Mastering the Art of Equity Trading Through Simulation, + Web-Based Software

The TraderEx Course

Robert A. Schwartz, Gregory M. Sipress, Bruce W. Weber

• Publisher: Wiley
• Year: 2010
• Print ISBN: 9780470464854
• eBook ISBN: 9780470642498
• Edition: 1
• Topic: Business
• Subtopic: Finance
• Index: Business

An interactive guide to successfully trading in today's markets

Mastering the Art of Equity Trading Through Simulation is a guidebook to interactive computer trading simulation designed to provide participants with hands-on experience in making tactical decisions and implementing them in different market environments-from continuous order drive markets to call auction markets, and from dealer markets to dark liquidity pools.

By showing traders how to operate in these different markets, this reliable resource quickly reveals a good deal about what trading involves and how market design impacts trading decisions.

• Provides a virtual platform that gives users hands-on experience in making tactical trading decisions
• Shows exactly how prices are established in the marketplace
• Teaches how the structure of a marketplace influences participant decisions

Learning to trade through study is like learning about a roller coaster ride verbally. You may get the idea of going up and down and around curves, but will lack the actual experience. Mastering the Art of Equity Trading Through Simulation will get you as close as possible to the markets-without actually going in them-and prepare you to profit once you're really there.

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 p...

Table of contents

• Title Page
• Copyright Page
• Foreword
• Preface
• Acknowledgements
• PART ONE - An Overview of Equity Market Trading
• PART TWO - TraderEx Exercises
• About the Authors
• Index