Lecture 01:

The Trading Process

• Why do markets exist?
• How does trading occur?
• Who are the participants?
• What instruments are traded?
• What are orders?
• How do we arrive at the “price”?

Dr. Yuanji Wen Chapters 1 & 2 FINA3307

Yuanji.wen@uwa.edu.au Trading in Securities
Markets
Related chapters

 Teall, 2018, Chps 1.1 – 1.6, 2.6, 2.7

 Hasbrouck, 2020, Chps 1, 2, 6

The University of Western Australia 2

Why do markets exist?

 Basic function of the market is to bring together buyers and

sellers.
• Capital allocation
– Capital market necessary for economic growth and development
– Companies need capital to fund projects
– Secondary market

• Price discovery and liquidity

– Price discovery is the process of determining the price for an asset through
the interaction of buyers and sellers

The University of Western Australia 3

Why do markets exist?

 Investing is linked to the rationale to buy or to sell (e.g., to

exploit undervaluation).

 Trade decision concerns how to execute the investment decision,

in which markets, and at what prices and times and through
which agents.
• Acquisition of information
• Routing of the order
• Execution of the trade
• Confirmation, clearance and settlement.

The University of Western Australia 4

Overview of the trading process

Buyer instructs adviser Seller instructs adviser

to buy security to sell security

Operator submits buy Operator submits sell

order order

Trading mechanism matches

orders and executes trades

Settlement of funds and

shares through clearing
house
The University of Western Australia 5
Who are the participants?

 The two sides of the trading industry

• Buy Side – People and institutions who use financial services.

• Sell-Side – Those who provide the financial services.

Buy-side players include Sell-side players include

Individuals Brokers
Corporate Dealers
Pension/investment funds Exchanges
Insurance reserve funds Clearing houses
Governmental funds Depositories and custodians

The University of Western Australia 6

Why do they trade?

Utilitarian traders Profit-motivated traders

 Investors  Speculators
 Borrowers  Arbitrageurs
 Asset exchangers  Dealers
 Hedgers  Algorithmic traders
 Tax-avoiders

The University of Western Australia 7

What instruments are traded?

 Real assets produce cash flows over time

• E.g., plant & machinery, factories, patents, flour, corn….

 Financial assets are instruments that represent ownership of real

assets and cash flow they produce.
• Examples?
• What about Chi-X’s TraCRs (Transferable Custody Receipts)?

 Derivative contracts derive their values from other instruments

values
• Examples?

The University of Western Australia 8

What are orders?

 Orders are instructions to trade, given to brokers and/or

exchanges.

Orders always specify Orders may specify

• Item to be traded • Price ($)
• Quantity • subject to tick rule
• Side – buy or sell • Method (e.g. whether can be partially filled)
• Timing (when the order can be executed)
• Expiration
• Market (where to present the order)
• Counterparts (trade with whom)

The University of Western Australia 9

Limit orders

 A limit order instructs the broker to trade at best price available,

but do not violate limit price condition.
- Do not buy at a price above the limit price.
- Do not sell at a price less than the limit price.
 Properties of limit orders
• Limit orders may not execute.
– When price moves away from orders, limit order traders
fail to trade and wish they had.
• Standing limit orders supply liquidity by allowing others to
trade when they want.
– Ex post regret & Adverse selection risk

The University of Western Australia 10

Market orders

 Market orders are buy- or sell- orders that are to be executed

immediately at the “market” price.
 Example of a market order:
Currently, there is a trader who has flagged that he is willing
to sell commodity A for $100.
If you are willing to pay the $100 to acquire the commodity,
you have placed/used a market order!

Buy
Buy @Mkt
$95 Sell
$100

You
The University of Western Australia
Market orders

 Properties of market order

• Consumption of liquidity
• Have market impact when brokers move prices to find
liquidity.
• Execution is near certain but the execution price maybe
uncertain

Buy Sell
Buy @Mkt $110
$95 X5 Sell X4
X3 $100
X2

You
The University of Western Australia
Market orders

 Properties of market order

• Consumption of liquidity
• Have market impact when brokers move prices to find
liquidity.
• Execution is near certain but the execution price maybe
uncertain

Buy Sell
Buy @Mkt $110
$95 X5 Sell X4
X3 $100
X2

You
The University of Western Australia
 Stop Orders

 Stop orders are price contingent orders.

• activate when their price contingency is met.
• almost always market orders.
• typically are used to close losing positions.

 E.g. Market sell order of BHP sales with stop price of $9.00. If
price falls to $9.00 or below, the broker will sell the shares at the best
price then available on the market.

Trade Price
 Also known as stop loss orders Stop Ask Price = $9

The University of Western Australia

Orders that stipulate duration

 Day order
 Good till canceled order

 Fill or Kill orders

 ASX: Fill and Kill orders (Immediate or Cancel orders)

The University of Western Australia 15

Trading process - How do we arrive at the “price”?

 Depend on the trading mechanism

• Bargaining
• Auctions:
– Oral, ascending-price (English) auction
– E.g., properties, art and antique
– https://www.youtube.com/watch?v=Eub-tfG3ufg
– First-price, sealed-bid auction
– E.g., procurement
– Oral, descending-price (Dutch) auction
– E.g., Google IPO
– https://www.youtube.com/watch?v=j-9ECL-t09o
– Second-price, sealed-bid (Vickrey) auction
– Double auctions/ Bilateral auctions

The University of Western Australia 16

Trading process - How do we arrive at the “price”?
Bargaining
 Bargaining is the negotiation process over contract terms (such
as price and quantity) that occurs between a buyer and a seller.
• Useful when dealing in large sizes

 Example: Liquidnet, an “upstairs” market that matches

institutional buyers and sellers of large blocks of equity
securities, enables institutions to directly bargain and trade
confidentially with one another.

 Expensive to transacting large blocks in “downstairs” market.

The University of Western Australia 17

Trading process - How do we arrive at the “price”?
Auctions (1/4)
 An auction is a competitive market process involving multiple
buyers, multiple sellers or both.
• Auctions are a useful and cost effective method for pricing a
security with an unknown value.

 Walrasian auction is a simultaneous auction where each buyer

submits to the auctioneer his demand and each seller submits his
supply for a given security at every possible price.
• It is primarily a theoretical construct.
• Example in life: open and close auctions on the ASX.

The University of Western Australia 18

Trading process - How do we arrive at the “price”?
Auctions (2/4)
 English auction
• It involves public sequences of bids, and provides some
degree of price discovery before it concludes.
• It ends and a “winner” is declared when no participant is
willing to bid higher

 First-Price Sealed-Bid auctions have all bidders simultaneously

submit sealed bids. The winner is the one that submits the
highest bid and pays the bid price.
• Does not allow for price discovery.
• The winner faces the “Winner’s Curse” problem if the
auctioned item’s value is not known with certainty.

The University of Western Australia 19

Trading process - How do we arrive at the “price”?
Auctions (3/4)
 Dutch auction (descending bid) auction.

2004,
Google IPO,
Sold 19.6 m
shares @$85

The University of Western Australia 20

Trading process - How do we arrive at the “price”?
Auctions (4/4)
 Continuous double auctions - NYSE, ASX
• Buyers submit bids (max. buy prices) and sellers submit
offers (min. sell prices).
• Bids and offers are ranked by their price levels.
• Transaction occurs when the highest bid and lowest offer
match.
 Recent development: Periodic auctions
• High-frequency auction
• Pros and cons

CBOE, Periodic Auctions

https://markets.cboe.com/europe/equities/trading/periodic_auctions_book/

The University of Western Australia 21

Last slide

 Lecture quiz – 5 minutes (feel free to refer to your notes)

• LMS Week 1 folder

 Next week
• Market structure
– Types of markets – quote-driven, order-driven, hybrid
– Electronic vs open outcry
– How does trading occur in Australia vs the U.S.?

The University of Western Australia 22