Equity Trading Gameand Tutorial

May 7, 2004

Directors:Sanjiv Parekh, John Kogel

Assistant Directors:J.P. Carlucci, Andrew Lisy,

Juthica Mallela, Raja Surapanani, Sarika Singh

Equity Trading Game and Tutorial

Welcome

• Sloan Trading Room Task Force was established in 1997 by Prof. Andrew Lo.

• Trading room is used for research, trading games and simulations, and finance classes.

• Types of trading games include: equity, fixed income, derivatives, and foreign exchange.

• Information: http://mitsloan.mit.edu/trader

• Email Us: taskforce@mit.edu

Equity Trading Game and Tutorial

Agenda

• Today’s Game: 2 Stocks

• Trading Interface

• Trading Mechanics: Bid-Ask

• Accessing Private Information

• Two Practice Games

• Questions and Answers

• The Final Game

Equity Trading Game and Tutorial

Case Scenario

• Two Stocks– ABC Company – CRA Corporation

• Two periods: Year 1 and Year 2

• 0% interest rate, no cost to borrow money

• Dividend paid at end of each period

Equity Trading Game and Tutorial

Private Information and Prices

• Different parties may have private information in the market. This information may give you an advantage in trading.

• Bid and Ask prices may reflect what private information other traders have

• If you know what the stock should be worth, take advantage of wrong prices through arbitrage

Equity Trading Game and Tutorial

Game Setup

• Dividend results rely on the state of the economy and firms

• The ABC Company has 3 different possible states in each period

• The CRA Corporation has 4 different possible states in each period

Equity Trading Game and Tutorial

• Realized events determine each stocks’ realized dividends

• Realized dividends determine each stocks’ price

• Events are all equally likely

• Traders will receive private information about which event is realized

ABC   Dividend

x Poor economic conditions, labor strike

0

y Poor economic conditions, no strike

12

z Fair economic conditions, good labor relations

24

CRA   Dividend

w Poor economic conditions, labor strike

0

x Poor economic conditions, no strike

12

y Fair economic conditions, no strike

12

z Fair economic conditions, good labor relations

24

 

Stock Fundamentals

Equity Trading Game and Tutorial

ABC Payoff Tree

Now

24

12

0

12

0

0

24

12

0

24

12

12

x

z

xyz

yxyz

xyz

Period 1

Period 2

Period 0

• Dividend in Period 2 depends on events realized in Period 1 and Period 2

• Starting out, probability of each event is equal

Equity Trading Game and Tutorial

ABC Payoff Tree

Min: 0 Max: 24

E [Price] = 9

Now

24

12

0

12

0

0

24

12

0

24

12

12

x, 1/2

z

x, 1/2y, 1/2

z

y, 1/2x, 1/2y, 1/2

z

xyz

Period 1

Period 2

Private Information:

Period 1: not z, Period 2: not z

• Use your Private Information to calculate the new expected stock price

Equity Trading Game and Tutorial

ABC Payoff Tree in Period 2

• Event y occurred, resulting in $12 dividend.

• Private Information still holds

• What is the expected value of ABC now?

Min: 0 Max: 12

E [Price] = 6

Period 1 24

12

0x, 1/2y, 1/2

zNow

Period 2

Equity Trading Game and Tutorial

Trading Mechanics

• Traders who want to sell stocks at a certain price post an Ask

• Traders who want to buy stocks at a certain price post a Bid

• Only Market Makers have the ability to post Bids and Asks

Equity Trading Game and Tutorial

The Bid-Ask Spread

BID

158 1/8

Market maker buys

Market taker sells

ASK

158 7/8

Market maker sells

Market taker buys

Equity Trading Game and Tutorial

Stay Within the Spread

Ask

sell buy

159 160

• Do not trade outside the spread• Be the market maker with unsophisticated traders in the market

$$$ $$$

Bid

sell buy

159 160

Equity Trading Game and Tutorial

Being the Market Maker

Ask

90

89*

Bid

80

81*

New Bid Makes the Market

(Market Maker)

New Ask Makes the Market

(Market Maker)

• Bid-Ask spread goes from 10 to 8 once the new bid and the new ask make the market

MARKET

Equity Trading Game and Tutorial

Being the Market Maker

Ask

90

91

Bid

80

79

Bid does NOT Make the Market

Ask does NOT Make the Market

MARKET

Equity Trading Game and Tutorial

Terminology

• Going Long: buy the stock– You think the stock price will go up

• Going Short: sell the stock– You think the stock price will go down– Selling more units than you have, known as short

selling, ends up with negative number of units.– In this game, you can short sell as much as you want– Have to cover short position at end by buying back

the stock. Done automatically in the game.

Equity Trading Game and Tutorial

Trading Interface

Stock NamesTraders in the FTSmarkets determine prices

Individualendowments

Seconds remaining for current trading period.

You can borrowor lend at a 0%interest rate

Realized payouts displayed here

Equity Trading Game and Tutorial

Enter any trading name(at least 3 characters)

Type in the actual names of each trader on the team

Logging In

DO NOT PRESS CONNECT UNTIL ASKED TO DO SO