Week 1 – Basics of Securities Trading
There are two “players” in securities markets:
“Buy” side: parties who demand trading services.
Individuals (retail).
Institutions (wholesale): mutual funds, pension funds,
corporates, etc.
These are the parties that want to trade.
“Sell” side: parties who supply trading services
Market makers (aka dealers, liquidity providers):
Acting as a “middleman” between buyers and sellers
Thereby providing liquidity but taking on risk. They take
on risk because the value of their inventory can fluctuate
unfavorably, for example. Or liquidity can dry up while
they still must provide liquidity in the market.
Market makers earn the bid-ask spread. They sell at the
ask price and buy at the bid price. While for the parties
demanding trading services, this is the other way
around.
Brokers
Buys and sells securities on exchanges on behalf of their
clients.
Brokers earn money with fees and commissions.
Or by lending out shares, interest income, or by luring
customers into high-fee products such as leverage or
crypto products.
And the last way for brokers to make money is Payment
For Order Flow (PFOF), where they earn money by
directing order flow to other parties (mostly market
makers) for execution, who then compensate the
brokers. This works because those market makers earn
money on the bid-ask spreads and are thus willing to pay
for extra order flows. However, this method provides a
conflict of interest, as brokers are looking to get the best
prices for their customers but are rather choosing the
higher PFOF’s.
Brokers-dealers: do both provide liquidity and act as market
makers and act as brokers.
There are three different types of orders:
Market orders:
Instructions to trade at the current best available price.
Is chosen by investors because the market order is executed
immediately; however, a market order has price uncertainty
because the current best price is chosen.
Limit orders:
, Instruction to trade at the best price available in the market
that is no worse than the specified limit price.
So, a limit order, generally, has a better price than a market
order. However, there is the possibility of delay and the risk
that the order will never be executed as prices may not reach
those levels again.
However, limit orders are also associated with adverse
selection risk and picking-off risk.
Adverse selection risk/picking-off risk: when a trader
places a limit order, and a more informed market
participant sees the order and executes against it. For
example, a trader places a buy limit order at $100 for a
stock they believe will rise in price. An informed trader
(that knows the price will likely fall) might observe this
limit order and place a sell order at $100, thereby selling
the stock at the higher price before the market moves
against them.
Stop orders:
Orders to sell (or buy) at the best available price once the
price moves below (or above) a specified price.
Stop limit order: Stop order & limit order combined.
Stop orders are mainly used to exit a trade to limit losses.
Other types of orders are IOC and FOK.
IOC: Immediate or cancel: the part of the order that can be
filled will be executed, the part that cannot be executed
immediately will be cancelled.
FOK: Fill or kill: execute the entire order immediately or cancel
entirely
Orders are filled based on the following conditions:
1. First, the orders with better prices have priority over other orders.
2. Then if orders have the same prices, displayed orders have
priority over hidden orders.
3. If orders have the same prices and visibility, then orders that are
older than other orders have priority.
4. If all these things are the same, larger orders have priority over
smaller ones.
Week 2 – Market Liquidity
2.1 Liquidity
Market liquidity: the ability to trade securities quickly and in possibly large
quantities at prices that are close to fair value. There are three dimensions
to market liquidity:
1. Market tightness refers to how narrow or wide the bid-ask spread is
in the market. A tight market means a small bid-ask spread; this
often reflects a high level of liquidity, as transactions can occur more
, easily without affecting the price too much. Also, a tighter market is
seen as more efficient, as traders can execute trades at prices closer
to fair value without substantial cost.
2. Market depth refers to the volume of buy and sell orders at various
price levels. A deep market has many orders on both sides of the
order book, meaning that there is enough liquidity at different prices
to absorb large trades without significantly moving the price.
3. Market resiliency refers to the ability of the market to quickly recover
and replenish liquidity after a large trade or price shock.
However, there are other meanings to liquidity than market liquidity:
So, market liquidity is the ease of trading, which is the focus of this
course.
Then there is funding liquidity:
Which is essentially about quickly obtaining financing to meet
payment obligations and other funding needs. This becomes
particularly important during financial crises. If entities cannot
obtain funding quickly, it can lead to a liquidity crisis where
they cannot meet their obligations, which can cause
widespread financial instability.
Lastly, there is monetary liquidity:
This type of liquidity refers to the availability of money (or
cash) in the economy. Representing the supply of cash, bank
reserves, and bank deposits.
2.2 Measures of market liquidity
There are different ways to measure market liquidity:
The quoted bid-ask spread
Covers market tightness
Relative spread = s = absolute bid-ask spread / mid-price (m)
(average bid-ask spread)
Price impact of small trade, relative to the mid-price = the
relative mid-price / 2 = s / 2
Weighted average bid-ask spread
For larger traders, transaction costs and price impacts may be
much larger; then the weighted average bid-ask spread will be
used.
Weighted average bid ask spread=S( q)=á ( q )−b́ ( q )
á ( q )= average execution price of buy market order
of size q
b́ ( q )= average execution price of buy market order
of size q
The inverse of S(q) is the market depth.
So, this measure covers market depth > as order size
increases and the weighted average bid-ask spread does not
increase much, this signals that the market is very liquid.
Price impact of buy order = (á−m ¿/m
Price impact of sell order = (m− b́)/m
There are two “players” in securities markets:
“Buy” side: parties who demand trading services.
Individuals (retail).
Institutions (wholesale): mutual funds, pension funds,
corporates, etc.
These are the parties that want to trade.
“Sell” side: parties who supply trading services
Market makers (aka dealers, liquidity providers):
Acting as a “middleman” between buyers and sellers
Thereby providing liquidity but taking on risk. They take
on risk because the value of their inventory can fluctuate
unfavorably, for example. Or liquidity can dry up while
they still must provide liquidity in the market.
Market makers earn the bid-ask spread. They sell at the
ask price and buy at the bid price. While for the parties
demanding trading services, this is the other way
around.
Brokers
Buys and sells securities on exchanges on behalf of their
clients.
Brokers earn money with fees and commissions.
Or by lending out shares, interest income, or by luring
customers into high-fee products such as leverage or
crypto products.
And the last way for brokers to make money is Payment
For Order Flow (PFOF), where they earn money by
directing order flow to other parties (mostly market
makers) for execution, who then compensate the
brokers. This works because those market makers earn
money on the bid-ask spreads and are thus willing to pay
for extra order flows. However, this method provides a
conflict of interest, as brokers are looking to get the best
prices for their customers but are rather choosing the
higher PFOF’s.
Brokers-dealers: do both provide liquidity and act as market
makers and act as brokers.
There are three different types of orders:
Market orders:
Instructions to trade at the current best available price.
Is chosen by investors because the market order is executed
immediately; however, a market order has price uncertainty
because the current best price is chosen.
Limit orders:
, Instruction to trade at the best price available in the market
that is no worse than the specified limit price.
So, a limit order, generally, has a better price than a market
order. However, there is the possibility of delay and the risk
that the order will never be executed as prices may not reach
those levels again.
However, limit orders are also associated with adverse
selection risk and picking-off risk.
Adverse selection risk/picking-off risk: when a trader
places a limit order, and a more informed market
participant sees the order and executes against it. For
example, a trader places a buy limit order at $100 for a
stock they believe will rise in price. An informed trader
(that knows the price will likely fall) might observe this
limit order and place a sell order at $100, thereby selling
the stock at the higher price before the market moves
against them.
Stop orders:
Orders to sell (or buy) at the best available price once the
price moves below (or above) a specified price.
Stop limit order: Stop order & limit order combined.
Stop orders are mainly used to exit a trade to limit losses.
Other types of orders are IOC and FOK.
IOC: Immediate or cancel: the part of the order that can be
filled will be executed, the part that cannot be executed
immediately will be cancelled.
FOK: Fill or kill: execute the entire order immediately or cancel
entirely
Orders are filled based on the following conditions:
1. First, the orders with better prices have priority over other orders.
2. Then if orders have the same prices, displayed orders have
priority over hidden orders.
3. If orders have the same prices and visibility, then orders that are
older than other orders have priority.
4. If all these things are the same, larger orders have priority over
smaller ones.
Week 2 – Market Liquidity
2.1 Liquidity
Market liquidity: the ability to trade securities quickly and in possibly large
quantities at prices that are close to fair value. There are three dimensions
to market liquidity:
1. Market tightness refers to how narrow or wide the bid-ask spread is
in the market. A tight market means a small bid-ask spread; this
often reflects a high level of liquidity, as transactions can occur more
, easily without affecting the price too much. Also, a tighter market is
seen as more efficient, as traders can execute trades at prices closer
to fair value without substantial cost.
2. Market depth refers to the volume of buy and sell orders at various
price levels. A deep market has many orders on both sides of the
order book, meaning that there is enough liquidity at different prices
to absorb large trades without significantly moving the price.
3. Market resiliency refers to the ability of the market to quickly recover
and replenish liquidity after a large trade or price shock.
However, there are other meanings to liquidity than market liquidity:
So, market liquidity is the ease of trading, which is the focus of this
course.
Then there is funding liquidity:
Which is essentially about quickly obtaining financing to meet
payment obligations and other funding needs. This becomes
particularly important during financial crises. If entities cannot
obtain funding quickly, it can lead to a liquidity crisis where
they cannot meet their obligations, which can cause
widespread financial instability.
Lastly, there is monetary liquidity:
This type of liquidity refers to the availability of money (or
cash) in the economy. Representing the supply of cash, bank
reserves, and bank deposits.
2.2 Measures of market liquidity
There are different ways to measure market liquidity:
The quoted bid-ask spread
Covers market tightness
Relative spread = s = absolute bid-ask spread / mid-price (m)
(average bid-ask spread)
Price impact of small trade, relative to the mid-price = the
relative mid-price / 2 = s / 2
Weighted average bid-ask spread
For larger traders, transaction costs and price impacts may be
much larger; then the weighted average bid-ask spread will be
used.
Weighted average bid ask spread=S( q)=á ( q )−b́ ( q )
á ( q )= average execution price of buy market order
of size q
b́ ( q )= average execution price of buy market order
of size q
The inverse of S(q) is the market depth.
So, this measure covers market depth > as order size
increases and the weighted average bid-ask spread does not
increase much, this signals that the market is very liquid.
Price impact of buy order = (á−m ¿/m
Price impact of sell order = (m− b́)/m
