1 penny.But if I trade 50 times that amount, I am no better off because my liquidity isnot at a penny wide. It is still at 6 cents.WOOD [From the Floor]: Given the size range that you are in, can youprovide us with a feel for any change that decimalization has had in youraggregate trading cost?CARDELLO: Our operation started about two years ago. When westarted, we were trading 10 lots. In those days, when decimalization wascoming in, it made a difference. But nowadays, with the sizes that we trade,we are typically several thousand up on liquid names, on individual posting,and maybe even five times that on facilitation type orders.29 Sodecimalization helps to the extent that it brings in more liquidity, but I wouldnot say that it makes much of an impact given the sizes we are trading now.KRELL: We have time for one more question.NARI JOTE30 [From the Floor]: Someone had said that, if there was novolatility, there would be no stock market. Is there any relationship betweenvolatility, transaction costs, and the cultural behavior of the individuals? I29
A facilitation type order occurs when a broker dealer takes some fraction of the “otherside” on an order to trade a number of contracts at a certain price.
30
Nari Jote is Management Consultant and Global Business Coordinator at Jote & Associates.
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have worked in India, in the U.K., and in this country. I see that people havea different behavioral sense when it comes to volatility. What do youcorrelate that with?I also have a second question. What part does an Enron type disaster playin volatility?KRELL: I didn’t really understand the first question. Let’s move to thesecond one.JOTE [From the Floor]: OK.KRELL: Does anyone wish to comment on the changing volatility in anEnron-type situation? How is that taken into account in options pricing?CARDELLO:Obviously, volatility goes up immediately.Theinteresting thing about something like an Enron is that, since the news didnot all come in one sudden instant, and since the price did notinstantaneously go to its lowest level within 20 minutes (it took a couple ofdays), and because there was a liquid underlying market, we were able tocontinue making markets in Enron even though the option volatilities wentway up. The implied skew of the option – the expectation that the stockprice would decline instead of rise – was also immediately changed. Wesaw that we were able to conduct orderly market making activity in Enronwhile the stock was open on the stock exchange. The options prices wentway up. This was largely because there was liquidity in the underlying stockduring that time, and the price movement did not occur all at once. Contrastthis with a case where a merger or an acquisition is announced and, all of asudden, the stock immediately goes up 10 points and stays there forever.That is an un-hedgable event.KRELL: I believe your first question was…JOTE [From the Floor]: My first question was cultural. Isn’t it a culturalfactor that different countries have different volatility factors?CARDELLO: A quick answer to that is to contrast the U.S. with HongKong. There is a very large speculative interest in Hong Kong. You seehigh volatility markets. You do not see very high liquidity except in some ofthe indices. And, in the U.S., because you do not have that level ofspeculative mentality, you have other institutional players in there.Consequently, the U.S. markets are not as ‘choppy.’KRELL: The other issue pertains to market structure. In India, forexample, until recently, you had a product called ‘badla.’ Basically, badlawas a way of buying and selling stock without paying for it. It is called‘kiting’ in the U.S., and it was outlawed after the Crash of 1929 because itwas cited as a contributing factor. But in India, it was legal and prevalent,extremely prevalent, until it was outlawed within the last year or eighteenmonths. Now I think it is much more likely that you will get a situationwhere you have true derivatives trading in India. But that was a way of
Chapter 2: Intra-Day Volatility: Friend or Foe?
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trading a derivative without trading on an organized exchange. Badla wasbasically a bet between two individuals on the price of the underlying stock.It was like a swap. And then the payments would be equalized. Am Icorrect on that?31JOTE [From the Floor]: That is true. And it is changing fast with theglobal economy integrating together.WOLF: In academia, and I believe also in practice, we find that whenthe market is down, volatility is up, and visa versa. Right now, we are goingthrough a different phase. The market is down and volatility is down.Putting this together, how would this effect the trading of options based onwhat we see right now?KRELL: We are recently undergoing a consolidation in the optionsindustry. You can read almost every week about the prices of membershipsat various exchanges, and about various trading groups consolidating. Weare in a unique situation. The competition between and among the marketsis so intense, that spreads have narrowed to their tightest levels in optionstrading in a decade. And volatility is at an all time low. That is not a goodcombination to have from an options trading perspective. It is all threeplagues happening at the same time: industry consolidation, narrower
31
Kiting was prevalent in the U.S. prior to 1929, according to financial historians. It had anunsavory connotation because kiting was used to prop up “bucket shops.” It allowedspeculators to buy and sell stocks without putting up any cash. For example, an investorcould buy a stock through a broker dealer for $10 without putting up the money and then,an hour later in a rising market, sell the stock for $11 dollars and pocket the difference of$1.
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spreads and volatilities at new lows.32 As a result, we are undergoing toughtrading times from a trader’s perspective. From the customer’s perspective,it is terrific, but from the trading perspective it is very, very difficult.I would like to thank our panelists, Tom and Avner, for a terrific job.Thank you all very much.
32
The larger, more capital-intensive firms in the U.S drive industry consolidation of smalloptions specialist firms. The multiple listing of stock options on various exchanges hashurt these small firms. Consequently, there are fewer traders on the floors and demand forseats has softened in part because of this trend. Decimal pricing has also hurt floor traders.In early 2003, there were five U.S. options exchanges and a sixth pending a launch in midyear. These six are the Chicago Board Options Exchange, the International SecuritiesExchange, the American Stock Exchange, the Philadelphia Stock Exchange, the PacificExchange and finally the Boston Options Exchange, which was expected to become thelatest.
CHAPTER 3: VIEW FROM THE TRADINGDESKSModerator – Robert Schwartz, Speiser Professor of Finance, Zicklin School ofBusiness, Baruch College, CUNY
Andrew Brooks, Vice President and Head of Equity Trading, T. Rowe Price AssociatesChristopher Killeen, Senior Trader, TIAA-CREF Investment ManagementMark Madoff, Director of Listed Trading, Bernard L. Madoff Investment SecuritiesBarry Small, CEO, Weeden & CompanyGeorge Sofianos, Vice President, Goldman SachsBruce Turner, Managing Director and Head of U.S. Equity Trading, CIBC
ROBERT SCHWARTZ: The seating, like the program, is in alphabeticalorder. Fortuitously for us, it meshes with another purpose I have in mind;clustering. My panelists are arranged in three clusters. First we have AndyBrooks and Chris Killeen, who are on the buy-side. Next we have MarkMadoff and Barry Small, who are on the sell-side. Finally, we have GeorgeSofianos and Bruce Turner, who are on both sides (laughter). But not at thesame time – they both have had the pleasure of working for a major marketcenter, and also for a broker dealer firm. The only thing that is missing fromthe panel is some people from the listing companies themselves. They neverappear on these panels because they don’t know what a limit order is(laughter).Let me start with the buy-side cluster. You guys are the ultimatecustomers, aren’t you? Chris, by the way, was a little late getting here thismorning because he was actually present at the volatility spike in the firsthalf hour of trading today. And, since he was trading my funds, I hope hegot a good executionCHRISTOPHER KILLEEN: I tried.SCHWARTZ: Andy and Chris, can I ask both of you first to give us aquick description of your orders? I know that you occasionally trade 1,000
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shares or even 100 shares. I do not care about those small orders. Tell usabout the tough ones.ANDREW BROOKS: I would like to start by emphasizing that marketquality, which is the title of today’s conference, has become a big issue. Formany of us, a very big issue.In response to your question Bob, we certainly do have 100 share orders.We try to process and route them as efficiently and as economically as wepossible can. We try to allow traders the opportunity to focus on the larger,tougher orders; the orders that are 20 times average daily volume. An orderof this size can represent 2% of a company’s outstanding shares. Theseorders are really difficult to handle, especially when there is news out or anevent. They are also difficult when there are lots of buyers and we are theonly seller, or when there are lots of sellers and we are the only buyer.Implementing an effective trading strategy in this situation is verydifficult. It may sound easy if there are lots of buyers and you are the onlyseller. You should not have a problem in selling but the issue becomes, atwhat price do you sell? You’d think you could sell higher but how high ishigh? You need to know if you have the luxury of patience. When we are abuyer, the answer would involve a conversation with the portfolio managerabout how to initiate a certain strategy to buy the shares for this large order.When we are a seller, if there is no luxury of time, for instance, you have tosell right away.SCHWARTZ: Could I quickly break in and ask Wayne Wagnersomething? What Andy is saying is common, isn’t it, Wayne? I have seenyour statistics on the number of orders that are bigger than average dailyvolume. I do not know about 20 times daily volume, but bigger than 100percent of daily volume is very common.WAYNE WAGNER33 [From the Floor]: We find that 80% ofinstitutional orders are for more than half a day’s volume.SCHWARTZ: Let us talk about market quality in this context. This isa fun one. Andy, back to you.BROOKS: For the big orders, what you think you will be able to do isoften impossible to achieve. I am sure that we have representatives ofpeople who gauge or assess the transaction costs on a particular stock. Forexample, this morning it might cost you 9 cents to buy 300,000 shares of‘telephone.’ But the market is up 100 points, and I bet it will cost you 29cents. (I do not know where ‘telephone’ is trading right now, I am justguessing.) Invariably that is the world we live in. You think you can be
33
Wayne Wagner is Chairman of Plexus Group.
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patient, you think you can trade tight. But it is not always possible to tradeat a level that you think is initially possible.I am delighted that we are, perhaps, starting to focus less on thenarrowing of spreads, and more on this intra-day volatility. Intra-dayvolatility is really making our jobs very difficult. It is making it very hard totrade, and our orders are indeed large.SCHWARTZ: Chris, how do you feel about this, and about whathappened this morning?KILLEEN: Our problem is that we have these institutional sizedorders in a market that has been designed for retail investors.SCHWARTZ: Could you repeat that? I didn’t hear you (laughter).KILLEEN: It seems as if the cards are stacked against the institutions.This is because the market has been designed for retail order flow.SCHWARTZ: Do people in the audience agree? Raise your hands.Thanks. I see a lot of agreement.KILLEEN: I would like to say something about what happened thismorning. We participated, with volatility, on the open. We had a buy and asell swap trade, in the same industry, and both stocks opened up higher. Asfar as participating on the open, which I know we want to talk about later,you have to take every trade, one by one. With the easier trades, we try tohandle and route them electronically for execution to save time for the moredifficult trades.When a trader considers participating on the opening price on the floor ofthe NYSE, every order must be evaluated individually to satisfy the bestexecution of the trade, using normal trading volume and price volatility as aguideline. The decision of whether or not to participate should be based onhow that opening price and volume would impact trading in the stock. If thestock isn’t very liquid and it looks as if a relatively large volume of stockwill trade on the open, then it would be wise to participate. It may be wiseto participate even without a great deal of volume. On a final note, thisdecision can be made with the help of a ‘look’ from a floor broker at thebooth where the stock is about to open. Included in this look is an indicatedprice spread along with the size of the orders, to buy and to sell. Of course,since the NYSE operates under the auction method, this look is subject tochange before the stock actually opens, but it is nonetheless the best andonly information about where the stock will be trading when it officiallyopens.Getting back to this morning, I had two stocks that opened up. Oneopened up $3 higher (about 2 ½ % higher) and the other one opened up $1higher. Common sense told me to stay away from the open on the stock thatI wanted to buy, and to sell into the strength of the one that I wanted to sell.SCHWARTZ: Did they then come back?
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KILLEEN: They did come back for a short time.SCHWARTZ: They both mean reverted?KILLEEN: Right, they did revert. Then, at 10: 00, some consumerconfidence numbers came out that buoyed the market a little bit, and themarket for all stocks strengthened. I tried to take advantage of that. It was avolatile period, the first half hour today. It was a big open. I came in andtried to snatch up some stock before they ran away. Meanwhile, I waskeeping up with the sell-side and trying to take advantage of the marketwhile it was hot. There was news related to the stock I was interested in, soit might hang out there all day in a strong upward move. By ‘hang out there’I am referring to the strength of the move in the stock’s price. The news outthat particular day had created an upward bias in the price of the stock. Ididn’t want to compete my order too early and miss higher prices to sell at,so I began pacing myself with the strength in the overall market.That is the challenge. We spend most of our time on the difficulttrades. I search for liquidity because the market is not built for trades ofhundreds of thousands of shares. You can get a typical order that can be halfa million shares, and the stock might trade 50,000 shares a day. That hugeorder is going to take time. You have to find the contra side of the trade, andthat is a battle. But we do have a number of tools and protocols that we usein the search.SCHWARTZ: Thanks, Chris. Mark, let me move quickly over to you.We are talking about market structure with regard to institutional needsversus retail needs. What are your thoughts?MARK MADOFF: Our focus is solely on the retail order. As Andymentioned, while he is trying to devote more time towards larger size trades,we try to become a destination for the smaller trades. That is what we focuson. The average retail investor either comes in through a mutual fund, orcomes in through an individual equity trade. We all need to do our job well.Everybody needs to focus on best execution from his or her own perspective,and we need to focus on it from the individual side. That is how we try toapproach things.SCHWARTZ: As you made that comment, which I do resonate with, Inoticed you flinch a little. I was not surprised, because I know that you areat a different end of the order size spectrum. But there is a thought that Ihave had. I was thinking about it late yesterday, and an image came to mymind.How many of you remember that old, very famous folk blues singer,Lead Belly? Are we dating ourselves on this one (laughter)? There is asong that Lead Belly sang which is pretty meaningful. It is meaningful forMark Madoff’s operation, and for you guys on the institutional side who arehaving trouble working your orders. The big players can be incurring
Chapter 3: View from the Trading Desks
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market impact, and they see it as a cost. But how does it affect the marketfor the retail order flow? Here is Lead Belly’s answer. The song is, ‘We arein the Same Boat Brother.’ The key line of the song is, ‘if you shake oneend you will rock the other, we are in the same boat brother.’ If you bigguys are knocking price around, how does it affect what others, includingretail, are seeing and feeling?MADOFF: It is hard for us to assess that. Decimalization has broughtthe average spread in the stocks in the S&P 500 from somewhere in thevicinity of 10 cents down to 2 cents. The decline is dramatic. But theshrinking of the spread, and the shrinking of the size at the spread, has had amuch smaller impact on the small order than it has on the large trade. Theaverage retail trade, globally in the industry, enjoys about a five-secondturnaround time. This means that they are achieving a level of automaticexecution. Those orders are coming in, and are being returned quickly to theinvestors as completed trades.But it is difficult for us to assess exactly what the impact would be if aretail order came in along with a 200,000 share institutional order. Whatwould happen to the small order? All we can do is focus on the small order.We can make sure that, at the point of entry, we take a snapshot of themarket, execute that order, and return it to the customer. And we can look atmarket impact versus the time lapse between order entry to the time of orderexecution.SCHWARTZ: Mark, you are talking about a five second turnaround.Andy, what are you guys thinking about when your order is equal to averagedaily trading volume, or, perhaps, 20 times daily volume? What is yourturnaround time?BROOKS: It varies. It all depends on how quickly you can locate theliquidity at the price point that you ...SCHWARTZ: Five seconds?BROOKS: Certainly not five seconds (laughter).SCHWARTZ: Five minutes, five hours, a day, more?BROOKS: It depends. Sometimes you could be initiating a position ordisposing of a position over several months. If a decision is made to disposeof a stock, it could take several weeks or several days to complete. It couldtake five seconds or 10 minutes if you get a hit in a crossing network, or ifyou call, for example, Weeden & Co. There is a random element andsometimes you don’t know what you could trade in the market until you try.But the question would then become, are you comfortable with the price atthat time? The answer is, you’d better be before you trade it all. You’dbetter be comfortable in your investment decision and be comfortable thatthe price you are trading at is a fair price.
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There is a myriad of choices to search for liquidity in this process. Youshould look to see where the stock has been trading and how much volumehas been done. There are market data facilities such as AutEx and Bridge, aswell as Nasdaq market maker data to show who is the largest dealer inparticular stocks. On the NYSE, you might check with a floor broker to seewho was the dominant player in a stock.SCHWARTZ: There are two dimensions to think about. One is the sizeof an order, and the other is the price of a trade. What happens to size andprice when things get turbulent? Isn’t one of the causes of turbulence yourelephant size orders? And how do you handle your elephant size orders inturbulent times?Let’s consider market quality in the context of a relatively stressful time.In particular, let’s focus on the first half hour of the trading day. That istypically a stressful time. How many of you knew already that volatility ishigher in the first half hour? Thanks. Great, a good show of hands. Isn’tthat a wonderful thing about rigorous statistical analysis? It tells you thatwhat you always knew to be true is indeed true at the .05 level.With that as background, I want to ask Chris and Andy another question.When you get an order to work that exceeds average daily volume or amultiple thereof, what do you start thinking about? What goes through yourmind?CHRIS: What I think about is accessing institutional size liquidity. Imight first try the stealth approach and enter my order in a crossing networksuch as POSIT and/or Liquidnet. I would then take a look at the previousday’s trading history to find out what broker was involved in the name. Imight then call that broker and have a discussion about the availability ofstock without tipping my hand to the exact size of my order. In extremecases, we might even contact the company directly to obtain stock. In theabsence of luck on these fronts, we usually expose small amounts to thefloor and work them patiently until the order is compete.BROOKS: In the context of the opening, you think about how big yourorder is relative to what is traded. Do you think you will be able to get itdone in a reasonable time frame? Is there a sense of urgency? Have youbeen instructed and communicated with your portfolio manager? Do youhave a strategy that he or she has bought into?Like you, Bob, I was giving some thought to this yesterday, and I cameup with an analogy. The first half hour is similar to the breaking of the gateat the Preakness. All the horses charge out and they are looking for position.Somebody wants to be on the inside rail. Somebody is holding back becausethey know that they will finish strong and they think that the start was tooquick. Chris talked about that today, about a stock opening up $3. If youare a buyer, do you want to be in on that part of the race, or do you want to
Chapter 3: View from the Trading Desks
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lay back? That is part of the reason why there is so much volatility at theopening. There is so much confusion. You have all of these horsesscrambling and trying to figure out what strategy they want to employ. Andthat strategy changes every day, based on God knows what – news, theenvironment, feelings, the weather, and lots of other things.SCHWARTZ: I know, Andy, that the opening is a period of particularinterest to you. I have empirical validation of that. Last week I wasinvolved with putting my material together, forgot to look at the clock, andcalled Andy at 9: 32. He could only pronounce the first two letters of myname (laughter). We continued the call later.One thing that you definitely think about is the time frame, right? Howquickly do you want the job done? In light of this, there is one question Ihave always wanted to get my arms around. I have talked to various peopleabout it, and rarely get a straight answer. The open, the first 15 minutes, orthe first half hour- is it a particularly difficult time, or is it not a particularlydifficult time to trade in?KILLEEN: It is a very difficult time.BROOKS: It is difficult because there is a lack of information. Stockscan get three different looks in that time span. In a rapidly changingmarketplace, a stock could get many different looks. By a look I mean, atleast on the floor of the exchange, that buyers and sellers will put theirorders in and then cancel out in that time frame. There is an information lagthere. If you have a market order, you have to be very careful with it. Youhave to make sure that the person you give your market order to understandswhat you are trying to accomplish and that he knows the price you arecomfortable with.SCHWARTZ: You want to look and go carefully. Is it because you areuncertain about the prices that you are seeing?BROOKS: That could be one part of it. It could also be that I do notwant to dominate the volume. That is, not unless I am very confident in myapproach. If I have a new order, I am going to look at it from a top downapproach. I am going to say to myself, where is the order coming from?What industry is it? What is the characteristic of the portfolio manager, orof the portfolio itself? Is it to add to an existing position, or is it a newposition? I will quickly think through all of that. Based on that, I will getthe look from the floor. If I think it is beneficial for us to participate, I willbe a good part of the volume.SCHWARTZ: Especially if the market is coming to you. If you want tobuy, and you just know it, and if prices happen to be lower, then you willtake advantage of the situation. Correct?BROOKS: But we also know from the work that you all have done, thatthe first hour of trading is a big part of the volume for the day. That is
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important to us. I also think that the specialists, or the people making themarkets, can profit the most in that opening 10 or 15 minutes, and maybe atthe close as well. So your question, Bob, how do you feel about the prices,is a very good one. It really comes down to how confident I am of the orderand what I have to do. And also how confident I am of what I really think isgoing on in terms of supply and demand that has not come to the market. Iam referring to the latent trading interest of those who are just looking. Youknow, those people who are staying out of the opening and who might showup at 10: 30.SCHWARTZ: Yes, the unrevealed orders. This relationship betweenvolatility and volume is a tricky one. It came up in the previous panel. Yousee a lot of volume in the first half hour, and that volume drives volatility.However, on the other hand, volatility can discourage volume. That is likethe identification problem that Paul Bennett was mentioning. Which waydoes it really go? Do you guys like to go in at the open, yes or no?BROOKS: In general?SCHWARTZ: In general and relative to other times. Is there somethingin you that holds you away from the opening?BROOKS: I would say my opinion on that has changed in the last fewyears. I have a positive bias and would probably want to be there on a stockthat has decent trading characteristics. By decent trading characteristics, Imean, if it has a decent trading volume on an ordinary day. That ispredicated on my confidence, and on whether or not I wanted to get the bigpiece of volume done relative to the order that I have on the desk.BROOKS: One of the challenges is, if you are interested in buying orselling a stock, and if there is going to be price dislocation and you are notthere, you are not represented. I had a situation ten days ago that shouldnever have happened, but it did. I missed the opening. The stock opened upa dollar, and I was not there to sell my 17,000 shares. I am still irritatedabout it. It was a lack of communication (laughter).34But that was a terrific opportunity. If we had been there, maybe it wouldnot have opened up a dollar. Maybe it would have opened up 40 cents. Thatis part of the gamesmanship going on. What cards are you showing, whatare you holding back? But invariably, you do not get to benefit from a pricedislocation unless you are there in the first place.KILLEEN: You have to be careful of price dislocation, which is a bigmove in the price of a stock since the previous day’s closing price. If you34
Chris Killeen notes that whenever a human broker working an order for a buyside traderneglects to give this trader a ‘heads up’ on a price dislocation, the broker is usually sent tothe ‘penalty box’ by the trader. He used the sports metaphor to mean that the trader wouldtemporarily stop using the services of the broker as a sort of professional reprimand.
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have an illiquid ‘open’ order on your desk, you would most likely want toparticipate when this happens, if only because it is usually associated withlarge volume causing the price movement. You don’t want your portfoliomanager asking, ‘How come you weren’t there?’SCHWARTZ: Do you have any particular opinion about the open?KILLEEN: I see more retail activity at the opening, and I see moreoverseas activity at the opening. The institutions are much more cautious.As Andy said, if they see a dislocation, they will take advantage of it. But Iknow the institutions do not want to go in, be in the opening, and have thesespecialists provide the liquidity. They do not want that to happen. But ifthere is natural liquidity there, that is to their advantage. Then they willplay.BARRY SMALL: We see that a tremendous percentage of the market’sdaily trading, probably around 20% to 25%, takes place on the opening, preopening market orders. A lot of the action comes from retail customers whohave spent the evening digesting the news that has taken place. It isprobably their best opportunity to be on an equal footing based on news.This is very important. We also see a lot of institutional buyers come in. Itis the small institutional players who prefer to put their orders in on theopen. They do not want to leave any subjectivity to a trader. Their attitudeis, get me the open and let me go home. The time difference also plays afactor on orders from overseas. These investors want to go home, and gettheir stuff done.SCHWARTZ: That is interesting. We see similar statistics from Europe,where electronic trading platforms characterize the markets, and electroniccall auctions are the formal opening procedures. Order flow at the Europeancall market openings is predominantly retail.I keep thinking about the heavy volume that we see in the first half hour.There are a lot of orders there that could have come in earlier. They couldhave come in at the open. But they don’t, because they are part of the horserace. Is that fair Andy?BROOKS: It is absolutely fair. We are fond of describing some of whatwe do as that big poker game in the sky. When you play that game, you takeyour time putting your cards down. You are careful how you do it.SCHWARTZ: I want to interrupt this discussion. There is a questionfrom the audience. Natan, what is it?NATAN TIEFENBRUN35 [From the Floor]: My question relates to thelack of confidence around the open. It is a U.S. problem. From myexperience trading in European markets, it is not a European problem. It has35
Natan Tiefenbrun is Senior Vice President at Instinet Corporation.
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to do with a lack of confidence in the price formation process. On the floorof the New York Stock Exchange, you have no idea where that price iscoming from. You do not know if it is a specialist applying liquidity, or if itis natural liquidity. Consequently, you have no confidence and you back offto see what happens.In Nasdaq, the problem is that you have so many small retail orders, somany little spikes, and so much noise. It is really hard in Nasdaq to see thetrue price formation that is going on.Across most of Europe, the open is liquid and transparent. Participantshave great confidence. Institutions do go in at the open in ContinentalEurope,