Market Microstructure

Market microstructure refers to the trading protocols that determines how a trader’s demand is translated into execution .

Markets

Three different type of markets exist:

1. Order Driven – prices established by public limit orders . ECN and automated auction markets .
2. Quote Driven – prices are established by a market maker or dealer .
3. Hybrid markets has a bit of both – NYSE

Difference between a broker and a dealer ?

Dealers provide liquidity. When a trader doesn’t have someone to take the other side of a trade a dealer will step in .

A Broker provides multiple services to a client:

1. Research Material
2. Representing the order
3. Escrow
4. Finding the buyer
5. Discretion
6. Support if the market mechanism

Effective Spread vs Bid-ask spread ?

Bid-ask spread is the bid price subtract ask price . Captures cost of trading .

Effective Spread – 2 x ( price paid – (price at order entry – execution price ) / 2 ) . Also captures cost of trading

Effective price is a better measure .

Market Quality Criteria

• Many Buyers and Sellers
• Diversity of Opinion
• Continuous operation during market hours
• Reasonable cost of transaction
• Market integrity

Transaction Costs

1 . Implicit cost- indirect cost , impact of the trade on the price received

2. Explicit cost – broker commission, taxes and fees

Implementation Shortfall – defined as an estimated transaction price calculated as (market price – all in transaction costs )

Different Type Of Traders

1. Information motivated trader
2. Value motivated trader
3. Liquidity motivated trader
4. Passive traders

Algorithmic Trading

Refers to automatic trading based on quantitive rules and user set constraints and bench marks .

Three Different Types

1. Participant strategy – Breaking up a large trader over a time period
2. Opportunity Trading- Passive trading that excites on opportunities in the market
3. Specialized Strategies