©R. Schwartz Equity Markets: Trading and StructureSlide 1 Topic 2

©R. Schwartz Equity Markets: Trading and StructureSlide 2 Purpose 1) Experience what trading involves –Tactical, fast decision making –Be a prop trader, buyside equity trader, market maker 2) Participate in a process that translates news into prices 3) Evaluate the effects of trading rules and alternative market structures on: –Investor participants (the naturals) –Market maker intermediaries –Market quality 4) Compare and understand alternative market structures 5) Compete and have Fun

©R. Schwartz Equity Markets: Trading and StructureSlide 3 An Important Distinction Simulations can be based on either 1. "Canned" data from past events 2. Computer-generated data TraderEx is based on computer-generated orders and price changes – not canned repeats of past events

©R. Schwartz Equity Markets: Trading and StructureSlide 4 A Trading Simulation Requires Prices can be affected by your actions You have some basis for anticipating future price changes Prices can move in harmony with news releases Prices do not follow random walks Simulation runs can be replayed Your performance can be assessed

©R. Schwartz Equity Markets: Trading and StructureSlide 5 Performance Assessment 1.Performance characteristics – Profit and loss (P&L) – Beat Volume Weighted Average Price (VWAP) – Control risk (avoid large inventory positions) – Get the job done (execute your orders, liquidate your positions) 2.Your Score – Weighted combination of the above

©R. Schwartz Equity Markets: Trading and StructureSlide 6 What Drives Trading? 1.New information (news) 2.Liquidity motives 3.Technical (noise) trading 4.Divergent expectations (people disagree with each other) Machine generated order flow is based on draws from various statistical distributions. We can view the statistical events as representing solid economic stories. Economic stories concerning the motives for trading

©R. Schwartz Equity Markets: Trading and StructureSlide 7 Trading Mechanism Informed Is p*>offer or p*<bid? Orders Come from 3 Types of Traders Liquidity Order Flow Quotes, Prices, Volume Technical Trading Is there a trend/ pattern? P* Do the informed Traders agree with each other? maybe not!

©R. Schwartz Equity Markets: Trading and StructureSlide 8 The Economic Story Behind the Consensus Price, P* Bid Ask SellsBuys P* Bid Ask

©R. Schwartz Equity Markets: Trading and StructureSlide 9 P* Day 1 Day 2 A Typical Random Walk Pattern Of P*

©R. Schwartz Equity Markets: Trading and StructureSlide 10 Ask Bid P* Day 1 Day 2 P* and Best Bid and Offer Quotes

©R. Schwartz Equity Markets: Trading and StructureSlide 11 P* and News 1.In simulations P* need not change according to random draws from a distribution 2.When united with news release, new P* values are set in accordance with the news

©R. Schwartz Equity Markets: Trading and StructureSlide 12 0%2%4%6%8%10%12%14% Price (5¢ Tick Size) Probability Limit sell orders Offer Bid Executable sell orders Distribution For Generation of Liquidity Motivated Sell Orders