Showing papers on "Algorithmic trading published in 1996"

Liquidity, Information, and Infrequently Traded Stocks

Abstract: This article investigates whether differences in information-based trading can explain observed differences in spreads for active and infrequently traded stocks. Using a new empirical technique, we estimate the risk of information-based trading for a sample of New York Stock Exchange (NYSE) listed stocks. We use the information in trade data to determine how frequently new information occurs, the composition of trading when it does, and the depth of the market for different volume-decile stocks. Our most important empirical result is that the probability of information-based trading is lower for high volume stocks. Using regressions, we provide evidence of the economic importance of information-based trading on spreads.

Transparency and Liquidity: A Comparison of Auction and Dealer Markets with Informed Trading

Abstract: Trading systems differ in their degree of transparency, here defined as the extent to which market makers can observe the size and direction of the current order flow. We investigate whether greater transparency enhances market liquidity by reducing the opportunities for taking advantage of uninformed participants. We compare the price formation process in several stylized trading systems with different degrees of transparency: various types of auction markets and a stylized dealer market. We find that greater transparency generates lower trading costs for uninformed traders on average, although not necessarily for every size of trade. IT IS A WIDELY HELD BELIEF among economists studying securities markets that greater transparency in the trading process enhances market liquidity by reducing the opportunities for taking advantage of less informed or nonprofessional participants. This has led, particularly in the United States, to a strong regulatory inclination to require as much trading information as possible to be made immediately available to all comers. To some extent, the purpose is to enable ordinary traders to check for themselves whether they have gotten a fair price, but the main idea is that making information visible to a large set of competing professionals improves price formation so greatly that ordinary traders obtain the best possible deal. In Europe, the speed of publication of trade data was a central issue in the drafting of the European Union's Investment Services Directive, implemented in January 1996, imposing a common regime on all securities firms operating in member countries. There was a difference of opinion on transparency between Britain, which favored slow publication of trade data, and most Continental regulators,

Trading costs and the relative rates of price discovery in stock, futures, and option markets

Abstract: In frictionless and rational markets, perfect substitutes must have the same price. In markets with trading costs, however, price differences may be as large as the costs of executing the arbitrage between markets. Moreover, if trading costs differ, trading activity will tend to be concentrated in the lowest-cost market. This study tests the differential trading cost hypothesis by examining the rate at which new information is incorporated in stock, index futures, and index option prices. The lead/lag return relations among markets are consistent with their relative trading costs. Prices in the index derivative markets appear to lead prices in the stock market. At the same time, index futures prices tend to lead index option prices, and the prices of index calls and index puts move together. The trading cost hypothesis reconciles the disparity found between the temporal relation in the stock index/index derivative markets versus the stock/stock option markets.

Evaluation of Value-at-Risk Models Using Historical Data

Abstract: Recent studies have underscored the need for market participants to develop reliable methods of measuring risk. One increasingly popular technique is the use of "value-at-risk" models, which convey estimates of market risk for an entire portfolio in one number. The author explores how well these models actually perform by applying twelve value-at-risk approaches to 1,000 randomly chosen foreign exchange portfolios. Using nine criteria to evaluate model performance, he finds that the approaches generally capture the risk that they set out to assess and tend to produce risk estimates that are similar in average size. No approach, however, appears to be superior by every measure.

A note on the weak form efficiency of capital markets: The application of simple technical trading rules to UK stock prices - 1935 to 1994

Abstract: Brock et al. (1992) found technical trading rules to have predictive ability with regards to the Dow Jones Index. The current paper considers whether this result can be replicated on UK data. The paper also considers whether investors could earn excess returns from technical analysis in a costly trading environment. The paper concludes that although the technical trading rules examined do have predictive ability in terms of UK data, their use would not allow investors to make excess returns in the presence of costly trading.

Trading Volume with Private Valuation: Evidence from The Ex-Dividend Day

Abstract: We test a theory of the interaction between investors' heterogeneity, risk, transaction costs, and trading volume. We take advantage of the specific nature of trading motives around the distribution of cash dividends, namely the costly trading of tax shields. Consistent with the theory, we show that when trades occur because of differential valuation of cash flows, an increase in risk or transaction costs reduces volume. We also show that the nonsystematic risk plays a significant role in determining the volume of trade. Finally, we demonstrate that trading volume is positively related to the degree of heterogeneity and the incentives of the various groups to engage in trading. Article published by Oxford University Press on behalf of the Society for Financial Studies in its journal, The Review of Financial Studies.

Index Arbitrage and Nonlinear dynamics Between the S&P 500 Futures and Cash

Abstract: We use a cost of carry model with nonzero transaction costs to motivate estimation of a nonlinear dynamic relationship between the S&P 500 futures and cash indexes. Discontinuous arbitrage suggests that a threshold error correction mechanism may characterize many aspects of the relationship between the futures and cash indexes. We use minute-by-minute data on the S&P 500 futures and cash indexes. The results indicate that nonlinear dynamics are important and related to arbitrage, and suggest that arbitrage is associated with more rapid convergence of the basis to the cost of carry than would be indicated by a linear model. Article published by Oxford University Press on behalf of the Society for Financial Studies in its journal, The Review of Financial Studies.

New York Stock Exchange Systems and Trading Procedures

Abstract: This paper is an expanded and updated version of NYSE Working Paper "Orders, Trades, Reports and Quotes at the New York Stock Exchange." The comments and opinions contained in this paper are those of the authors and do not necessarily reflect those of the directors, members or officers of the New York Stock Exchange, Inc. This paper does not constitute an official statement and interpretation of Exchange rules and procedures and it has no legal standing. Whenever possible, the paper provides citations to official sources. Preface This paper provides a selective description of New York Stock Exchange systems, trading rules and procedures. The paper's primary objective is to provide researchers with a detailed institutional framework for studying quote and transaction data generated by U.S. securities trading. It is also meant to serve as a guide to the New York Stock Exchange system, for economics, business and legal scholars needing a reference aid for their research. Among the topics examined are: order entry and execution, trade and quote reporting, the audit trail, SuperDot, the Intermarket Trading System, crossing orders and the upstairs positioning of large block trades. The paper provides descriptions of New York Stock Exchange systems, rules and procedures that are constantly changing, as they were at the beginning of 1993.

Call and Continuous Trading Mechanisms Under Asymmetric Information: An Experimental Investigation

Abstract: I examine the relative performance of call and continuous auctions under asymmetric information by manipulating trading rules and information sets in laboratory asset markets. I find significant differences in an environment that extends the Kyle (1985) framework to permit the exogenous liquidity trading motive to have a natural economic interpretation. The adverse selection costs incurred by noise traders are significantly lower under the call auction, despite no significant reduction in average price efficiency. This result suggests that discussions of the costs and benefits of insider trading should take place within the context of a specific trading mechanism. UNDERSTANDING THE INFLUENCE of the trading process on the price formation process is a fundamental goal of the large microstructure literature. An important feature of much of this work has been the replacement of the "Walrasian auctioneer" of general equilibrium theory with market makers who stand ready to provide liquidity and immediacy when buy and sell orders are imperfectly synchronized. In this framework, the presence of agents with "inside information" has an important influence on market liquidity and the price formation process. Seminal theoretical works here include Glosten and Milgrom (1985) and Kyle (1985). A primary purpose of this study is to extend this work by examining the behavior of competitive market makers under alternative trading arrangements that differ on the fundamental dimension of whether orders are temporally consolidated prior to execution. The method of inquiry is experimental economics. The two mechanisms I investigate are a call auction, in which all buy and sell orders arriving during a specified interval are batched and executed at a single price, and a continuous auction, in which each buy and sell order is executed upon arrival. Both mechanisms are widely employed. While a call auction is the primary trading mechanism on many continental European stock exchanges, the growing Nasdaq over the counter (OTC) market relies exclusively on a continuous mechanism. In addition, hybrid systems that

Testing for micro-structure effects of international dual listings using intraday data

Abstract: This paper examines the impact on the liquidity of NYSE/AMEX listed stocks when they were subsequently listed on the London or the Tokyo Stock Exchanges. It can be argued that the increased competition from foreign market makers will reduce the monopoly rents that specialists can earn, thereby improving their quotes. We find, however, that spreads do not decrease following a dual listing, though the depth of the quotes increases as predicted. The apparent increase in depth disappears once we account for changes in price, volume and return variance. We also find that the level of informed trading increases, which increases the cost to the specialist of providing liquidity, and explains why spreads do not decline in spite of increased competition. Consistent with an increase in informed trading, we also document an increase in trading activity.

Market Manipulation and the Role of Insider Trading Regulations

Abstract: We model the impact of insider trading regulations on the dynamic trading strategies of corporate insiders. We focus our attention on Section 16(a) of the Securities and Exchange Act -- the trade disclosure rule. In a rational expectations equilibrium, we show that when an informed insider has to disclose her trades after they are made, she has an incentive to manipulate the market by sometimes trading in the "wrong" direction, i.e., buying with bad news or selling with good news. This strategy reduces the informativeness of her subsequent trade disclosure since a buy (sell) no longer unambiguously conveys good (bad) news and allows her to reap large profits in later periods by trading in the right direction. Such manipulation lowers initial bid-ask spreads and market efficiency and it can be curtailed by enforcing the short swing profit rule (Section 16(b) of the Act). The manipulation is more likely to occur when the market is liquid and when the insider's information advantage over the market is small. But it is less likely to occur when we allow for (i) the possibility of the insider being uninformed, (ii) the possibility of early arrival of public information, (iii) multiple insiders, and (iv) multiple trade sizes for the insider to choose from.

Alternative Securities Trading Systems: Tests and Regulatory Implications of the Adoption of Technology

Abstract: Reasons for the mixed reactions to today's electronic off-exchange trading systems are examined, and regulatory implications are explored. Information technology (IT) could provide more automated markets, which have lower costs. Yet for an electronic trading system to form a liquid and widely used market, a sufficient number of traders would need to make a transition away from established trading venues and to this alternative way of trading. This transition may not actually occur for a variety of reasons. Two tests are performed of the feasibility and the desirability of transitions to new markets. In the first test, traders in a series of economic experiments demonstrate an ability to make a transition and develop a critical mass of trading activity in a newly opened market. In the second test, simulation is used to compare the floor-based specialist auction in place in most U.S. stock exchanges today to a disintermediated alternative employing screen-based order matching. The results indicate that redu...

Stock Market Volatility around Expiration Days in Japan

Abstract: This study evaluates the impact of stock trading activity around expirations of Japanese stock index options and futures contracts on the underlying stock prices. Though these expiration days are associated with higher than average trading volume, tests indicate that the intraday return volatility in the last hours of trading on expiration days and the first hours following expirations is only marginally greater than that on non-expiration days. Moreover, portfolio return reversals of 0.1% or less during the last hour of trading at expiration and the first hours of trading following the expiration are statistically insignificant and smaller in magnitude than typical bid-ask spreads, commission rates and market impact costs would warrant. Finally, in comparing the expiration effects for the two similar Nikkei index futures contracts traded in the Singapore and the more-heavily-regulated Osaka/Tokyo markets, no important differences can be discerned. The implications of these findings for the newest restrictions on index arbitrage activity by Japan's Ministry of Finance and the Tokyo Stock Exchange are discussed.

Trading patterns of small and large traders around stock split ex-dates

Abstract: We investigate the trading patterns of small and large traders around stock split ex-dates. Using the intraday transaction database for the Toronto Stock Exchange during 1983–89, we find that stock splits are associated with significant changes in trading patterns. Although stock splits appear to have little effect on the trading behavior of large traders (trade value of at least $100,000), they are associated with significant decreases in odd-lot trading and increases in small board-lot trading (trade value of less than $10,000). Although the liquidity premia decrease for all trade sizes, trade direction changes significantly from sell to buy after split ex-dates for all but the large trades, where the change is in the opposite direction. The significant increase in variances after split ex-dates is explained by various microstructure-related variables, and small (large) trades appear to be (de)stabilizing.

Trading cost expectations: Evidence from S&P 500 index replacement stock announcements

Abstract: This paper tests the effect on stock value of an expected change in future trading costs. The capitalized value of a reduction in trading costs is hypothesized to increase the stock value, a trading cost effect. Improved liquidity reduces trading costs. Inclusion as an S&P 500 Index replacement stock is an event hypothesized to increase liquidity. We use 114 observations between January 1, 1983 and October 12, 1989 of stocks added to the Index as replacements for stocks removed. The abnormal return of each stock is regressed against the ratio of the bidask spread to the price of the stock, the change in trading volume of the stock, and the open interest in the Index futures contracts at the close of the month prior to the replacement announcement.

International linkages in Nikkei Stock Index futures markets

Abstract: This paper analyzes the linkages and information transmission of similar Nikkei stock index futures contracts traded on three international exchanges, the OSE, SIMEX, and CME. Comparisons between the trading and nontrading time variances within individual markets and across markets indicate that relevant information is revealed during the trading hours of the OSE and SIMEX, but not the CME. An approach of variance decomposition and impulse response functions exploring the common stochastic trend in the cointegration system is employed. The common factor is found to be simply driven by the last trading market in the 24-hour trading sequence. Specifically, each market, while it is trading, impounds all the information that will affect other markets, and rides on the common stochastic trend. Granger-causality also runs from the market(s) that is placed in the last trading order within 24 hours in the vector error correction model but this causal relationship is shorter than one day. On balance, the three markets are informationally efficient on a daily basis.

Comparing the Robustness of Trading Systems to Higher Order Uncertainty

Abstract: This paper compares the performance of a decentralized market with that of a dealership market when traders have differential information. Trade occurs as a result of equilibrium actions in a Bayesian game, where uncertainty is captured by a finite state space and information is represented by partitions on this space. In the benchmark case of trade with common knowledge of endowments, the two mechanisms deliver virtually identical outcomes. However, with differential information, the dealership market has strictly higher trading volume, and yields an efficient posttrade allocation in most states. In contrast, the decentralized market suffers from suboptimal trading volume. The reason for this poor performance is the vulnerability of the decentralized market to higher-order uncertainty concerning the fundamentals of the market. Traders may know that mutually beneficial trade is feasible, and perhaps know that they know, and yet a failure of common knowledge that this is so precludes efficient trade. The dealership market is robust to this type of uncertainty.

Effectiveness of simple technical trading rules in the Hong Kong futures markets

Abstract: Weak-form market efficiency states that past information cannot be used to consistently generate excess returns. So, technical analysis which uses past information on securities should not help generate abnormal profits consistently in a weak-form efficient market. In the present study, two simple technical trading strategies - Moving-Average-Oscillator and Trading Range Break-Out - are implemented to test whether they result in excess returns. The study is performed on the Hang Seng Futures Index, traded at the Hong Kong Futures Exchange. It is found that the moving average strategy does not produce significant excess returns, but four out of the six Trading Range Break-Out rules resulted in significant positive returns for the buy signal.

The Impact of Decimalization on Market Quality: An Empirical Investigation of the Toronto Stock Exchange

Abstract: Much recent debate has revolved around "decimalization", i.e., the trading of securities on cent ticks as opposed to fractions of a dollar. Advocates of decimalization argue that such a move will reduce the costs of trading by permitting liquidity providers to tighten the bid-ask spread. Recently, the major Canadian stock exchanges moved from fractional pricing to decimal pricing in an attempt to lower the costs of trading. I examine the effect switching to decimal pricing has had on market quality using data acquired from the Toronto Stock Exchange, the largest and most active of the Canadian exchanges. I find that quoted and effective spreads decline significantly following the switch to decimal trading, indicating that trading costs incurred by investors are reduced. Quoted depths in the post-decimalization period, however, also decline dramatically. Furthermore, I find that the change in volume is not sufficient to offset the per share profit decline experienced by liquidity providers in the post- decimalization period. This result indicates that part of the gain to investors is simply a wealth transfer from liquidity providers.

Beyond Technical Analysis: How to Develop and Implement a Winning Trading System

Abstract: Preface Developing and Implementing Trading Systems Principles of Trading System Design Foundations of System Design Developing New Trading Systems Developing Trading System Variations Equity Curve Analysis Ideas for Money Management Data Scrambling A System for Trading Selected Bibliography Index

The dual listing of stock index futures: arbitrage, spread arbitrage and currency risk

Abstract: This paper shows that riskless spot-futures arbitrage is impossible if the futures contract multiplier is in a foreign currency from that of the underlying shares. However, a no-arbitrage condition involving only futures contracts (spread arbitrage) exists for such cases when there is also a future with a contract multiplier in the same currency as the underlying shares. Where the contract multiplier of the second future is in a foreign currency, virtually riskless arbitrage is possible. Mispricings from this no-arbitrage condition were investigated for Nikkei Stock Average futures traded in Osaka, Singapore, and Chicago

Trading mechanisms and trading preferences on a 24-hour futures market: A case study of the Floor/GLOBEX switch on MATIF

Abstract: MATIF is the only major exchange offering a 24-hour non-interrupted trading cycle accommodating two distinct non-overlapping trading mechanisms. We find that trading volume on the floor is significantly higher than that on GLOBEX around the switch of trading mechanism. GLOBEX is mainly used by institutions to hedge their cash positions. The higher trading volume on the floor may be attributed to several factors: trade immediacy vs. transaction cost, liquidity trading by locals, inertia to trade under a new mechanism, and transparency vs. anonymity. In addition, the floor's open is unique with large interday return volatility.