Building Betler

gforrlD
Perfortn.tnce

COMMENTARY 78 OCTOBER 2OO3

THE SEARCH ENGINE

A client recently asked what kind of discipline their desk needs to develop in order to become
one of the top desks. Underlying the question is whether trading is an art or a science. We
acknowledge that there is art to determining changes in market sentiment. But good traders
also have a disciplined process for determining Strategy and Tactics when accessing liquidity.

Strategy is the determination of Urgency (aggressive market orders vs, limit orders) and
Exposure (hiding vs. going fcr the ful! monty). Tactics are the types of Orders and the broker -
venues available once strategy has been determined. Broker selection comes from venue
(commitments and relationships step in at this point) while prices are a function of Order tactic
(arguing price at the last minute risks dimes to save pennies).

A recent Wall Street Journal article, carrying the heading

"lt's time for the kiddies to get out of the pool," focused Trading Strategy
on how different professional traders deal with today's
markets. The difference? Experience. More specifically,
experience in accessing liquidity at an acceptable price. Strategy includes both Urgency, how quickly to trade,
and Exposure, how to deal with size. The trader's #1
Internet search engines lead to lower costs for those who task is to determine how quickly to work an order given
know how to use them. In essence, the wider the search, the manager's
the better the potential outcome. But market Iiquidity is motive, the
Market prevailing
not as simple: prices do not stand sti'1, Search;ng for
lower prices or more liquidity carries risks that prices may
Order market trend
drift away before the trade is executed, or worse, may
I dULIU-
and volume,
move away as a result of the search. and any antici-
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Pciigu llllul-

Experienced traders often act as search engines. mation. The

snooping through various market venues and players to most expensive
seek liquidity. When volatility is low, all traders benefit trades are often
from available time. When volatility spikes - as it did last those where
October - good traders stand out in their ability to rapidly the trader or
find liquidity at a reasonable price. the portfolio
manager "argued" with the market over the conflicts
Expert traders divide the search engine task in two: between price rationale and process discipline.
determining strategy, and determining the tactics, both .
venue and the right pace. Strategy is the big picture: While there are many variations, the primary tactical
think of this as the manager's motive for this order. market instructions are either market or limit. Urgent,
Tactics are the tools used to implement the strategy. liquidity-demanding traders use market orders to absorb
whatever is available. As the chart above shows, they
are willing to pay the impact cost to trade quickly. Trading Tactics
Liquidity providers will use more limit orders. Less time-
sensitive orders tend to favor limit order tactics, trading Buyside traders need to consider all three issues -
off speed for a hopefully better completion price, Of urgency, size and liquidity - when determining both
course, an expert trader will vary the tactics as time trading tactics (what orders) and venue (to whom to
elapses and prices move, although size can be an issue expose orders). We begin by examining liquid orders.
even when stocks are trendless. Rather than discuss the merits of each type, we will focus
instead on their applicability.
While small or liquid orders need to consider only
The graph of order types has two parameters: urgency
urgency, order exposure tactics become increasingly
and liquidity. For liquid orders, urgency is the primary
important as size grows and/or liquidity deteriorates.
consideration. Small or urgent liquid orders can be
Traders in today's narrow spread/higher transparency
traded as market orders through either dealers or via
markets are less willing to expose their orders. In
ECN's, while larger orders may have to 'absorb'the order
addition, brokers are far less willing to commit capital to
books or rely on a
all but their very broker for liquidity.
best customers. Fnr locc I rrda ni
Basket/ <-- Principal ________> Agency Blockl
Program Seco noa ru ^-A^.^ .,^-i^+i^^^
utuut), vdt tdLtuilJ
Exposing orders at of both VWAP and
the wrong time Iimit orders allow
(e.9., mid-day) or to flexibility
the wrong crowd fl?,to" oo"" +- Market
Fiil - Kitl
MNH - Best Efforts
markets
should
change.
\/\^/AP
(e.9., an indiscrete Smart order
broker, too many management
ILLIQUID
brokers, to the algorithms will
world) can lead to allow both floating
front ru nn ing, Smart/Floating Limit + Fixed
limits and orders
chasing prices with that change to
limit orders, and NOT URGENT market orders
high costs even in when prices begin
the absence of to move adversely.
worthwhile decision information. Traders need to
determine a strategy for exposing the order without As order size grows, order types become more complex.
roiling prices. For small cap stocks, reduced resiliency Urgent orders may require either broker or agency
adds to the exposure problem. In contrast to trading in capital via a block or secondary trade. Obviously, the
large cap stocks, repeated trades in a small cap stock concession will be a function of both size and market
leads to "stickier" price moves, even after the trader capitalization; consistent with the risks of providing
backs off. Therefore, even a 'non-exposing' strategy liquidity. But the potential reward for correct calls in
that takes advantage of available liquidity has to be smaller cap stocks is also much greater (Note: the
weighed for its possible price impact. biggest rewards typically come from timely selling rather
than buying). Exposure is not a significant issue for
urgent orders; the desk's emphasis should be on finding
liquidity within an acceptable horizon.
Because of time constraints, searching
ability is limited and price is a
secondary consideration. For that
reason, it is important to know which
brokers are best at providing liquidity at
a fair price on a consistent basis.
\rVe often find that using broker capital to initiate an order
s a trading mistake. Brokers often suggest this to 'get an
='t r the order, but the suggestion is not in the buyside's
::s: -:srest Capital is fine for finishing an order, but
,', -3- . s rsed to initiate it reduces the flexibilitv of where
to trade resiCua shares, and puts the desk into a
competing pos t on vrith the broker who needs to unwind
the initial trade at a minimal loss. Plexus finds that
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costly as the initial trades and twice the expected
PAEG/L cost.
For lower urgency trades, price is more important.
Traders are willing to accept the chance of adverse price
moves to keep impact low, But as size grows, exposure
creates its own price impact. Domestic brokers are less
likely to frontrun stated client intentions than they once
were due to improved market monrtoring, but the
problem has not completely gone away. Frontrunning
appears much worse in non-US markets where shopping
information in exchange for increased commission flow
remains a problem. Another danger is revealing your
intent to too many players, resulting in their moving their
price targets away. After all, no one wants to be the first
fill against a very large block trade
Urgency
rokeia . Fuli ServlCe |L-liah
,,v,,
. Execution High
losses to more knowledgeable traders. The trader and
the manager must be confident that the order reflects
correct fundamentals. Exoosure also increases the risk
of uncompleted trading when it establishes a floor or
ceiling for others to use advantageously. For these
reasons, large limit orders will expose
only a modest number of shares with
most going to the reserve book. The
downside is that exchanges provide
price, time, size priority - and reserve
shares lose time priority to exposed
others arrivino at a later time.
to either
Experienced traders will adjust their orders
expose or hide their interest depending on market
conditions. Today's markets are deepest at the open and
the close, so larger portions can be hidden in the crowd.
During thin mid-day periods, the experienced traders
hicje their orciers by using market orders to hit bicisioffers.
They will also use fill-or-kill orders to absorb available
volume. They may split orders into small chunks and use
either a single broker or multiple markets to capture
liquidity without being too observable. The key is to be
unpred ctable: orce the market figures you out. either
you pay up or walK away.
Trading Venue
The other question is: Where do I trade? Note that we
don't ask 'with whom?' The answer to that ouestion is
determined by venue, just as price is determined by
order type.
Liquidity xposure
-\/ larr,
LwYv l-.l in h
) Low Ld gv Medium (if using 1

broker)
. Research Med ) Low Med to Small Medium
. Service Med ) Low Med to Small Medium

. Bloomberg/lnstinet Fligj6llCmaltordeaa,\ > Low 1 Srrlf- butca'n trade laige i .q^ml-t--aim;i ii -"i6;
volumes over time danger is being
n rori inla h lo

ATS'S Low Med for Liqtidjty provtdlng Anonymous

Low for Liquidity-demanding
eet-me Markets . LiquidNet Med ) Low I arno Aomi..mnnvm;i ;" - -
. Harborside expose size only to
counter party
High (small orOeis) 5-t-ow Small---- Low - -- -
May trade in size with
Corporations

Limit traders want to maximize their exposure while Traditional brokers are still the mainstay of the business,
market traders want to minimize theirs. Exposing orders and remain the up-front providers of liquidity. But they
,.,,ill attract the other side, but also risks adverse selection are often the most exoensive route in terms of market
impact and commission. For small and less urgent
orders, there are many alternative routes that offer lower
costs. These routes do not ouarantee execution.
Technology has spawned alternatives to traditional
brokerage and has increased the liquidity pool. But the
growth is in terms of breadth and speed more than depth.
Buyside traders have more places to search, but need
help via automation to maximize their hits. When liquidity
is found, traders also need to develop skills (both manual
and automated) to mine the sources without tipping off
competitors. Traditional brokers can multiply the trader's
available search engines, but at the risk of exposure. As
urgency rises, the tradeoff is often justified.
Our goal in this commentary is to introduce a systematic
approach to the trading process for the less experienced
trader who needs a guide when markets become murky.
This broader view may also provide some grist for
experienced traders who already function as effective
search engines, but who are open to tinkering as
markets change.
The process always starts with a trade-by-trade
understanding of the urgency and size issues. These
determine the appropriate processes that the desk can
use. Order tactics, in turn, determine the market venues
that represent the best alternatives. At that point, the
soecific broker route deoends on the desk's
commitments, who is already trafficking in the name, and
the desk's comfort with the specific broker (traditional or
electronic).

Plexus News
Plexusis p/eased to announce that Marie Konstance has joined JPMIS as the head of Global Sales. We look
forward to a wealth of fresh ideas emanating from Marie's extensive knowledge and experience.

Re/ease 2 0 or our lceBreaker'dritt-down',":;.;.;;:::r.;;.:r..;;.""";r";;"n* ,", reviewing daity tradins activity was made
available last month. More detailed descriptions and instructions will be communicated very soon, or contact your consultant
to get the latest information.

t,

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lexu
DIeXrrSCrfouIt
11150 W. Olympic Blvd., #900 Los Angeles, CA 90064
PH: 31 0.31 2.5505 FAX: 31 0.31 2.5506 www.plexusgroup.com
Plexus Group is a wholly owned subsidiary of JPMorgan lnvestor Servrces Company,
a division of JPMoroan Chase.

A 2003 Plexus Group, lnc.