and unsolicited opinions that appear in them.Bulls and BearsTraders call rising markets bull markets and falling markets bear markets. According to legend,these terms originated from morbid contests that promoters once staged between bulls and bears.Bulls fight by thrusting upward with their horns. In contrast, bears fight by striking downwardwith their claws. This image has generated a small cottage industry of artisans who create bullfighting-bear sculptures that traders buy to adorn their offices and living rooms.I took the examples that appear throughout the book from all types of markets and from manydifferent countries. A disproportionate number, however, involve equity trading in the UnitedStates since these are the best-known markets in the world. As noted above, most principles thatapply to these markets also apply to all other markets.1.7 An Important DisclaimerTraders often encounter significant legal and tax issues. Some types of trades are illegal, manytrades create significant tax liabilities, and many commercial relationships in trading createimportant legal liabilities. If you trade, you must know the legal consequences of your actions.The purpose of this book is to examine economic issues in trading, not legal issues. The textaddresses many legal issues because legal issues often have significant economic implicationsfor the markets, and because economic issues often are the basis for legal regulation. This bookwill help you to better understand the economic implications of laws that regulate securities,contracts, traders, and exchanges. It will also help you understand the economic bases for manyregulations. It is not an authority for what the law is nor for what laws you should pay attentionto.Do not rely upon this book for guidance on any legal issues. Your author is not a qualified legaladvisor. Consult a qualified attorney when you must address legal questions.1.8 SummaryThis book will help you understand the theory and practice of trading in exchange markets anddealer networks. When you master this subject, you will be able to trade more effectively, youwill better appreciate the organization of our markets, and you will be able to form well-reasonedopinions about how the markets should be organized.Markets have changed substantially during the last 100 years, and they will continue to change inthe next 100 years. The current pace of change is fast and accelerating. By the time you readthis, some specific descriptive information in this book will undoubtedly be dated. The
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economic principles governing markets and the traders in them, however, will remain the same.These concepts will help you understand all markets—past, present, and future.
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Chapter 2Trading StoriesThis chapter presents stories about how traders arrange routine trades in stocks, bonds, futurescontracts, and currencies. If you are new to trading, you should read this chapter to help youappreciate the trading problems that people solve. If you are already quite familiar with trading,you also may want to read this chapter. Although these stories describe routine trades, theyhighlight difficult issues that traders confront when trading.This chapter is full of institutional details. Do not worry if you do not understand every detail onyour first reading. After you have finished reading this book, you will be able to understandthese stories completely. For now, just read them to get a feel for what trading is about. Theimpressions that you form will help you appreciate the practical importance of the analyses thatthis book presents.2.1 A Retail Trade in a NYSE-listed StockJennifer wants to buy 200 shares of AT&T. She calls her retail broker with whom she hasalready established an account. (Jennifer could also have used her broker’s Internet-based orderentry system.) Jennifer’s broker might work for a full service broker/dealer, such as MerrillLynch, a national discount brokerage, such as Charles Schwab, or perhaps a local deep discountbrokerage, such as Los Angeles-based Dreyfus Brokerage Services.Jennifer provides the broker with her account number and identifies herself. She then asks forthe current quotes for AT&T common stock. The broker looks at a screen on his desk thatappears like the Bridge Information Systems quotation display in Figure 2-1. The screen showsthe best bids and offers for AT&T that traders display in the Consolidated Quotation System.The quotes come from dealers at the New York Stock Exchange, from dealers at several regionalexchanges, from some independent NASD (National Association of Securities Dealers) dealers,and from some electronic communications networks (ECNs) that display limit orders that theirclients have placed with them. The broker responds by quoting the best current prices at whichtraders can immediately buy or sell AT&T (ticker symbol “T”) shares. Given the information inFigure 2-1, the broker reports that the best (highest) bid for AT&T is for 19.83 dollars and thebest (lowest) offer is at 19.85. The broker also tells Jennifer that the last trade in AT&T was at19.84 dollars, which is down 0.10 from the previous day’s close. Jennifer considers the quote.She then gives her broker instructions to buy the shares.
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19.84 DN
E/MM(N)CAES(T)TRIM(B)(M)(P)MADF(C)SBSH(X)NYDSWSTARCA
TIME14.06 +14.0614.06 +14.0614.04 +14.06 +14.01 +14.0614.06 14.0014.06 +12.249.4214.06
OI BUY :OI SELL :T/q
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AT and T Corp *#0.10 (N) 14.06
LEHMPRUS
-BID19.8319.8319.8319.8319.8019.7319.7219.7019.7019.6919.5819.5090.01FBCOUBSS
SIZE(H)6 dq11130120511150011GSCONATW
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20E/MMMADFCAES(T)(C)(N)ARCA(B)(M)(P)TRIMNYD(X)SBSHSWST
TIME14.0614.0614.0614.0614.0614.0614.0414.0614.0114.0612.2414.0614.009.42
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Common Stock19.51 V 8,341,400
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-ASK19.8519.8519.8519.8519.8619.8919.9419.9619.9819.992020.1120.1424.99
SIZE(H)505050133 dq5301202500111
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04-Oct-01 14:06 NYC
(c)BRIDGE
Figure 2-1. A Quotation Montage for NYSE-listed AT&T Common StockSource: Bridge Information SystemsThe first line shows that this quotation montage provided by Bridge Information Systems is for US ticker symbol T, which correspondsto AT&T Corp common stock. The plus at the beginning of the second line shows that this price is higher than the last different tradeprice. AT&T last traded at 19.84, down 0.10 from the previous day’s closing price. The trade took place at the NYSE (N) at 14:06Eastern Time (2:06 PM). The highest price of the day so far was 20 and the lowest was 19.51. The total trading volume so far was8,341,400 shares.The table that follows consists of a two sets of four columns each for bid and ask quotes. The first column of each set identifies thequote maker. Exchanges have one and three letter symbols. Dealer-brokers and electronic communications networks have four lettersymbols. The exchanges listed here are the New York (N and NYD), Boston (B), Pacific (P), Cincinnati (C), Philadelphia (X), andChicago (M) Stock Exchanges. The symbol (T) refers to the best quote from an NASD over-the-counter dealer. The next three columnsshow the time when the quote was made, the price, and the number of shares (in hundred lots) for which it is firm. The dealer-brokersthat appear on this list are Bernard L. Madoff Investment Securities, Inc. (MADF), Salomon Smith Barney, Inc. (SBSH), SouthwestSecurities, Inc. (SWST), and Trimark Securities, Inc. (TRIM). The electronic communications networks are Archipelago (ARCA) andthe Nasdaq Computer Assisted Execution System (CAES).The rows on the bid side are sorted so that the bids with the highest prices are at the top. Bids that have the same price are sorted so thatbids with larger sizes are above bids with smaller sizes. Bids that have the same price and size are sorted so that bids made earlier appearabove bids made later. The rows on the ask side are sorted so that the asks with the lowest prices are at the top. Otherwise, the sort orderis the same as that for the bids.The first line on the bid side shows that the NYSE specialist indicated that at 14:06, buyers there indicated that they were willing to buyat least a total of 600 shares for 19.83. This interest may come from traders on the floor of the exchange, from the specialist’s limit orderbook, or from the specialist himself. The plus sign next to the time indicates that this bid was higher than the last different bid price.The “dq” next to the NYSE bid size indicates that the NYSE has also distributed a depth quote. The symbol NYD identifies the NYSEdepth quotes. Traders at the NYSE are willing to buy at least 50,000 shares for 19.50.The NYSE ask quote is not the lowest price ask in the market. The Madoff offer for 5,000 shares and the Cincinnati Stock Exchangeoffer for 100 shares are one penny lower. The Madoff offer generated the lines that start with T and CAES.The two rows near the bottom of the screen present order indications (OI) that brokers and dealers have asked Bridge to display toBridge clients. The first order indication on the buy side is from Lehman Brothers, Inc. (LEHM). The first indication on the sell side isfrom Prudential Securities, Inc. (PRUS).The first item on the last line of this screen shows the command that requested this display. (Sometimes this line also shows thecommand that Bridge expects you will next want to enter.) The first part of the command, “T,” indicates the ticker symbol. The nextpart “/q” requests Bridge’s quote montage. The Bridge server filled this request on October 4, 2001 at 14:06 New York City time.
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To convey her intentions, Jennifer will use either a market order or a limit order. A market orderinstructs the broker to buy at the best price available. A limit order instructs the broker to buy atthe best price possible, but in no event pay more than a limit price that Jennifer specifies. IfJennifer uses a limit order, she will also specify when she wants the order to expire. Forexample, a day order will expire when the trading session ends.Jennifer decides to submit a day limit order to buy 200 shares of AT&T, ticker symbol “T,” forno more than 19.80 dollars per share. The broker enters Jennifer’s order into his computerizedorder entry system. The system then confirms that Jennifer is authorized to make the trade.Next, the broker reads back the order to ensure that it is exactly what Jennifer intended. (Thebrokerage firm records the telephone calls in case a dispute arises about what they said.) AfterJennifer confirms the order, the broker releases it, and the order entry system sends it to anexchange or to a dealer.Although AT&T primarily trades at the New York Stock Exchange, Jennifer’s brokerage housemight not send her order there. As Figure 2-1 demonstrates, many other exchanges and dealersalso trade AT&T. The brokerage might send the order to a regional exchange or to a NASDdealer. Where the brokerage order system sends the order may depend on the prices the variousmarkets quote. It may also depend on cash payments and other nonmonetary inducements thatdealers offer brokerages to obtain their order flow.The brokerage’s order entry system sends Jennifer’s order to the NYSE by transferring it to theNYSE’s SuperDot order routing system. SuperDot then presents the order to the specialist whomanages AT&T trading on the floor of the exchange. The specialist will act as the floor brokerfor Jennifer’s order. Jennifer’s order appears on a workstation screen that the specialist rentsfrom the exchange.The AT&T specialist is a trader who works for a member firm of the New York Stock Exchange.He sometimes trades as a dealer for his firm’s account and sometimes as a broker for his clients.The Exchange gives the specialist some special privileges and special responsibilities. Thespecialist receives all of the SuperDot order flow in AT&T. He organizes the AT&T trading toensure that it is orderly, and he represents all orders entrusted to him. In exchange, the Exchangerequires that he trade for his own account to fill customer market orders if no one else is willingto do so.Since Jennifer’s order is a limit order, the specialist first sees if anyone is interested in filling itimmediately. No sellers are presently interested because other traders are bidding higher prices.The specialist then places her order in his electronic limit order book. Jennifer’s order will standin the book until the specialist can match it with someone who wants to sell at or below its limitprice, until the order expires, or until Jennifer tells her broker to cancel it.(If Jennifer submitted a market order instead of a limit order, the specialist would conduct anauction to find the trader willing to sell at the lowest price. A trader on the floor, a standing limitorder in the order book, or the specialist himself might offer that price. If no one wants to fill themarket order, the specialist would fill it himself by selling some of his own shares in AT&T toJennifer.)A few minutes after Jennifer entered her order, a large seller sends a market order throughSuperDot. The specialist uses his computer to match this order with several orders including
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Part IThe Structure of TradingThe chapters in this part of this book describe how traders arrange their trades. We start inChapter 3 with a quick introduction to the trading industry. This chapter provides you with somebackground information about who trades, what they trade, where they trade, and how theirtrading is regulated. You can safely skip reading this chapter if you are already familiar with theindustry.Chapter 4 describes how traders communicate their orders to the brokers, dealers, and exchangesthat arrange their traders. We describe the orders that traders use and examine the properties ofthose orders. We also establish important concepts about the origins of liquidity in this chapter.In Chapter 5, we consider how market structures vary. The differences in how markets organizetheir trading are important because they affect the profitability of different types of traders. Westart to consider the relative advantages of various trading systems in this chapter.Chapter 6 describes how exchanges use order-driven market mechanisms to arrange trades. Thediscussion introduces important issues that affect how traders formulate optimal ordersubmission strategies.Chapter 7 discusses how brokers serve their clients. We carefully describe their roles as tradenegotiators and as clearing and settlement agents. You may find this chapter most interesting forits discussions about how markets prevent traders from engaging in various types of fraudulentactivities.
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Chapter 3The Trading IndustryThis chapter provides a brief survey of the trading industry. If you are already familiar with theindustry, you can safely skip this chapter. If you are new to trading, the discussions here willprovide you with the “big picture” that will allow you to better understand the rest of this book.In particular, you will be better able to discriminate between issues of primary and secondaryimportance if you know the context in which traders solve their trading problems.This chapter is full of financial jargon and institutional detail. Most of it is not necessary forunderstanding the remainder of this book. If you are interested only in understanding marketstructure, you need not master the details.We first consider who trades. Then we characterize trading instruments and the markets wherethey trade. Finally, we examine how regulators oversee trading.3.1 Who Are the Players?Traders are people who trade. They may arrange their own trades, they may have others arrangetrades for them, or they may arrange trades for others. Proprietary traders trade for their ownaccounts while brokers arrange trades as agents for their clients. Brokers are also called agencytraders, commission traders, or commission merchants. Proprietary traders engage inproprietary trading, and brokers engage in agency trading.Traders have long positions when they own something. Traders with long positions profit whenprices rise. They try to buy low and sell high.Traders have short positions when they have sold something that they do not own. Traders withshort positions hope that prices will fall so that they can repurchase at a lower price. When theyrepurchase, they cover their positions. Short sellers profit when they sell high and buy low.The trading industry has a buy side and a sell side. The buy side consists of traders who buyexchange services. Liquidity is the most important of these services. Liquidity is the ability totrade when you want to trade. Traders on the sell side sell liquidity to the buy side. Asubstantial fraction of this book considers how interactions between buy side and sell side tradersdetermine the price of liquidity.(The buy- and sell sides of the trading industry have nothing to do with whether a trader is abuyer or seller of an instrument. Traders on both sides of the trading industry regularly buy andsell securities and contracts. The terms buy side and sell side refer to buyers and sellers ofexchange services.)3.1.1 The Buy SideThe buy side of the trading industry includes individuals, funds, firms, and governments that usethe markets to help solve various problems that they face. These problems typically originateoutside of trading markets. For example, investors use securities markets to solve intertemporalcash flow problems: They have income today that they would like to have available in thefuture. They use the markets to buy stocks and bonds to move their income from the present to
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the future. We discuss this problem and other buy side trading problems in Chapter 8 (WhyPeople Trade).Many buy side institutions are pension funds, mutual funds, trusts, endowments, and foundationsthat invest money. These institutions are known collectively as investment sponsors. Investmentsponsors frequently employ investment advisors to manage their funds. Investment advisors arealso called investment counselors, investment managers, or portfolio managers. Investmentadvisors often employ traders to implement their trading decisions. These traders are buy sidetraders. The people and institutions who will ultimately benefit from the funds that investmentsponsors hold are beneficiaries. A summary of buy side traders appears in Table 3-1.Table 3-1. The Buy Side of the Trading IndustryTrader type
Generic examples
Why they trade
Typical instruments
Investors
IndividualsCorporate pension fundsInsurance fundsCharitable and legal trustsEndowmentsMutual fundsMoney managers
To move wealth from thepresent to the future forthemselves or for theirclients.
StocksBonds
Borrowers
HomeownersStudentsCorporations
To move wealth from thefuture to the present.
MortgagesBondsNotes
Hedgers
FarmersManufacturersMinersShippersFinancial institutions
To reduce businessoperating risk.
Futures contractsForward contractsSwaps
Assetexchangers
International corporationsManufacturersTravelers
To acquire an asset thatthey value more than theasset that they tender.
CurrenciesCommodities
Gamblers
Individuals
To entertain themselves.
Various
3.1.2 The Sell SideThe sell side of the trading industry includes dealers and brokers who provide exchange servicesto the buy side. Both types of traders help buy side traders trade when they want to trade.Dealers accommodate trades that their clients want to make by trading with them when theirclients want to trade. Dealers profit when they buy low and sell high. We discuss dealers inChapter 13.In contrast, brokers trade on behalf of their clients. Brokers arrange trades that their clients wantto make by finding other traders who will trade with their clients. Brokers profit when their©2002 Oxford University Press
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clients pay them commissions for arranging trades with other traders. We discuss brokers inChapter 7.Many sell side firms employ traders who both deal and broker trades. These firms therefore areknown as broker-dealers or dual traders.The Wire in WirehouseTraders often call large broker-dealers wirehouses. The word “wire” in wirehouse once referredto the telegraph. Following its invention, broker-dealers used the telegraph to collect orders frombranch offices in distant cities. Those who quickly adopted it were able to expand theirbusinesses substantially and thereby greatly increase their profits. The ability to communicatequickly was—and remains—very important in the trading industry.The sell side exists only because the buy side will pay for its services. We therefore mustunderstand why the buy side trades before we can understand when the sell side is profitable.We consider how and why both sides trade in subsequent chapters. Table 3-2 provides asummary of sell side of the trading industry.Table 3-2. The Sell Side of the Trading IndustryTrader type
Generic examples
Well-known US examples
Why they trade
Dealers
Market makersSpecialistsFloor tradersLocalsDay tradersScalpers
Spear Leads & KelloggLaBranche & Co., Inc.Bernard L. Madoff InvestmentSecuritiesKnight Trading GroupTimberHill LLC
To earn tradingprofits bysupplyingliquidity.
Brokers
Retail brokersDiscount brokersFull-service brokersInstitutional brokersBlock brokersFutures commissionmerchants
Charles Schwab & Co.E*TradeDreyfus Brokerage ServicesAbel/Noser Corp.XpressTradeCargill Financial Markets Group
To earncommissions byarranging tradesfor clients.
Broker-dealers
Wirehouses
Goldman SachsMerrill LynchSalomon Smith BarneyMorgan Stanley Dean WitterCredit Suisse First Boston
To earn tradingprofits and tradingcommissions.
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Chapter 4Orders and Order PropertiesOrders are trade instructions. Orders specify what traders want to trade, whether to buy or sell,how much, when and how to trade, and most importantly, on what terms. Traders issue orderswhen they cannot personally negotiate their trades.Orders are the fundamental building blocks of trading strategies. To trade effectively, you mustspecify exactly what you intend. Your order submission strategy is the most importantdeterminant of your success as a trader. The proper order used at the right time can make thedifference between a good trade, a costly trade, or no trade at all.Many markets arrange all their trades by using a set of rules to match buy and sell orders thattraders submit to them. To understand how these markets work and to use them effectively, youmust understand how traders specify their orders.Understanding orders will also allow you to see where liquidity comes from. Liquidity is theability to trade when you want to trade. Some orders offer liquidity by presenting other traderswith trading opportunities. Other orders take liquidity by seizing those opportunities. Traderdecisions to offer or take liquidity therefore affect market quality. To understand liquidity, youmust understand how traders form their order submission strategies.This chapter will show you what orders are, how traders specify them, and most importantly,what properties they have. Traders choose orders that have properties that allow them to bestsolve their trading problems.Familiarize yourself with the many trading terms introduced in this chapter. We will use themthroughout the book. Traders use specialized words and phrases to communicate quickly andaccurately with each other. Whether you intend to trade or simply want to learn about trading,you need to be familiar with market nomenclature.Although order instructions have the same meanings in all markets, their properties differdepending on the type of market to which traders submit them. In this chapter, we will assumethat traders submit their orders to a continuous trading market that arranges trades as ordersarrive. Identical orders have slightly different properties in call markets that collect and processall orders at the same time. We examine call markets and the properties of orders submitted tothem in Chapter 6 (Order-driven Markets).4.1 What Are Orders, and Why Do People Use Them?Orders are instructions that traders give to the brokers and exchanges that arrange their trades.The instructions explain how they want their trades to be arranged.An order always specifies which instrument (or instruments) to trade, how much to trade, andwhether to buy or sell. An order may also include conditions that a trade must satisfy. The mostcommon conditions limit the prices that the trader will accept. Other conditions may specify forhow long the order is valid, when the order can be executed, whether it is okay to partially fillthe order, where to present the order, and how to search for the other side. Some orders evenspecify the traders with whom the trader is willing to trade.
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An Order ExampleHarry wants to sell 7,600 shares of Exxon Mobil (XOM) at no less than 41.05 dollars per share,but only if he can trade during the current trading session and only if he can trade the entirequantity at once. He would issue an all-or-nothing, day order to sell 7,600 shares of XON, limit41.05 dollars.Orders are necessary because most traders do not personally arrange their trades. Traders whoarrange their own trades—typically dealers—do not use orders. They decide on the spot whatthey want to do and how to do it. All other traders must carefully express their intentions aheadof time.For many small traders, it is not economical to continuously monitor the market. These tradersuse orders to represent their interests when they are not paying close attention to the market.Traders who arrange their own trades have an advantage over traders who use orders to expresstheir intentions. The former can respond to market conditions as they change. The latter mustanticipate such changes and write contingencies into their orders to deal with them. Carefullywritten orders will adequately represent traders’ interests even when conditions change. Whenorders do not do so, traders must cancel them and resubmit new instructions. During the time ittakes to cancel and resubmit orders, traders can lose because their old orders trade before theycan cancel them, or because they cannot submit new orders in time to take advantage of thechanging market conditions. Traders therefore must carefully specify their intentions when theyuse orders to trade.In general, traders who can respond most quickly to changes in market conditions have anadvantage over slower traders. Traders who submit and cancel orders manually are slower thantraders who use computers to monitor and adjust their orders. Where speed is of the essence,floor traders and computerized traders are the most successful traders.Clear and efficient communication is essential when trading in fast markets. Brokers mustunderstand exactly what traders intend. Otherwise, extremely costly errors may occur. To avoidmistakes, most traders use standard orders to decrease the probability that they willmisunderstand each other when communicating quickly. All traders recognize and understandthese orders.This chapter introduces the standard orders and describes their properties. We must define somebasic terms first.4.2 Some Important TermsTraders indicate that they are willing to buy or sell by making bids and offers. Traders quotetheir bids and offers when they arrange their own trades. Otherwise, they use orders to conveytheir bids and offers to the brokers or automated trading systems that arrange their trades. Bidsand offers usually include information about the prices and quantities that traders will accept.Traders call these prices bid and offer prices. They also use the terms bidding price, offeringprice, asking price, or simply bid and ask. They refer to the quantities as sizes.Prices are firm when traders can demand to trade at those prices. Prices are soft if the traderswho offer them can revise them before trading. Orders generally have firm prices.
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The highest bid price in a market is the best bid. The lowest offer price is the best offer (orequivalently, the best ask). Traders also call them the market bid and the market offer (or marketask) because they are the best prices available in the market. A market quotation reports the bestbid and best offer in a market. A market quotation is often called the BBO, which is the acronymfor Best Bid and Offer. Many markets continuously publicize their market quotations. The bestbid and offer anywhere in the United States is the NBBO—National Best Bid and Offer.The difference between the best ask and the best bid is the bid/ask spread. Traders sometimescall it the inside spread because the space between the highest bid price and the lowest ask priceis inside the market. The English often refer to the spread as the touch. In sports bettingmarkets, bettors and bookies call it the vigorish.An order offers liquidity—or equivalently supplies liquidity—if it gives other traders anopportunity to trade. For example, suppose Joe issues an order to buy 100 shares of IBM for nomore than 100 dollars per share from the first person to contact him before trading closes today.Joe’s bid offers liquidity because other traders now have the opportunity to sell IBM for 100dollars per share. Joe’s bid is a day limit order because it is only valid for the day, and becauseJoe limits the price that he will pay.Buyers and sellers can both offer liquidity. Buyers offer liquidity when their bids give othertraders opportunities to sell. Sellers offer liquidity when their offers give other tradersopportunities to buy.The dual use of the word “offer” may seem confusing. It may refer to an offer of an item forsale, or to an offer of liquidity. If you think of liquidity—the ability to trade when you want totrade—as a service that you can buy or sell, the use of the word “offer” makes sense. Thisperspective leads to many useful insights. For example, dealers make money by selling liquidityto