Market microstructure notes

MARKET MICROSTRUCTURE

Lecture 1 18-09-2017

Market microstructure trading process

à

If transaction costs increase, the return decreases.

Low liquidity higher expected cost of the capital (for the firms), higher expected return (for

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the investors).

Example: Coupon (return)

Bond Coupon paid on the bond (cost)

Lecture 2 (slides 1-32) 20-09-2017

Gross return – transaction costs = profit for investors

The implicit costs are not added to the top of the prices, are included in the price paid.

The bidding block is the order because whenever we want to trade, we need to start from an

order to buy or sell a security. It’s important to realize that once we understand what are the

order types, we are able to design an order placement strategy (= strategy that we decide in

order to buy or sell the stock).

Liquidity depends on orders because there are some orders that demand liquidity (à market

orders) and some orders that supply liquidity ( limit orders). When trading using limit orders

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there are some costs and benefits. If I use a market order, I’m basically consuming market

liquidity, decreasing the level of liquidity in the market. If I’m using limit orders, I’m supplying

liquidity to the market, increasing the level of liquidity in the market.

Orders are instructions to trade. We need to see what traders want to trade (the stock), whether

we want to buy or sell, how much, the conditions required for the resolution, …

Whenever we want to buy or sell, we will be using the bid/bidding price when we buy, and the

ask/offering price when selling.

The quantity is also called the depth of the market: if there is a large quantity available, the

market is deep, if the quantity available is very small, the market is thin.

Quotes are firm if they are forced to go to get the trade executed and are not negotiable. Soft

quotes are not binding (I want to advertise that I’m part of the market, but the quote I’m

displaying will not require me to execute the trade, I need to get in touch with the dealer and if

the dealer confirms, then I will get the trade done). With soft quotes, you are able to price in a

discriminatory way. Market quotes are usually known as NBBO (= National Best Bid Offer) in the

US.

Limit orders supply liquidity because I’m going to give other traders the opportunity to trade and

consequently I’m making the market more liquid. Instead with a market order I’m looking at the

market and I see what is the market quote available and I just accept the offers that the other

traders made. Both bidders and sellers can offer liquidity: buyers offer liquidity when the bid gives

other traders the opportunity to sell. 1

Looking at this matrix, I realize that there are two dimensions: liquidity (buy or sell) and stock (buy

or sell). Once I decide that I want to buy the stock, I have two possibilities: buy market order or

buy limit order. With a buy market order, I’m not setting the price, I just take the best available

offer in the market, when I sell limit order I’m making the market because I’m the only one selling

using limit order. A limit order is an order where I set the price which is called limit price and is

the minimum price I’m willing to accept.

Limit orders are supplying liquidity when they buy and when they sell. The trade will be done

when somebody else wants to buy the stock at the best possible price which is available in the

market. How trades can be executed? When another trader arrives wishing to sell the stock

using a sell market order (“I want to sell the stock, I don’t care, whatever price I will get is fine to

me”), this is a market order because I’m just accepting the price made by somebody else.

If I want to be sure that I will buy, I use market orders. The factor that may differentiate the

decision is the profit, the price: when I want to buy a stock, I need to be careful about the price.

I trade off the speed of execution with the price, I pay an extra price for the execution.

Limit orders are instructions to trade at the best price. In a buy order, the trade price must be at

or below the limit price. In a sell order, the trade price must be at or above the limit price. There

are orders that are standing limit orders.

26 is the best bid, 21-25 are behind the market. 21 is far from the market. The market is 26-28.

Market prices simply jump up and down between these two prices: the price will be 28 when

someone buys, 26 when someone sells. These are not transaction prices, but quotes. They will

become prices when the trade is executed, when there is a limit order crossing with a market

order. I’m aggressive when I’m bidding the highest price (instead of bidding 26 I bid 27) and

when I’m offering the lowest possible price.

Limit order execution is not certain. There are some limit orders that are called marketable limit

orders. A marketable limit order is when I use a limit order to buy at 28. Why should I use a limit

order to buy at 28? To be sure that I don’t pay too much since market conditions change quickly,

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even if I’m buying at 28, to be on the safe side I will always use a limit price and I will not pay

more than 28. This is a type of insurance in order to get that price.

A market order is an instruction to trade at the best possible price currently available on the

market. Usually it fills (= getting the execution) but sometimes at inferior prices. Impatient traders

and traders (e.g. high-frequency traders, insiders) who want to be certain of execution use

market orders to demand liquidity. Market prices are unpredictable if the market is efficient, but

an insider, by definition, knows where the market is going and uses a market order because he

cannot wait. A limit order is not a clear evidence of insider trading because if I’m in a rush I

wouldn’t use a limit order to trade. Market orders pay the spread; when I buy using a market

order I’m paying 28, if I use a limit order I pay 26. The difference between the price that I’m

paying and the best price that I’d have paid using a limit order is 26, I’m paying the bid-ask

spread. The theoretical price will be 27. If we believe in this assumption, we can look at the bid-

ask spread as the extra cost that we pay when we buy because we buy at 28 instead of buying

at the true level (27). The bid-ask spread is the price of one transaction. But if I buy (28) and then

I sell (26), then the cost of the two transactions is half the bid-ask spread.

Price improvement means that I will not always pay the full bid-ask spread, but a discounted

price when I buy or an extra cost when I sell, the market order will get better terms. If I get a

price improvement on the bid side, I will not get 25.5 but 26.5. This creates the effective bid-ask

spread based on effective prices. In the derivatives market the traders usually negotiate the

prices.

Market orders move prices against me because if I buy I pay more and if I sell I receive less. This

is one feature of the market. These adverse movements are called market impact.

Market liquidity can be measured according to the distance between the bid-ask with respect

to the level of the prices.

Limit orders can be seen as options, like derivatives because with a limit order I’m giving other

traders the opportunity to buy or sell at specific condition, the limit price. They are like American

options because I’m giving the option and the expiration is when somebody will exercise, there’s

no expiration date. A buy limit order is a put option (a right to sell) in short position and the seller

of the option is obliged to buy the underlying asset, so a buy limit order means a short position

in a put option. The sell limit order obliges to sell. When we have an option and it is exercised, it

is bad news for the seller because if the option is exercised, this means that I’m selling at 10 and

the market price is 12. When I’m giving up limit orders, I’m giving up options, which is bad news

when I get the execution. The advantage of sending a limit order is that I’m getting a better

price and the price of the option is basically the price I said

Lecture 3 (slides 33-49) 25-09-2017

The limit order specifies a limit price and is matched with a corresponding market order on the

opposite side of the market. Using the market order, I pay the highest price on the market, the

ask (10.50) and is the best available price on the opposite side of the market. If I use a limit order

and the order gets executed, I pay the best bid (9.50). This means that the most important

benefit of using a limit order lies in the fact that I would save money because instead of paying

10.50 I’m going to pay 9.50. This is the benefit of limit order and it can be seen as the cost of

market order. What is a benefit of limit order, is the cost for a market order.

Costs and benefits of placing orders

Adverse informational change. There are two basic factors to explain price movements:

• 1. Information: good news will make the price to go up (from 10 to 10.5) and the price

will stay at that level until another news arrive. This is a permanent change. When

there are adverse informational changes, the market moves against the limit order

trader (I want to buy the stock and I send a limit order to buy at 10. If there is an

adverse informational change, the company announces a reduction of one unit per

share during the next quarter, and I already set the price at 10, then the price will go

down from 10 to 9. My order will be executed, but I pay too much with respect to the

current market condition). This is a possible cost of limit order trading, the fact that

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the market may move against limit order trader. The same also applies when I lose a

sell limit order because if I want to sell the stock at 11 and a very good news will arrive

in the market, the stock price will move up and I will sell the stock at 11, but given the

new information, the stock price should be 12. Informational change is always against

a limit order trader: if I’m buying the stock price goes down and I’m paying too much;

if I’m selling I will sell at 11 but I’m receiving a lower price than the current market

price 12. In both cases I will regret my decision and the execution of the order.

2. Friction related factors: a friction can be a transitory price and supply disequilibrium

(e.g. there are a few sellers on the market at that point in time, there isn’t a strong

demand so the price will move from 10 to 10.5). Friction is by definition temporary

because it is just the result of a transitory disequilibrium between demand and supply,

if the price goes up for this type of reasons, then probably other traders see the new

price, which is higher than the correct one, and will enter the market to sell their stock

and this will push the price back at 10. So, if the reason for the price change is friction

related, this implies that the change will not last forever but it will be transitory (à

mean reversion).

Cost of non-execution. With limit orders, I’m not sure that the trade will be executed

• because I send the limit order to the market at 9.5 (this will be the best limit price on the

bid side), but this doesn’t imply that I will get the trade done because in order to get it

done, there should be somebody on the opposite side of the market at that point in time

sending a sell market order. So, there is the risk of non-execution. The risk is the highest

when there is an informational change. In this case, the change is in my direction (if I

want to buy, I offer 9.5 as bid price. However, just after my order there is a positive news

arriving in the market. This will make the price to go up at 11 and nobody will sell with a

market order at 9.5 and I won’t get my order executed. If the price is so high, I will need

to update my order and to buy at the higher price.). If I want to sell the stock at 10.5 and

after a bearish news the stock price goes down (prior to my execution), the order at 10.5

will not be the first of line because somebody else will offer 10.4. As a limit order trader, if

there is another informational change, I will regret the execution and to me this is a cost

and I lose also in case of positive informational change.

Adverse (buy limit order)

DP

Ø Liquidity event

(adverse

11 (ask) informational

10 (bid) news release)

9 t t t

0 1 2

when I send the order

I send the order at 10 in t . Then there is a reduction (adverse informational change) due to the

0

press release of bad news. My order will be executed at 10 because I will be the first order on

the top of the book on the bid side because everybody else will be offering 9 or lower. But I will

regret the execution because I’m paying 10 and the current price is 9 and if I mark-to-market

my portfolio I lose 1. 4

Positive (buy limit order)

DP

Ø Liquidity event

(adverse

12 informational

11 (ask) news release)

10 (bid) t t t

0 1 2

when I send the order

For positive informational change, I will not get the execution. The change is positive in the sense

it is in the direction of my order if I’m buying and the price goes up (if I’m selling and the price

drops). I send the order at 10 at t , at t there is he positive price change, in t I will not get the

0 1 2

execution because as long as the price goes up, there is somebody which will be offering 10.5,

and so on, so I will not be the first on the bid side of the book. Consequently, I will not get the

trade done for 10. This is bad news to me because the price is going up but I’m not buying. This

is the cost of a non-executing limit order.

Looking at the two graphs, I have two negative events in both cases: the price goes up and I

regret the execution and the price goes down and I will not get the execution. So, why should I

place a limit order if it is always causing me a negative result? Because in the first graph we sell

at 10, the price drops at 9, but then instead of being in the light green area, the price will keep

going up and this will make two results: I will get the execution and the price goes in my direction

thanks to this small reversion in the price. The key point is to distinguish between permanent and

transitory price changes. If the price change is permanent, for a limit order trader, this is a bad

situation because only negative outcomes will arise. By contrast, if the price change is transitory,

sending a limit order is profitable because I buy at the best possible price and I get the trade

done and the price goes up exactly as I was imagined (graph 1). Instead of paying 11, I’m

paying 10 and I’m saving the bid-ask spread. Saving the bid-ask spread is the main advantage

of using a limit order: instead of paying 11 I pay 10 thanks to the price reversion. A market-maker

makes money when the price is volatile but without big jumps because if it is volatile, it means

that the price goes up and down and every time it goes up and down it is a source of profit,

while the big jumps are source of losses. At the end of the day, market makers usually try to get

rid of all the stocks, to sell the shares in the portfolio because they don’t know what can happen

in foreign markets when the trading desk is closed. Consequently, they don’t want to be at risk,

to carry the risk overnight.

The benefit of limit order is that it gets better prices, which means paying the lower price when I

buy, receiving the highest price when I sell. I’m buying and I pay the bid instead of paying the

ask. If I’m selling, I’m getting the highest price because I’m selling at 10.5, if I use a market order

to sell, I would get the best available bid on the opposite side of the market.

Chase price I’m paying a larger price I would have paid using a market order immediately

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(graph 1). This is a big risk if I’m using a limit order. If I’m a market insider I should use a market

order because I get the execution immediately, then the price goes up but I’m fine because

I’m already holding the stock.

To summarize: we have a better price when a liquidity event (= transitory price movement when

there is disequilibrium between demand and supply) occurs. This is the ideal market condition

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to use a limit order. The trader should be uninformed and impatient because if it is informed and

he’s selling and knows in advance that the price will drop, he waits and gets a better price,

selling with a market order.

Mean reversion in the pricing process when I use a buy limit order, I hope that the prices go

à

down and then go up, when I use a sell limit order, I want the opposite price behaviour. Mean

reversion is the driver, if there is mean reversion using a limit order is convenient. If the price

change is driven by a permanent reason, don’t use a limit order; if it is transitory, using a limit

order is convenient. 10

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Efficient volatility Inefficient volatility

(market order) (limit order)

Efficient means that reflects all the available information and if there is bad news, this news

should cause a change in the stock price. Efficient volatility is permanent. Transitory volatility is

inefficient because the price goes down and then reverts to the original value.

Price discovery process means that market prices try to mimic, to replicate the behaviour of

à

the true underlying prices, the true values of stock. We don’t know the true value of the stock.

The bid and ask prices are observed, while the true value of the stock is unobserved.

Order placement strategy

The gain from trading is saving the bid-ask spread.

The reservation price (= target price) is the estimate of the true value of the stock. Actual market

prices should converge to it.

The gain with the market order is lower but certain, the gain with the limit order is greater but

uncertain. The final outcome depends on how large is the probability of the limit order

execution. The probability of execution of a market order is always 1 since the execution is

certain. The probability of execution is endogenous, depends on the limit price I’m offering.

Lecture 4 (slides 50-63) 27-09-2017

Which type of order we would like to submit to the market: limit order or market order? The main<