The Plays: Order Types and Algorithms

Study Notes:

In the previous lesson, we talked about broker-dealers, the players in the field of trading. But what does the game really look like? What’s the jump shot or the tackle or the field-goal equivalent in trading? How do these broker-dealers actually get their jobs done and execute trades either for themselves or on behalf of their clients?

Speed of Trading

To understand how broker-dealers trade, one of the most important dynamics to look at is the speed of trading.

Decades ago, you could basically understand what’s going on in the market by watching the floor of the New York Stock Exchange and seeing in real time how prices were going up and down.

Today, trading happens in nanoseconds. In just seconds, markets can skyrocket or plummet.

Ex: Imagine the crash of 1929, happening in the blink of an eye.

This isn’t a sport that humans can watch on their television screens anymore. It is happening in computer time.

This transformation is the result of technological innovation and intense competition.

As we discussed in Lesson 1, as trading became increasingly computerized, the markets were connected electronically. In that landscape, speed became a huge competitive advantage.

A speed advantage is like getting to watch the game in slow motion, like when the bullet slowed down in the matrix while everyone else is in regular time.

In many ways, this technological and speed advancement has made the markets better. The stock market today can incorporate new information into the price of a stock nearly instantaneously. It’s extremely efficient.

However, as you can imagine, it can eventually have diminishing returns and lead to an uneven playing field when some participants make money primarily through trading based on how prices are moving on very short time horizons. Many people believe that’s where the trading landscape has progressed to today.

Order Types

Putting that aside, once you’re operating at the speed of trading today, how do orders get traded? That is, how do you go from an instruction like buy1,000 shares of Microsoft to actually transferring ownership of those shares?

The basic tools of a broker are called order types. Order types are directions that get paired with an order that tell the trading venue how to handle that order, namely the constraints that govern how that order can be paired with another to execute a trade.

Some order types, like market and limit orders, are well understood by the general public:

• A market order is willing to buy or sell at the prevailing price in the market. It’s aggressive about trading, regardless of the price.
• A limit order has a maximum or minimum price that it is willing to buy or sell at.

However, there are also other order types that offer more complex functionality. In fact, one study from 2014 found that there were over 130 unique order types across exchanges. One particularly prevalent category of order types are pegs.

Pegs float with the quote, meaning that they’re price-based on the prevailing best bid and offer in the market. Exactly where, in relation to the best bid and offer, varies.

For instance, there are midpoint pegs that rest at the price, directly between the best bid and offer, and pegs that rest at the near touch, which is the best bid for buys and best offer for sells.

You can also add a limit to a peg order, indicating that you want to float with the quote as long as the price is within that limit. Pegged orders are also non displayed, meaning that when they post, when they don’t execute right away, the price is not advertised to the broader market.

Additionally, there are many instructions that can be attached to orders that specify things like what time of day the order can trade, or the minimum number of shares that must be fulfilled in a given trade. These specifications help investors andbroker-dealers adjust to specific needs and situations.

Algorithmic Trading

Of course, trading in today’s high-speed market isn’t just individual people plugging in distinct orders, selecting an order type, and pressing execute.

Much of today’s trading is run by algorithms, which are basically pre-programmed sets of rules that make decisions about trading within a set of parameters.

Ex: So, for instance, if an investor selects a particular algorithm for a broker to buy 10,000 shares of Apple, that algorithm already has instructions that guide how it should split up that order, what order types it should use, and how it should make particular decisions based on the inputs and responses they get from the market.

That’s how the market can move so fast. Every time something happens, there doesn’t have to be a pause while a human decides how to react. Those responses have already been programmed and happen automatically in response.

There are different categories of algos, like VWAPs and dark aggregators, that have general objectives and approaches. They are kind of like overall strategies in a sport, like a zone defense. When the offense makes a pass, the defense doesn’t have to call a timeout and talk to the coach about how to react. The idea of a zone defense already has the reaction built in. The players just respond to the other team’s moves based on the guidelines of a zone defense.

Note that videos were recorded in December 2019.

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