Market Structure

Market Structure - Market Structure Order specifies what to...

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Market Structure Order – specifies what to trade, how much, buy or sell, and conditions Orders are made because traders do not usually arrange their own trades – go through a broker or dealer Terms Ask = offer Bid Size = quantity Firm Price – for actively traded securities Soft Price – for thinly traded securities Best Bid and Best Offer Inside Spread Offering or supplying liquidity (posting bid and ask quotes) – gives other traders an opportunity to trade Dealers make money by selling liquidity – posting bid and ask quotes Standing order = open order → an open offer to trade Taking liquidity – accepting an offer to trade Market liquidity – degree to which traders can trade without affecting prices Market order – trade at the best price currently available in the market Fills quickly, but perhaps at an inferior price Market orders take liquidity from the market Transaction cost = ½ the spread Price Improvement – trader steps in front of best bid or ask to take an incoming market order Market Impact – traders move prices in order to fill their orders – the most significant cost of trading large orders Limit Orders – trade at the best price available, but only if it is no worse than the limit price. Limit Buy – trade at or below limit price Limit Sell – trade at or above limit price Limit Order Book – standing limit orders Buy limit orders with high prices and sell limit orders with low prices are priced aggressively 1
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Marketable limit order – can be executed immediately Standing limit orders are free options – but, unlike regular options, they can be cancelled by the writer at any time Options to trade Sell limit orders are calls Buy limit orders are puts Strike is the limit price Option value depends on the limit price, how long it will stand, and the volatility Since bid and ask are limit orders (options), and options are worth more in volatile markets, spreads tend to be wider as volatility increases Compensation for offering liquidity – expect better prices than with market orders You make money on the spread with a limit order, but the spread costs you money with a market order Risks of standing limit orders 1. Execution uncertainty – if prices move away from your limit order, you don’t trade, but wish you had 2.
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