Equities

Rob GraffeoDec 14, 2009

• What is a stock?

• A stock, also referred to as an equity or common equity, represents ownership in a company.

Capital Structure

LoansLoans

Credit (Bond Issue)Credit (Bond Issue)

Preferred EquityPreferred Equity

Common EquityCommon Equity

What is a stock exchange?

What is a stock exchange?

• It is simply a place for buyers and sellers of stocks to come together to trade stocks

Where else can equities trade?

• Pink Sheets• Bulletin Boards

How it all works

• Customers• Trading Desks• Exchanges– Dark Pools– Crossing Networks– Internal Matching

• Market Making

Two types of execution

• Principal– A trader executes from a firm position

• Agent– A trader matches or executes from an external

position.

Trading capabilities

• Electronic– DMA– Program– Algorithmic

• Shares– Block– Single Order Execution

Direct Market Access Trading• The foundation of DMA is based on direct exchange feeds• Process large volumes of

– market data– Orders– Executions

• Access provided via:– Highly optimized server processes– A graphical front end

• Some basic statistics– 180 GB of market data processed daily (and growing)– 6.5 billion “ticks” (4.5 billion options, 2 billion cash)– 190,000 order / day– 700,000 executions / day

Program Trading

• Basket management• Blind Risk• Index rebalance• Customer portfolio rebalance

Algorithmic execution• Algorithms provide anonymity and are intended to

minimize market impacts• Basically two types of algorithms

– Market micro-structure (behavioral)– Statistical

• Standard Algorithms– TWAP, VWAP– TVOL– Arrival Price

• Specialized Algorithms• Smart Order Routing (SOR)

Algorithms 1st Generation Examples

• Volume Weighted Average Price (VWAP)– A sophisticated method of predicting volume for individual securities.

Delivers an average execution price in line with the VWAP benchmark while minimizing impact to the VWAP itself

• Target Volume (TVOL)– Determines comletion time of the order and price based on market

“ticks” or volume. Basically works order in line with market volume, freeing the trader to focus on other pressing matters.

• Time Weighted Average Price (TWAP)– Aims to evenly distribute an order over user-specified duration

dynamically balancing adverse selection and market impact in real time.

Exchanges

• What are exchanges• Nasdaq, NYSE/EuroNext, Boursa

• What is the the fundamental difference between the NYSE and most other exchanges?

Important Technology Components

• One of the most important components in equities trading is the Fix protocol.– Details available at http://www.fixprotocol.org.– Fix provides a standard way of communicating

between the buy side (asset managers, insurance companies, hedge funds) and the broker dealers.• A broker dealer is some either brokers a trade or deals

directly from inventory.

Communications Continued

• The fix protocol also provides the ability for the broker dealers to communicate between each other and the execution venues.

• Example schema for entering a new order<FIXML xmlns="http://www.fixprotocol.org/FIXML-4-4" xmlns:xsi="http://www.w3.org/2001/XMLSchema-instance"

xsi:schemaLocation="http://www.fixprotocol.org/FIXML-4-4 ../../schema/fixml-main-4-4.xsd" v="4.4" r="20030618" s="20040109"><Order ID="123456" Side="1" TxnTm="2003-12-18T12:00:00" Typ="2" Px="85.00"><Hdr TID="SSB" SID="FCM" SeqNum="1" Snt="2003-12-18T12:00:00"/><Instrmt Sym="IBM"/><OrdQty Qty="100"/></Order></FIXML>

OMS continued

• Order Management systems handle a variety of tasks– Primary task is to manage state of an order (open

or closed)• Executions, Fills, leaves• Interface with Fix engines• Interface with booking engines

Options

• What’s an option?

What’s an option

• An option is right to buy or sell an instrument at an agreed upon price at a future date. – American options– European options– Leaps

Options Risk measurement• Delta – measures the sensitivity of an options price to

changes in the underlying stocks price• Gamma – measure the rate of change of delta, thus it

is the first order derivative of delta• Theta – is the amount of premium paid for time or

time decay• Vega – the only non-greek letter for risk, but that isn’t

why it is unique. Vega measures the change in a an options price to a change in volatility.

• There are others but beyond the scope for today’s overview.

Why are options important?

• Hedging (portfolio insurance• Profit enhancement strategies• Speculation