Session 2: Overview of Market Microstructure

Agenda Education Session 1: Industry Introduction and Derivatives Overview Session 2: Overview of Market Microstructure Session 3: Prerequisites for Algorithmic Trading System (ATS) Development and Selecting a Platform Session 4: Review of the Scientific Method and the ATS Development Process Session 5: Formulation and Specification of a Strategy Session 6: Backtesting and Optimization Session 7: Implementation / Risk Management Research Session 1: Workshop Session 2 Workshop Competition - 2 weeks (10 days)

What is Market Microstructure? Market microstructure studies the process by which investors' latent demands are translated into prices and volumes. Studies the game board (exchange, rules) and the players (traders). It is based on theoretical, empirical and experimental studies relating to markets and trading. We will take an information-based treatment of it.

A central idea in this field… Prices don’t have to equal full-information expectations of value because of a variety of frictions Previous models before microstructure theory assumed perfectly competitive markets and frictionless trading Slide from Trading & Exchanges: Market Microstructure for Practitioners by Larry Harris

To Trade Effectively, You Have to Understand… Liquidity Transaction Costs Informative Prices Volatility Trading Profits Slide from Trading & Exchanges: Market Microstructure for Practitioners by Larry Harris

Key Recurring Themes… Information Asymmetries – traders who know more about values and traders who know more about what other traders intend to do have a great advantage over those who do not. Options – the option to trade is valuable. Clever traders can extract value from these options. Externalities (positive – do something that benefits people for no compensation; negative – do something that harms people with no penalty). Pay close attention to when, why, and how traders offer to trade.

Key Recurring Themes… Market Structure – consists of trading rules, the physical layout, information systems and communications systems. Affects what traders can do and what they can know. It therefore affects strategies, the power relationships among different types of traders, and ultimately trader profitability. Competition with free entry and exit – traders compete in markets to make profits. Trading strategies that generate large profits attract traders who want to participate in those profits. Their entry lowers profits for everyone on average. Converseley, traders quit trading strategies because their not profitable, allowing other traders to potentially obtain profit.

Key Recurring Themes… Communications – markets are information processing mechanisms. They process information about who wants to trade, how much, and at what prices. Resulting prices aggregate information about fundamental values. Principal-agent problems – occurs when agents do what they want to do as opposed to what principals want them to do. Trustworthiness and creditworthiness– people are trustworthy if they do what they say they will do. Since people aren’t always trustworthy or creditworthy, you need an institution to enforce contracts. Slide from Trading & Exchanges: Market Microstructure for Practitioners by Larry Harris

Key Recurring Themes… The zero-sum game – all trades involve two or more parties. Understanding origins of profits means we must understand both parts of a trade. We must understand why traders on one side expect to profit, and why traders on other side are willing to lose or do not understand that they should expect to lose.

Let’s look at the players… *Chart from Trading and Exchanges: Market Microstructure for Practitioners by Larry Harris* - attached in following pictures on web site.