Summary Financial Markets
Lectures & Slides
University of Amsterdam
Week 1: Basics of Securities Trading
In securities markets we can distinguish between two types of players:
- Buy side: these are players that demand trading services such as individuals (retail)
and individual investors (wholesale) like pension funds, mutual funds, corporates,
etc.
- Sell side: these are players who supply trading services:
o Market makers (MM): market makers provide liquidity and immediacy by
quoting prices at which they are willing to buy/sell securities (Note: these can
differ for wholesale transactions or transactions through the exchange).
Market makers absorb risk into their inventories and take risk. Their business
model relies on profiting from the bid-ask spread.
o Brokers: brokers trade on behalf of their clients. They send order to the
exchanges (or market makers), and do not trade themselves.
o Broker-dealers: do both.
Brokers can make money in various ways:
- Through fees and commissions.
- By lending out shares they possess.
- Receiving interest.
- Payment for order flow (PFOF): the compensation a broker receives for directing
orders for trade execution to a particular market maker. It transfers some of the
trading profits of the MM to the brokers.
To illustrate the above, let us consider the example below (see figure 1). Instead of sending
the respective sell and buy orders of Sue and Ben directly to the stock exchange, the brokers
direct the order to a Wholesale MM. This market maker earns a bid-ask spread of 0.03, of
which a part flows back to the brokerage firms in return.
,Figure 1: an example of PFOF.
In the example above the bid/ask prices offered on the exchange are relatively worse than
those offered by the wholesale market maker. This might seem puzzling: why don’t the
brokers go to the exchange with their orders? The reason is that outside of the exchange the
market maker only works with retail investors. On the exchange on the other hand, the
market maker cannot distinguish between orders and does not know where the orders come
from. There could be large orders there from hedge funds and hence market making on
exchanges involves more risk. As a result bid/ask prices on the exchange are usually slightly
worse than those offered by wholesale market makers outside the market.
The above also means that retail brokers can trade at better execution prices than other
parties that use the exchange.
When trading securities, there are several types of orders to be considered:
1. Market orders: a market order is an instruction to buy/sell at the best available price.
On the one hand this entails immediate execution, but on the other hand the price is
uncertain.
2. Limit orders: are instructions to trade at the best available price provided that it is no
worse than a specified limit price. Advantage: may improve the price at which the
security is traded compared to market orders, and the prespecified limit gives some
certainty. Disadvantage: however, there can be a cost of delay/non-execution. There
is so-called adverse selection or picking-off risk: the mere fact that our order is
waiting in the order book gives traders an opportunity to quickly trade against us. For
example: negative news hits the market and you did not cancel your old order yet.
3. Stop orders: are orders to buy/sell at the best available price once the price moves
above/below a specified stop price.
Note: may take a couple of milliseconds for a (market) order to arrive through the broker at
the exchange.
Consider the following example (for more, see lecture slides):
Buy 4500 shares, limit 100
In this example, there are no sellers willing to sell at a price of a 100. Therefore, this buy
order is added to the orderbook on the bid side. This shows that the limit order has provided
additional liquidity to the market.
When a limit order is executed immediately, we call it a marketable limit order. When it is
not, and added to the orderbook, it is a non-marketable order.
, A situation is also possible where a limit order can only be executed partially. Consider the
following example where the non-marketable part of the order is added to the other side of
the orderbook:
It is not always the case that the non-marketable part of an order is added to the other side
of the orderbook. It depends whether there is one of the following order qualifications:
- Immediate or cancel (IOC): all or part of the order is executed immediately, any
unfulfilled portion (the non-marketable part of the order) is automatically cancelled.
Useful if: you want to avoid picking-off. There is no non-marketable part in the
orderbook that might be taken advantage of.
- Fill or kill (FOK): either the entire order is executed immediately, or it is cancelled
entirely.
Useful if: you do not want partial execution, for example when you need an exact
amount of shares for hedging/voting purposes.
- All or nothing (AON): the order is executed in its entirety, either now or later. If the
order cannot be executed entirely, the order just remains active until market closure.
Remark: it is not added to the other side of the orderbook if it cannot be executed.
Remark:
Ask price = the price you should pay when you want to buy.
Bid price = the price you would receive if you sell your security.
Bid-ask spread = Ask - Bid, and Ask > Bid.
Relative spread = bid-ask spread / midpoint
Lectures & Slides
University of Amsterdam
Week 1: Basics of Securities Trading
In securities markets we can distinguish between two types of players:
- Buy side: these are players that demand trading services such as individuals (retail)
and individual investors (wholesale) like pension funds, mutual funds, corporates,
etc.
- Sell side: these are players who supply trading services:
o Market makers (MM): market makers provide liquidity and immediacy by
quoting prices at which they are willing to buy/sell securities (Note: these can
differ for wholesale transactions or transactions through the exchange).
Market makers absorb risk into their inventories and take risk. Their business
model relies on profiting from the bid-ask spread.
o Brokers: brokers trade on behalf of their clients. They send order to the
exchanges (or market makers), and do not trade themselves.
o Broker-dealers: do both.
Brokers can make money in various ways:
- Through fees and commissions.
- By lending out shares they possess.
- Receiving interest.
- Payment for order flow (PFOF): the compensation a broker receives for directing
orders for trade execution to a particular market maker. It transfers some of the
trading profits of the MM to the brokers.
To illustrate the above, let us consider the example below (see figure 1). Instead of sending
the respective sell and buy orders of Sue and Ben directly to the stock exchange, the brokers
direct the order to a Wholesale MM. This market maker earns a bid-ask spread of 0.03, of
which a part flows back to the brokerage firms in return.
,Figure 1: an example of PFOF.
In the example above the bid/ask prices offered on the exchange are relatively worse than
those offered by the wholesale market maker. This might seem puzzling: why don’t the
brokers go to the exchange with their orders? The reason is that outside of the exchange the
market maker only works with retail investors. On the exchange on the other hand, the
market maker cannot distinguish between orders and does not know where the orders come
from. There could be large orders there from hedge funds and hence market making on
exchanges involves more risk. As a result bid/ask prices on the exchange are usually slightly
worse than those offered by wholesale market makers outside the market.
The above also means that retail brokers can trade at better execution prices than other
parties that use the exchange.
When trading securities, there are several types of orders to be considered:
1. Market orders: a market order is an instruction to buy/sell at the best available price.
On the one hand this entails immediate execution, but on the other hand the price is
uncertain.
2. Limit orders: are instructions to trade at the best available price provided that it is no
worse than a specified limit price. Advantage: may improve the price at which the
security is traded compared to market orders, and the prespecified limit gives some
certainty. Disadvantage: however, there can be a cost of delay/non-execution. There
is so-called adverse selection or picking-off risk: the mere fact that our order is
waiting in the order book gives traders an opportunity to quickly trade against us. For
example: negative news hits the market and you did not cancel your old order yet.
3. Stop orders: are orders to buy/sell at the best available price once the price moves
above/below a specified stop price.
Note: may take a couple of milliseconds for a (market) order to arrive through the broker at
the exchange.
Consider the following example (for more, see lecture slides):
Buy 4500 shares, limit 100
In this example, there are no sellers willing to sell at a price of a 100. Therefore, this buy
order is added to the orderbook on the bid side. This shows that the limit order has provided
additional liquidity to the market.
When a limit order is executed immediately, we call it a marketable limit order. When it is
not, and added to the orderbook, it is a non-marketable order.
, A situation is also possible where a limit order can only be executed partially. Consider the
following example where the non-marketable part of the order is added to the other side of
the orderbook:
It is not always the case that the non-marketable part of an order is added to the other side
of the orderbook. It depends whether there is one of the following order qualifications:
- Immediate or cancel (IOC): all or part of the order is executed immediately, any
unfulfilled portion (the non-marketable part of the order) is automatically cancelled.
Useful if: you want to avoid picking-off. There is no non-marketable part in the
orderbook that might be taken advantage of.
- Fill or kill (FOK): either the entire order is executed immediately, or it is cancelled
entirely.
Useful if: you do not want partial execution, for example when you need an exact
amount of shares for hedging/voting purposes.
- All or nothing (AON): the order is executed in its entirety, either now or later. If the
order cannot be executed entirely, the order just remains active until market closure.
Remark: it is not added to the other side of the orderbook if it cannot be executed.
Remark:
Ask price = the price you should pay when you want to buy.
Bid price = the price you would receive if you sell your security.
Bid-ask spread = Ask - Bid, and Ask > Bid.
Relative spread = bid-ask spread / midpoint
