Once you have all the access, machines, network, middle office, clearing, etc etc etc, what do you do now? \u00c2\u00a0Well, you need to figure out what to do. \u00c2\u00a0There are two basic things folks do here, one of which is basically a subset of the other. \u00c2\u00a0How do you pay for it? \u00c2\u00a0And What do you do with it?<\/p>\n
The individual markets want action. \u00c2\u00a0They want you to be able to buy or sell easily on their markets. \u00c2\u00a0Sure, they go for big numbers, too, but what they want is liquidity. \u00c2\u00a0If average Joe on the street can’t go into BillyBob Exchange, LLC and buy 100 shares of That Gargle Interweb thing, but can elsewhere, they’re not going to be an exchange for much longer.<\/p>\n
MarketMakers<\/a> add liquidity to the market<\/p><\/blockquote>\n
There’s not always enough people in the market at a given time to make it liquid enough for every single instrument traded on it. \u00c2\u00a0So the exchanges have people called MarketMakers. \u00c2\u00a0Their job is literally that – to make the market. \u00c2\u00a0If you’re a registered marketmaker, you have to be in the market for a given amount of time or get in trouble. \u00c2\u00a0 You can be a marketmaker for one symbol or a hundred, it’s whatever you can keep up the action for. \u00c2\u00a0Marketmakers can make an okay living doing this, but it can be risky too. \u00c2\u00a0They live on both sides of the “price” for a symbol. \u00c2\u00a0If something is “worth” some arbitrary amount of money, they will buy it for a little less than that, and sell it for a little more. \u00c2\u00a0(Bid and Ask) \u00c2\u00a0If the market moves too quickly in one direction, there’s a risk that they are making bad trades because they haven’t updated their prices to account for the risk. \u00c2\u00a0More risk means trading wider around the price. \u00c2\u00a0You can also adjust your price to account for your position. \u00c2\u00a0If you’re long something, you may be willing to take slightly less money to unload so you don’t have that position. \u00c2\u00a0In return for this risk – the exchanges “bribe” the marketmakers. \u00c2\u00a0They get a nice discount on their trades.<\/p>\n
While it may cost you $7.95 per trade, a marketmaker can pay 1\/1000 of that – or less. \u00c2\u00a0Or nothing. \u00c2\u00a0Or they can get paid to trade.<\/p><\/blockquote>\n
It’s in the ratio. \u00c2\u00a0Quoting (marketmaking) gets you a rebate, taking liquidity costs you money. \u00c2\u00a0Marketmakers also have an obligation to quote a certain amount and hours per day. \u00c2\u00a0That doesn’t mean they can’t quote extra wide, but they’re not making money then and not making the exchange happy.<\/p>\n
Arbitrage<\/h3>\n
I love arbitrage. \u00c2\u00a0 In it’s most basic definition, it is taking advantage of price differentials. \u00c2\u00a0Say the price of AAPL on the TSX is $201\/share, on Nasdaq it’s $200 a share. \u00c2\u00a0So you buy it on Nasdaq and sell it on the TSX and pocket the dollar, minus any fees. \u00c2\u00a0My favorite is Berkshire Hathaway (BRK) – it has two classes of stock, A and B. \u00c2\u00a0They’re related – you can exchange A for B. \u00c2\u00a0One class-A share equals 30 class-B shares. \u00c2\u00a0Since most people don’t buy BRK to vote, there is a very, very strong relationship between the two. \u00c2\u00a0So if it’s ever not very very close to a 30:1 price ratio, there’s a simple arbitrage opportunity.<\/p>\n
A surprising amount of what the proprietary trading companies do is arbritage. \u00c2\u00a0Everything from distance (latency, really) based, to ratios like the BRK example, to the symbols within a larger context. \u00c2\u00a0For example, you can trade the component stocks of the S&P 500 against a future of the S&P 500 index itself. \u00c2\u00a0Since one is literally made of the other, the price in one underlying symbol means that the other is worth a different amount.<\/p>\n
Another good example is pricing options. \u00c2\u00a0Most of the market prices options based on the Black-Scholes<\/a> formula (roughly speaking). \u00c2\u00a0This means that there’s a pretty standard way of figuring the prices that the market generally gravitates toward. \u00c2\u00a0Those who can program a faster algorithm for computing this can price them faster, and have a pure arbitrage opportunity. \u00c2\u00a0Options are also fun in another way. \u00c2\u00a0You can “create” shares from options. \u00c2\u00a0Wikipedia<\/a> explains it better than I could, but basically you can buy and sell options in a certain way that lets you simulate having a share of stock. \u00c2\u00a0Or better yet, simulate selling one or selling one short when you can’t really sell it short.<\/p>\n
Correlation<\/h3>\n
This is basically taking advantage of similarities between companies. \u00c2\u00a0If oil goes up, companies that use lots of oil tend to go down. \u00c2\u00a0Or on a more practical example I like to give, if oil goes up, American car companies tend to go down. \u00c2\u00a0Hand in hand with that, similar companies tend to follow each other also. \u00c2\u00a0GM and Chrysler did for a while. \u00c2\u00a0Big steel companies, when they existed. \u00c2\u00a0Heck, weather futures against crop futures. \u00c2\u00a0Think of a few on \u00c2\u00a0your own, it’s fun! \u00c2\u00a0Basically anything you can think of that may have an effect on something else can be priced. \u00c2\u00a0It doesn’t have to be a 1:1 ratio either. \u00c2\u00a0The companies aren’t priced the same, nor is the relationship between them perfect.<\/p>\n
In practice – order types (list<\/a>)<\/h3>\n
The market open and market close are where almost all of the fun in the markets happens. \u00c2\u00a0Open especially. \u00c2\u00a0You can saturate a 1GB connection to a market just with data feeds. \u00c2\u00a0(Get a bigger connection). \u00c2\u00a0For perspective, that line that is getting completely overrun with data is probably 500 to 1000 times faster than yours at home. You put your quotes and orders in before open or right at open and the insanity happens. \u00c2\u00a0Now when the market moves on you, you need to change your quotes. \u00c2\u00a0If the “value” is $10.00 and you’re at $9.95 and $10.05 and it inches higher, pretty soon your asking price is so low that you’re losing money on every trade. \u00c2\u00a0So you update the price to move with the market. \u00c2\u00a0You can have one order in at the beginning of the day and update it 100,000 times throughout the day. \u00c2\u00a0These orders (market or limit) are normally “day” orders, and are valid until canceled. \u00c2\u00a0So you can update it or do a cancel and replace. \u00c2\u00a0The are liquidity *adding* orders. \u00c2\u00a0The marketmaker uses them to get into the market and stay there until filled, at which point they’ll adjust their prices depending on whether they’re long or short and put in a new order. \u00c2\u00a0Why is this *adding* liquidity? \u00c2\u00a0Because it is giving others the opportunity to trade. \u00c2\u00a0You you just out there saying “Here I am, I’ll trade with you if you want. Here are my prices.”<\/p>\n
Immediate or cancel, fill or kill, whatever you want to call it – these are the market *taking* orders. \u00c2\u00a0You see an opportunity for some quick profit that will remove liquidity from the market. \u00c2\u00a0There’s a price mis-match somewhere, someone put in an order you think is “wrong”, there are plenty of reasons. \u00c2\u00a0But you only only only want to get it at that price. \u00c2\u00a0If it’s not immediately filled at that price, the order is canceled and nothing happened. \u00c2\u00a0Why does this remove liquidity? Because unlike the day orders, you’re not actually giving an opportunity to someone else to trade, you’re trying to take it away from someone else. \u00c2\u00a0 It removes one open order from the market, takes the numbers a little lower from the exchange, and thus they charge you for the privilege.<\/p>\n
Another interesting thing about the markets that one has to account for is what’s called an Iceberg. \u00c2\u00a0Say you have a lot of stock you have to sell. \u00c2\u00a0Putting a giant order out there will change the market – people will see you need to sell a lot and the price will got down accordingly. \u00c2\u00a0 Of course, you don’t want the price to go down as much – you want more money for your stock! \u00c2\u00a0The markets let you put something called an iceberg order into the market. \u00c2\u00a0It lets you specify how much the market sees of the order. \u00c2\u00a0Instead of 10,000 or 100,000 maybe you want to show 1,000. \u00c2\u00a0Eventually the market will figure out that there’s a lot of selling going on and price itself accordingly, but you haven’t thrown it for a loop with your giant numbers – it’s gradual. \u00c2\u00a0So you can set \u00c2\u00a0your order as an iceberg, and the people on the other side ordering against you can also place their order for *more* than it shows the offer is. \u00c2\u00a0So you see an offer in the market for 500 shares @ $10.00, and you think that’s a great price – you can try an order larger than that, and if it’s an iceberg, you’ll trade for the larger quantity. \u00c2\u00a0Neat stuff.<\/p>\n","protected":false},"excerpt":{"rendered":"
Once you have all the access, machines, network, middle office, clearing, etc etc etc, what do you do now? \u00c2\u00a0Well, you need to figure out what to do. \u00c2\u00a0There are two basic things folks do here, one of which is basically a subset of the other. \u00c2\u00a0How do you pay for it? \u00c2\u00a0And What do […]<\/p>\n","protected":false},"author":1,"featured_media":0,"comment_status":"open","ping_status":"open","sticky":false,"template":"","format":"standard","meta":[],"categories":[22],"tags":[34],"_links":{"self":[{"href":"http:\/\/www.imaginarybillboards.com\/index.php?rest_route=\/wp\/v2\/posts\/116"}],"collection":[{"href":"http:\/\/www.imaginarybillboards.com\/index.php?rest_route=\/wp\/v2\/posts"}],"about":[{"href":"http:\/\/www.imaginarybillboards.com\/index.php?rest_route=\/wp\/v2\/types\/post"}],"author":[{"embeddable":true,"href":"http:\/\/www.imaginarybillboards.com\/index.php?rest_route=\/wp\/v2\/users\/1"}],"replies":[{"embeddable":true,"href":"http:\/\/www.imaginarybillboards.com\/index.php?rest_route=%2Fwp%2Fv2%2Fcomments&post=116"}],"version-history":[{"count":6,"href":"http:\/\/www.imaginarybillboards.com\/index.php?rest_route=\/wp\/v2\/posts\/116\/revisions"}],"predecessor-version":[{"id":146,"href":"http:\/\/www.imaginarybillboards.com\/index.php?rest_route=\/wp\/v2\/posts\/116\/revisions\/146"}],"wp:attachment":[{"href":"http:\/\/www.imaginarybillboards.com\/index.php?rest_route=%2Fwp%2Fv2%2Fmedia&parent=116"}],"wp:term":[{"taxonomy":"category","embeddable":true,"href":"http:\/\/www.imaginarybillboards.com\/index.php?rest_route=%2Fwp%2Fv2%2Fcategories&post=116"},{"taxonomy":"post_tag","embeddable":true,"href":"http:\/\/www.imaginarybillboards.com\/index.php?rest_route=%2Fwp%2Fv2%2Ftags&post=116"}],"curies":[{"name":"wp","href":"https:\/\/api.w.org\/{rel}","templated":true}]}}