Slide 1©R. Schwartz Equity Markets: Trading and Structure

Topic 2

Slide 2©R. Schwartz Equity Markets: Trading and Structure

Purpose

1) Experience what trading involves– Tactical, fast decision making– Be a prop trader, buyside equity trader, market maker

2) Participate in a process that translates news into prices 3) Evaluate the effects of trading rules and alternative market

structures on:– Investor participants (the naturals)– Market maker intermediaries – Market quality

4) Compare and understand alternative market structures5) Compete and have Fun

Slide 3©R. Schwartz Equity Markets: Trading and Structure

An Important Distinction

Simulations can be based on either

1. "Canned" data from past events

2. Computer-generated data

TraderEx is based on computer-generated orders and price changes – not canned repeats of past events

Slide 4©R. Schwartz Equity Markets: Trading and Structure

A Trading Simulation Requires

• Prices can be affected by your actions

• You have some basis for anticipating future price changes

• Prices can move in harmony with news releases

• Prices do not follow random walks

• Simulation runs can be replayed

• Your performance can be assessed

Slide 5©R. Schwartz Equity Markets: Trading and Structure

Performance Assessment

1. Performance characteristics– Profit and loss (P&L)– Beat Volume Weighted Average Price (VWAP)– Control risk (avoid large inventory positions)– Get the job done (execute your orders, liquidate

your positions)

2. Your Score– Weighted combination of the above

Slide 6©R. Schwartz Equity Markets: Trading and Structure

What Drives Trading?

1. New information (news)2. Liquidity motives3. Technical (noise) trading4. Divergent expectations (people disagree with each other)

Machine generated order flow is based on draws from various statistical distributions. We can view the statistical

events as representing solid economic stories.

Economic stories concerning the motives for trading

Slide 7©R. Schwartz Equity Markets: Trading and Structure

Trading Mechanism

Informed

Is p*>offeror p*<bid?

Orders Come from 3 Types of Traders

LiquidityOrder Flow

Quotes,Prices,Volume

Technical Trading

Is there a trend/pattern?

P*

Do the informedTraders agree with

each other? maybe not!

Slide 8©R. Schwartz Equity Markets: Trading and Structure

The Economic Story Behind the Consensus Price, P*

Bid

Ask

Sells Buys

P*

Bid

Ask

Slide 9©R. Schwartz Equity Markets: Trading and Structure

$22.00

$23.00

$24.00

$25.00

$26.00

$27.00

$28.00

P*

Day 1 Day 2

A Typical Random Walk Pattern Of P*

Slide 10©R. Schwartz Equity Markets: Trading and Structure$21.00

$22.00

$23.00

$24.00

$25.00

$26.00

$27.00

$28.00

Ask

Bid

P*

Day 1 Day 2

P* and Best Bid and Offer Quotes

Slide 11©R. Schwartz Equity Markets: Trading and Structure

P* and News

1. In simulations P* need not change according to random draws from a distribution

2. When united with news release, new P* values are set in accordance with the news

Slide 12©R. Schwartz Equity Markets: Trading and Structure

0% 2% 4% 6% 8% 10% 12% 14%

25.80

25.90

26.00

26.10

26.20

26.30

26.40

26.50

26.60

Price (5¢ Tick Size)

Probability

Limit sell orders

Offer

Bid

Executable sell orders

Distribution For Generation of Liquidity Motivated Sell Orders