Trading Dr. Himanshu Joshi

Trading Investment Process Portfolio Manage ment Security Analysis Trading

Portfolio Manager’s (or Investment Adviser) objective is to execute portfolio decisions in the best interests of the client. The portfolio manager’s agents in doing so are the firm’s traders. These buy-side traders are the professional traders employed by the investment managers or institutional investors who place the trades that execute the decisions of portfolio managers. The job of such traders is to execute the desired trades quickly, without error, and at favorable prices. Execution is the final critical step in the interlinked investment process.

Understanding Market Micro Structure We can view our security markets and security prices from long run and short run perspectives. Long run price of securities are driven by “fundamental Considerations” of security value: (a) Expected Cash Flows, (b) Long Term Risk, (c) Required Return. Short run prices of any security are driven by (a) liquidity (b) Trading Mechanism.

Understanding Market Micro Structure This is of course an over simplification of the factual position of the stock market! Certainly long term and short term prices are linked. The long term characteristics of a security will be determined in part by (a) who hold it? (b) who trade it? (c) and how it will be traded? Infosys and TCS and may be Wipro. Conversely, the features of the trading environment may affect the long term dynamics of security prices. Infosys and TCS and may be Wipro. Or in a world with perfectly frictionless (cost less and infinitely liquid) markets, how would we expect security prices to behave? Or in a world with perfectly frictionless (cost less and infinitely liquid) markets, how would we expect security prices to behave?

How Securities are Traded in the Market Primary Market for Equity Shares (IPOs and Seasoned Equity offerings) Secondary Market for Equity Shares Public Offerings and Private Placement of Bonds. Trading on Margin (Margin Money and Daily Settlement)

How Firms Issue Securities Primary – New issue – Key factor: issuer receives the proceeds from the sale Secondary – Existing owner sells to another party – Issuing firm doesn’t receive proceeds and is not directly involved

Types of Markets – Direct search Least organized – Brokered Trading in a good is active – Dealer Trading in a particular type of asset increases – Auction Most integrated

Dealer Markets Vs. Auction Markets When trading activity in a particular type of asset increases, dealer market arise. Dealers specialize in various assets, purchase these assets on their own accounts, and later sell them for a profit from their inventory. The spread between dealer’s buy (bid) prices and sell (ask) prices are source of profit. In Auction Market all traders converge at one place (either physically or electronically) to buy or sell an asset. The NSE is an example of an auction market. An advantage of auction market over dealer markets is that one need not search across dealers to find best prices for a good or asset. If all participants converge, they can arrive at mutually agreeable prices and save the bid- ask spread. Continuous Auction Markets Vs. Periodic Auction Markets.

Orders and Order Properties Understanding orders will allow you to see where liquidity comes from.

What is liquidity? Liquidity is the ability to trade when you want to trade. Some orders offer liquidity by presenting other traders with trading opportunities. Other orders take liquidity by seizing those opportunities.

What are orders, and why do people use them? Orders are instructions that traders give to the brokers and exchanges which arrange their trades. The instructions explain how they want their trades to be arranged. An order always specifies: 1.which instrument(s) to trade, 2.How much to trade, 3.Whether to buy or sell.

What are orders, and why do people use them? An order may also include conditions that a trade must satisfy: The most common conditions limit the prices that the trader will accept. (in case of both buying and selling orders). Other conditions may specify for how long the order is valid, when the order can be executed, whether it is okay to partially fill the order, where to present the order, how to search for the other side.

Why orders are necessary? Orders are necessary because most traders do not personally arrange their trades. Traders who arrange their own trades-typically- dealers-do not use orders. They decide on the spot what they want to do and how to do it. All other traders must mention their intentions carefully ahead of time. For many small traders it is not economical to continuously monitor the market. These traders place orders.

Dealer vs. Trader Traders who arrange their own trade (Dealers) have an advantage over traders who use orders to express their intentions. Dealers can respond to market conditions as they change. Other traders must anticipate such changes and write contingencies into their orders to deal with them. Carefully written orders will adequately represent trader’s interests even when conditions change.

Dealer vs. Trader When orders are not specifying the best interest of the traders, they must cancel them and submit new instructions. During the time it takes to cancel and resubmit orders, traders can loose because: a.Their old orders may trade before they cancel them. b.They can not submit the new orders in time to take advantage of the changed market conditions.

Dealer Vs. Trader A trader has given price contingent buy order to purchase 100 share of RIL at price not more Rs. 800, in a market where best bid rate is Rs. 799 and Ask is Rs.803. Now suddenly RIL stock started tumbling. And goes down to Rs.790.

Traders.. In general, traders who can respond most quickly to changes in market conditions have an advantage over slower traders. Algorithm Trading.

Some important Terms in Trading. Offers: traders indicate that they are willing to buy or sell by making bids and offers. Traders quote their bids and offers (ask) when they arrange their own trade. Other wise they use orders to instruct their brokers. Bids and offers refer to price and quantity.

The highest bid (buy) price in a market is the best bid price. (Market Bid) The lowest offer (sell) price is the best offer. (Market offer). The difference between the best ask and best bid price is the bid/ask spread.

Order and Liquidity An order offer liquidity- if it gives other traders the opportunity to trade. For example, Mr. X issues an order to book 100 shares of IBM for no more than $100 per share from the first person to contact him before trading closes today. Which offer it is? Buy (bid) or Sell (Ask)? Mr. X bid, offers liquidity because other traders now have the opportunity to sell IBM for $100 per share. It is day limit order.

Order and Liquidity Both buyers and sellers can offer liquidity. Buyers offer liquidity when their bids give other traders opportunities to sell. Sellers offer liquidity when their offers give other traders opportunities to buy.

Order and Liquidity Traders who want to trade quickly demand liquidity. Traders take liquidity when they accept orders. If Mr. Y is willing to sell 100 shares of IBM at $100, she can initiate a trade by taking Mr. X offer. A market is liquid when a trader can trade without significant adverse effect on price. A market with several standing limit orders and small bid/ask spreads are usually quite liquid.

Trade Prices.. The prices at which orders fills are trade prices. Buy orders that trade at higher prices and sell orders that trade at lower prices are inferior prices.

Market Orders A market order is an instruction to trade at the best price currently available in the market. Market orders usually fills quickly, but sometimes at inferior prices. Impatient traders and traders who want to be certain that they will trade, use market orders to demand liquidity. So, the execution of the market order depends upon the size of the order and the liquidity available in the market. A small market order fills quickly at best bid or ask prices.

Market Order Example.. An order to buy 10,000 shares of BP directed to the London Stock exchange (LSE) would execute at the best price available when the order reached that market. Suppose when the order reaches the LSE, the lowest price at which a seller is ready to sell BP is 642p in quantity up to 8,000 shares. The second- lowest price is 643p in quantity up to 6000 shares. Thus 8,000 shares of the market order would be filled (executed) at 642p and the balance 2000 shares at 643p.

Market Orders pay the Spread. Market order trader pay the bid/ask spread. Example: Amy uses a market buy order, followed by a market sell order, to complete a quick round trip bond trade. Her market buy order buys the bond for 102, when the best bid is 100 and best offer is 102. Her market sell order sells the bond for 100, assuming that the best bid did not change. What is the loss of Amy?

Market Order Pays the Spread Amy pays bid-ask spread for two opportunities to trade immediately, her transaction cost per trade (exclusive of commission) is half of the spread. The spread-actually half of the spread – is the price traders pay for immediacy when using market orders.

Best Estimate Method for calculating Transaction Cost.. If we assume that Amy is an uninformed trader (her erratic behavior seems to bear it out): The only available information to us about the value of bond is ? Two traders quotes. One is willing to buy at 100 and other is willing to sell at 102. With no further information take the average price of both so, average price = 101. Amy paid 102 for bond worth 101. Transaction Cost =1 Amy got 100 for bond worth 101. Transaction cost =1.

Price Improvement.. Price improvement takes place when a trader is willing to step in front of the current best price to offer a better price to the incoming Market Order. This often happens when the spread is wide and the incoming market order is small. Price improvement lowers the cost of liquidity. Thus one important function of market order is price improvement.

Price Improvement ANN Bid: $23.35 – Ask: $ At these prices, buyers are willing to purchase 500 shares and sellers are willing to sell 1000 shares. Tom submit a market order to sell 300 shares of ANN. The ANN specialist (a dealer who trades for his own account on the floor of the exchange ) may choose to fill the order at $ if he does, Tom would receive a price 3 cents better than the bid price.

Execution Price Uncertainty The prices at which market orders trade depends on current market conditions. Market conditions can change quickly, traders who use market orders risk trading at worse prices than they expect. It occurs due to quote change between submission of an order and its execution.

Limit Orders. A limit order is an instruction to trade at the best price available, but only if it is no worse than the limit price specified by the trader. For buy orders, the trade price must be at or below the limit price. For the sell orders, the price must be at or above the limit price.

Limit Orders In continuously trading markets, a broker (or an exchange) will attempt to trade a newly submitted limit order as soon as it arrives. If no trader is immediately willing to take the opposite side at an acceptable price, the order will not trade. Instead, it will stand as an offer to trade until someone is willing to trade at its limit price, until it expires, or until the trader who submitted it cancels it. Standing limit orders are placed in a file called a limit order book.

Limit Order Example Suppose that instead of market order above, the trader places an order to buy 10,000 shares of B.P at 641p limit (which mean at a price of 641p or lower), good for one day (the order expires at the end of the trading day). Suppose that this buy order’s price is higher than that of any other limit buy order for BP shares at the time. If that is the case, the 641p becomes the best available bid or market bid, for BP shares. If a market sell order for 6000 shares of BP arrives the instant after the trader’s buy limit order for 10,000 shares, it will execute against that limit order.

Limit Order (Example) The trader will get a fill (execution) for 6000 shares at 641p, leaving 4,000 shares of the order unfulfilled. At that point, favorable news on BP might reach the market. If so, the price of BP could move up sharply and not trade at or below 641p for the remainder of the day. If that is the case, at the end of the day, the trader will have 4,000 shares of his or her order unfilled and the order, which was good for one day, will expire.

Limit Order By specifying least favorable price at which an order can execute, a limit order emphasizes price. However, limit orders can execute only when the market price reaches the limit price specified by the limit order. The timing of the execution, or even whether the execution happens at all, is determined by the ebb and flow of the market. The limit order thus have execution uncertainty.

Market bid =100 Ask = 103 Buy Order specified = Buy order specified =102 Buy order specified =103.5 Whether order will executed?

Market-not-hold Order This variation of the market order is designed to give the agent greater discretion than a simple market order would allow. “not held” means that the broker is not required to trade at any specific price or in any specific time interval, as would be required with a simple market order. The broker may choose not to participate in the flow of orders on the exchange if the broker believes he or she will be able to get a better price in subsequent trading.

Participate (Do not initiate Order) This a variant of the market-not-held order. The broker is to be deliberately low key and wait for and respond to initiatives of more active traders. Buy-side traders who use this type of order hope to capture a better price in exchange for letting the other side determine the timing of the trade.

Undisclosed Limit Order Also known reserve, hidden, or iceberg order. This is a limit order that includes an instruction not to show more than some maximum quantity of the unfilled order. For example: A trader might want to buy 2,00,000 shares of an issue traded on exchange. The order size would represent a substantial fraction of average daily volume in the issue, and the trader is concerned that share price might move up if the full extent of his interest were known. The trader places an undisclosed limit order to buy the 2,00,000 shares, specifying that no more than 20,000 shares of unfilled order be shown to the public at a time.

Market on Open Order This is a market order to be executed at the opening of the market. similarly, a market on close order is a market to be executed at the market close. These are examples of orders with an instruction for execution at a specific time. The rationale for using these two types of orders is that the opening and close in many markets provide good liquidity.

Stop Orders Stop orders are similar to limit orders in that the trade is not to be executed unless the stock hits a price limit. For Stop-Loss orders, the stock is to be sold if its price falls below a stipulated level. The order lets the stock be sold to stop further losses from accumulating. Stop-Buy orders stop buy order specify that a stock should not be bought when its price rises above a limit. These sales often accompany Short Sales.

Figure 3.5 Price-Contingent Orders

Stock Margin Trading If Margin is 50%; you can borrow up to 50% of the stock value Maintenance margin: minimum amount equity in trading can be before additional funds must be put into the account Margin call: notification from broker that you must put up additional funds

Trading on margin The percentage margin is defined as the ratio of the net worth, or the equity value of the account to the market value of securities. Suppose investor pay $6000 towards the purchase of $10,000 worth of stock (100 per share), borrowing the remaining the $4000 from a broker. Initial balance sheet? Initial percentage margin? If stock price fall to $70? New percentage margin? Suppose maintenance margin is 30%. How far could the stock price fall before the investor would get a margin call?

Margin Trading - Initial Conditions Example 3.1 X Corp$100 60%Initial Margin 40%Maintenance Margin 100Shares Purchased Initial Position Stock $10,000 Borrowed $4,000 Equity $6,000

Margin Trading - Maintenance Margin Example 3.1 Stock price falls to $70 per share New Position Stock $7,000 Borrowed $4,000 Equity $3,000 Margin% = $3,000/$7,000 = 43%

Margin Trading - Margin Call Example 3.2 How far can the stock price fall before a margin call? (100P - $4,000) * / 100P = 30% P = $57.14 * 100P - Amt Borrowed = Equity

Buying On Margin : Suppose you have Rs 1,00,000 with you in your Bank account. You can use this amount to buy 10 shares of Infosys Ltd. at Rs 10,000. In the normal course, you will pay for the shares on the settlement day to the exchange and receive 10 shares from the exchange which will get credited to your demat account. Alternatively you could use this money as margin and suppose the applicable margin rate is 25%. You can now buy up to 40 shares of Infosys Ltd. at Rs 10,000 value Rs 4,00,000, the margin for which at 25% i.e. Rs 1,00,000. Now as you do not have the money to take delivery of 40 shares of Infosys Ltd. you have to cover (square) your purchase transaction by placing a sell order by end of the settlement cycle. Now suppose the price of Infosys Ltd rises to Rs before end of the settlement cycle. In this case your profit is Rs 40,000 which is much higher than on the 10 shares if you had bought with the intent to take delivery. The risk is that if the price falls during the settlement cycle, you will still be forced to cover (square) the transaction and the loss would be adjusted against your margin amount.

The Cost of Trading Trading costs are having two major components: 1.Explicit Costs: Direct cost of trading, such as broker commission costs, taxes, stamp duties, and fees paid to the exchanges. 2.Implicit Costs: It represents indirect trading costs, no receipt could be given for implicit costs, but they are real.

Implicit Costs of Trading 1. Bid-ask spread. 2. Market impact (or the price impact): It is the effect of trade on transaction prices. for example, suppose a trader splits a purchase of 400 bonds into two equal market orders when the quote for a bond is to The first order executes at the ask price of , after which market quotation becomes to The second order is placed and executes at The trader moved the price obtained in the second order up by – = 0.039, or $0.39 per thousand dollars of face value.

Implicit Costs of Trading Missed Trade Opportunity costs (or unrealized profit/loss): it arise from failure to execute a trade in a timely manner. For example a futures trader places a limit order to buy 10 contracts at a price of or better, good for one day, when market quote is to The order does not execute, and the contract closes on The difference of =$0.76 reflect missed trade opportunity cost per trade.

Implicit Costs of Trading Delay Costs (also called slippage): arise from inability to complete the desired trade immediately due to its size and the illiquidity of the markets. Delay costs are measured on the portion of the order carried over from one day to the next. One reason delay can be costly is that while trade is being stretched out over time, information is leaking in the market.

Calculating Implicit Trading Costs Most traders measure implicit costs with reference to some price benchmark or reference point. One such benchmark is the time-of-trade mid-quote (quotation mid point), which is used to calculate effective spread. When such precise information is not available, the price benchmark is taken as volume weighted average price (VWAP). VWAP of a security is the average price at which the security traded during the day, where each trade price is weighted by the fraction of the day’s volume associated with the trade.

Calculating Implicit Trading Costs The VWAP is an appealing price benchmark because it allows the fund sponsor to identify when it transacted at a higher or lower price than the security’s average trade price during the day. For example, if a buy order for 500 shares was executed at $ and the VWAP for the stock for that day was $ The estimated implicit cost of the order would be 500*( ) = $625. Bloomberg terminals report VWAPs.