FIN 320- Equity Markets (5)

Identify trading venues for US equities
Define market and limit orders
Discuss differences between market and limit orders
Define dealer and auction markets
Discuss differences between dealer and auction markets
Define liquidity and identify the various dimensions of liquidity
Identify and discuss components of the bid-ask spread
Discuss notable issues in the recent history of US equity markets

To invest in financial assets, you need to trade
Trading is costly
Given that you have decided on what to trade, how you trade and where you trade affect your trading cost
This in turn affects your investment return
We examine trading in US equity markets

On Friday, 9/5/2008, Intel Corp’s closing price was $20.61 per share.
Over the weekend, you analyzed Intel’s financial statements and read a couple of analyst reports.
Your estimate of Intel’s intrinsic value = $21
Intel is underpriced.
Decision: buy 1,000 shares of Intel on Monday, 9/8/2008

Over the weekend, there was no news about Intel => no change in Intel’s value
Monday Intel prices
Dealer’s Bid: $20.35
Dealer’s Offer: $20.85

You bought 1000 shares of Intel from dealer at $20.85
You sold your shares later once Intel’s price reached $21

The cost you incurred in trading with the dealer reduced your return from 1.9% to 0.7%.

To trade effectively, you need to know how equities trading is carried out in the US

An order is an instruction specifying:
the direction of the trade (buy or sell)
which security to trade (e.g., Coca-Cola)
what quantity to trade (e.g., 100 shares)
conditions that the trade must satisfy (e.g., buy at $50 or lower)

Example: buy 100 shares of Coca-Cola at $50 or lower

An investor can submit a variety of orders. The two most common are:
Market order
Limit order

an instruction to trade at the best price currently available

buy at the lowest possible price available

sell at the highest possible price available

AstroPower (APWR) trades in the Nasdaq market. Nasdaq dealers are willing to buy APWR at $36.80 and willing to sell at $36.85.
These quotes are good for 500 shares on the bid side and 400 shares on the ask side.
Bill submits a market order to buy 200 shares of APWR.
What is Bill’s purchase price?

an instruction to trade at the best price available, but only if it is no worse than the limit price specified by the trader

buy stock at or below the limit price

sell stock at or above the limit price
Limit orders that have not executed are “standing limit orders”. These orders enter into the Limit Order Book

Sandy wants to buy 1000 shares of IBM if the price drops below $95. Right now, IBM is trading at $100. Sandy submits a limit buy order with a $95 limit price.
1) Suppose 2 hours later, IBM’s price falls to $93. Will the limit order be executed?
2) Suppose 2 hours later, IBM’s price rises to $103. Will the limit order be executed?

Market Limit
Immediacy of execution Immediate execution.
No waiting. Execution not immediate.
Need to wait.
Cost More costly: pay bid-ask spread Less costly: avoid bid-ask spread
Certainty of execution Certain Uncertain: order may fail to execute
Execution price Little control: take whatever price is available More control over execution price
Picking-off risk Protected: best available prices should reflect 
up-to-date information Exposed: if not updated, order can be executed against better informed traders

Stock Exchanges
OTC markets
Alternative Trading systems

New York Stock Exchange (NYSE)
American Stock Exchange (AMEX)
Regionals: Cincinnati, Philadelphia, Boston, Chicago, Pacific

National Association of Securities Dealers Automated Quotation System (Nasdaq

Electronic communication networks (ECNs): Inet, Archipelago
Crossing networks

Trading venue Listed stock traded volume (million)
NYSE 51,248
AMEX 998
NASDAQ 32,174

Dealer (a.k.a. “market maker”)
A financial intermediary who stands ready to buy and sell a fixed quantity of stock (or any financial asset in general)
Provides a buying price (bid) and a selling price (ask or offer)
Typically, ask price > bid price
Bid-ask spread: Ask price – bid price
Provides the service of immediate execution to investors
Bid-ask spread is dealer’s compensation for providing this service

Dealer market
Investors buy at dealer’s ask price
Investors sell at dealer’s bid price
Buying and selling prices are set by the dealer
Typically, multiple dealers will offer to trade in a single stock. They can compete by adjusting their bid-ask spread.
Example of dealer markets: NASDAQ, bond market, foreign exchange market

No dealers; investors submit limit orders
Market buy order executes against the ask price established by a previously placed limit sell order of another investor
Market sell order executes against the bid price established by a previously placed limit buy order of another investor
If you don’t like the best available bid/ask price, you can submit your own limit order
Examples: NYSE, Paris Bourse, Tokyo Stock Exchange

High liquidity Low liquidity
Bid-ask spread Small
Trading is less costly Big
Trading is more costly
Price impact Small
Prices do not move a lot when you buy/sell a fixed quantity Big
Prices move a lot when you buy/sell a fixed quantity
Depth Many shares available at bid and ask prices Few shares available at bid and ask prices
Trading speed High
Trades accomplished quickly Low
Trades take a long time to execute
Resiliency Prices recover quickly after a large trade Prices takes a long time to recover after a large trade

Flotsam and Jetsam are two companies selling widgets. Both have similar market capitalizations and both are traded on Nasdaq. If Flotsam is more liquid than Jetsam, which of the following would you expect to see?
Flotsam has a spread of $0.10/share; Jetsam has a spread of $0.05/share
A trader takes 30 minutes to sell 10,000 shares of Flotsam and 45 minutes to sell 10,000 shares of Jetsam
For Flotsam, there are 5,000 shares at the bid and ask prices. For Jetsam, there are 7,000 shares at the bid and ask prices
For Flotsam, a market buy order of 10,000 shares moves the price by $1. For Jetsam, a market buy order of 10,000 shares moves the price by $0.50.

Order processing cost
Inventory cost
Adverse selection cost
Competition

Encompasses costs directly associated with dealer’s market making service, e.g.,
Floor space rent
Costs of computer, communications and office equipment
Clerical cost of processing trade
Opportunity cost of market maker’s time
Largely fixed for any particular transaction
However, order processing cost per share declines with trade size

Has two components:
Opportunity cost of funds tied up in carrying market maker’s inventory

Expected loss from adverse movement in inventory value
Higher when stock is very volatile

Expected loss from trading with informed traders
Informed trader
Someone with better information than market maker regarding security value
E.g., company insiders, portfolio managers, people with information that is not known to the public
Uninformed trader
Someone who does not have better information than market maker regarding security value

Market maker loses on trades with informed traders
Market maker makes a profit on trades with uninformed traders
Bid-ask spread must be wide enough so that on average, profits from uninformed trades offset losses from informed trades

This is the spread component due to competition among market makers
If many market makers compete to supply market making services, competition intensifies and bid-ask spread narrows, vice versa
Think of spread as the “price” charged for market making services
If competition increases, market makers reduce their “prices” or spreads to attract customers’ order flows
Caveat: large numbers of market makers does not guarantee intense competition and narrow spreads

Researchers at Duke, Vanderbilt and Australian National Universities examined bid-ask spreads of Nasdaq stocks at three points in time: 3/1996, 4/1998, 12/2001

Source: Bollen, Nicolas P. B., Tom Smith, and Robert E. Whaley, 2004, Modeling the bid/ask spread: measuring the inventory-holding premium, Journal of Financial Economics 72, 97-141.

Key findings:
On average, spreads have narrowed over time due to decimalization
Importance of competition component has declined
Importance of inventory holding and order processing costs have increased
Importance of adverse selection fluctuated

Month Average spread (cents) Percentage due to:
Minimum tick size Order processing Competition Inventory holding Adverse selection
Mar 1996 27.39 31.95 8.92 21.15 29.28 8.70
Apr 1998 20.55 1.08 15.79 19.20 32.25 31.68
Dec 2001 7.91 16.16 15.27 14.40 44.68 9.48

Suppose you have private information about ABC Co. (i.e., you are an informed trader). On the basis of your private information, you know ABC is worth $30/share. Currently, ABC is $28.50 bid and $28.75 ask.
Assuming that you have enough money, would you:
Buy 100 shares at $28.75
Buy 10,000 shares $28.75?

Informed traders prefer to trade large quantities to fully exploit their superior information
Risk of trading against informed rises with trade size
Researchers from LSU have found that as trade size increases,
Adverse selection component of the spread indeed increases
Order processing cost per share decreases
Lin, Ji-Chai, Gary C. Sanger, and G. Geoffrey Booth, 1995, Trade Size and Components of the Bid-Ask Spread, The Review of Financial Studies 8, 1153-1183.

Yes, if more market makers -> more intense competition and price cutting

No, if market makers tacitly agree to maintain wide spreads

In 1994, researchers from Vanderbilt and Ohio State published a study suggesting that NASDAQ dealers tacitly colluded to keep spreads of at least $0.25/share by avoiding odd-eighth quotes
Christie, William G., and Paul H. Schultz, 1994, Why Do NASDAQ Market Makers Avoid Odd-Eighth Quotes?, Journal of Finance 49, 1813-1813.

Quote: price at which dealer offers to trade
Tick size: smallest allowable change in quote/price (a.k.a. “minimum price increment)

Before June 1997, tick size was one-eighth of a dollar ($0.125)
Implies that narrowest possible spread was one-eighth

Christie and Schultz (1994) used data from the 100 largest NASDAQ stocks in 1991
Sample stocks included Apple, Lotus, MCI, etc
A stock can have as many as 60 market makers

Compared to NYSE/AMEX stocks, spreads based on even-eighth quotes were far more common for NASDAQ stocks
Odd-eighth spreads of $0.125, $0.375, $0.625 were rare
Even-eighth spreads of $0.25, $0.5 and $0.75 were common
This can happen if NASDAQ dealers avoid changing quotes by odd-eighths

When odd-eighth quotes were posted on NASDAQ, they were available for very short durations
Even-eighth quotes were available for much longer periods of time
Average duration of:
Odd-eighth quote: < 2 minutes
Even-eighth quote: 20 – 35 minutes
Very hard for public to take advantage of narrower odd-eighth quotes

Is there an incentive for a dealer to deviate from tacit collusion?

What is needed to ensure that dealers do not deviate from tacit collusion?

In a follow-up study, Christie, Harris and Schultz (1994) reported large reductions in spreads and more frequent use of odd-eighth quotes
Christie, William G., Jeffrey H. Harris, and Paul H. Schultz, 1994, Why Did NASDAQ Market Makers Stop Avoiding Odd-Eighth Quotes?, Journal of Finance 49, 1841-1841.

May 26 and 27, 1994
Findings of Christie and Schultz were published in several national newspaper

May 27, 1994
NASDAQ dealers in Amgen, Cisco Systems and Microsoft sharply increased use of odd-eighth quotes
Average spreads dropped by nearly 50% 
(from above $0.25 to $0.151-0.175)

May 28, 1994: spreads for Apple also fell by about 50%

Civil lawsuits were filed against NASDAQ dealers (on behalf of customers)
May 1999: suits consolidated & settled for ≈ $1billion

Dramatic drop in spreads after publication of findings on May 26/27 1994

Previous discussion draws attention to the issue of tick size
Starting in the late 1990s, US equity markets saw reductions in the tick size

Dates
June 2, 1997 Nasdaq: 1/8th ($0.125) ↓ 1/16th ($0.0625)
June 24, 1997 NYSE: 1/8th ($0.125) ↓ 1/16th ($0.0625)
January 29, 2001 NYSE: 1/16th ↓ 1 penny
April 9, 2001 Nasdaq: 1/16th ↓ 1 penny