limit price on a sell limit order specifies the lowest (minimum) price a seller is willing to receive. The trader placing a limit order is a price maker, and limit orders that are posted on a market are pre-positioned. The pre-positioned orders to buy and to sell that are the most aggressive establish the best market quotes and thus the market’s bid-ask spread.

• Market Bid-Ask Spread: The best (lowest) market ask minus the best (highest) market bid. The bids and offers can be market maker quotes and/or the prices that individual participants put on their pre-positioned limit orders. The market spread is sometimes referred to as the inside spread or as the BBO (best bid and offer).

• Market Order: An individual participant’s un-priced order to buy or to sell a specific number of shares of a stock. A market order can execute against a dealer quote or against a pre-positioned limit order. Market orders to buy are typically executed at the best (lowest) quoted ask, and market orders to sell are typically executed at the best (highest) quoted bid. When placing a market order, you are a price taker.

• Short Selling: A participant who does not own shares of a company but believes that the shares are overpriced can act on his or her opinion by selling short. A short sale involves selling borrowed shares. If the price does fall, the short seller will buy the shares back in the market and return them to the lender. Short selling enables a participant to have a negative holding. Negative holdings are called short positions, and positive holdings are called long positions. A short sale that is executed without the shares having been previously borrowed is a naked short.

• Arbitrage trading: Arb opportunities exist in two forms. In the rare risk-free form, a mispricing of related securities gives “free” money to someone. If a convertible bond can be bought for $9 and converted into a share worth $10, you arb the price difference until it has been whittled down to the cost of establishing the position. When one stock is seemingly overpriced relative to another stock, you may seek to profit from that discrepancy, but your trades will entail risk. Short selling enables arbitrage trading. An arbitrageur will exploit a pricing discrepancy by buying the underpriced asset (acquiring a long position in it) and shorting the overpriced asset (acquiring a short position in it). The arbitrageur then profits as the prices of the two stocks regain their proper alignment. We refer to arb operations in the next section of this chapter, where we focus on liquidity. As you will see, in the perfectly efficient, frictionless world of the Capital Asset Pricing Model, arbitrageurs are the ultimate source of the liquidity that characterizes that model.

It is helpful to distinguish between two types of traders: active and passive. During normal trading hours, an execution is realized whenever two counterpart orders cross. This happens if one of the following three events occurs:

1. A public trader first posts a limit order, and then another public trader submits a market order that executes against the limit order.

2. A market maker (dealer) sets the quote, and then a public market order executes against the quote.

3. Two or more public traders negotiate a trade. The negotiation may take place on the floor of an exchange; in a brokerage firm in the so called “upstairs market”; in a privately owned, alternative trading system; or via direct contact between the two trading partners.

For each trade, one party to it may be viewed as the active trader who is the instigator or liquidity taker, and the other party may be viewed as the passive trader who is the liquidity provider or price maker. The one who initiates is seeking to trade without delay and is the active trader. Active traders are the public market order traders (cases 1 and 2 above) and the trader who initiates the negotiation process (case 3). Passive traders include the limit order trader (case 1), the market maker (case 2), and the trader who does not initiate the negotiation process (case 3). If you are an active trader, you will generally incur execution costs; these payments are positive returns for passive traders. On the other hand, if you are a passive trader, you run the risk of a delayed execution or of not executing at all.

With these definitions, we can identify the implicit execution costs of trading. The major execution costs for a smaller, retail customer are the bid-ask spread and opportunity costs. A large institutional customer may also incur market impact costs.

• The Bid-Ask Spread: Because matched or crossed orders trigger transactions that eliminate the orders from the market, market bid-ask spreads are always positive and, with discrete prices, must be at least as large as the smallest allowable price variation (currently one cent in the United States for most traded stocks). An active trader typically buys at the offer and sells at the bid, and the bid-ask spread is the cost of taking a round trip (buying and then selling, or selling short and then buying). Conventionally, half of the spread is taken to be the execution cost of either a purchase or a sale (a one-way trip).

• Opportunity Cost: This cost refers to the cost that may be incurred if the execution of an order is delayed (commonly in an attempt to achieve an execution at a better price), or if a trade is missed. A buyer incurs an opportunity cost if a stock’s price rises during the delay, and a seller incurs an opportunity cost if a stock’s price falls during the delay.

• Market Impact: Market impact refers to the additional cost (over and above the spread) that a trader may incur to have a large order executed quickly. It is the higher price that must be paid for a large purchase, or the reduction in price that must be accepted for a large sale.

LIQUIDITY

Liquidity is a nebulous term that nobody can define with precision, but which many would accept is the ability to buy or to sell a reasonable number of shares, in a reasonably short amount of time, at a reasonable price. But what is reasonable? The inability to answer this question with precision suggests why formal liquidity models and empirical liquidity studies have not been forthcoming to anywhere near the extent that they have been for risk, the other major determinant of a stock’s price.

Illiquidity is the inevitable product of market frictions. We do not operate in a frictionless environment (and never will). No matter how efficient our trading mechanisms may be, there are limits to the liquidity that participants can expect to receive. Of course there are trading costs, both explicit and implicit and, as a manifestation of trading costs, intra-day price volatility is elevated (especially at market openings and closings). Of course strategic decisions have to be made concerning how best to supply liquidity or whether to access the liquidity that others have provided.

Implicit trading costs such as spreads and market impact are manifestations of illiquidity, but they address only part of the story. To probe deeper, we focus on two major functions of an equity market: price discovery and quantity discovery. Price discovery is the process of finding a value that best reflects the broad market’s desire to hold shares of a stock. The process is complex and it is protracted. In large part this is because of friction in the production, dissemination, assessment and implementation of information. Information sets are huge, information bits are generally imprecise and incomplete, and our tools for assessing information are relatively crude. Consequently, different individuals who are in possession of the same publicly available information may form different expectations about the risk and expected return parameters for any given stock or portfolio. Moreover, when participants have different expectations, they can also change their individual valuations at any time, particularly when they learn the valuations of others. A divergence of expectations and the attending interdependencies between different people’s valuations profoundly impact the process of price formation.