Financial Markets and Trading

An informative guide to market microstructure and trading strategies

Over the last decade, the financial landscape has undergone a significant transformation, shaped by the forces of technology, globalization, and market innovations to name a few. In order to operate effectively in today's markets, you need more than just the motivation to succeed, you need a firm understanding of how modern financial markets work and what professional trading is really about. Dr. Anatoly Schmidt, who has worked in the financial industry since 1997, and teaches in the Financial Engineering program of Stevens Institute of Technology, puts these topics in perspective with his new book.

Divided into three comprehensive parts, this reliable resource offers a balance between the theoretical aspects of market microstructure and trading strategies that may be more relevant for practitioners. Along the way, it skillfully provides an informative overview of modern financial markets as well as an engaging assessment of the methods used in deriving and back-testing trading strategies.

• Details the modern financial markets for equities, foreign exchange, and fixed income
• Addresses the basics of market dynamics, including statistical distributions and volatility of returns
• Offers a summary of approaches used in technical analysis and statistical arbitrage as well as a more detailed description of trading performance criteria and back-testing strategies
• Includes two appendices that support the main material in the book

If you're unprepared to enter today's markets you will underperform. But with Financial Markets and Trading as your guide, you'll quickly discover what it takes to make it in this competitive field.

Preface ix

Acknowledgments xiii

Part One

Market Microstructure 1

Chapter 1

Financial Markets: Traders, Orders, and Systems 3

Traders 3

Orders 5

The Bid/Ask Spread 7

Liquidity 9

Market Structures 9

Continuous Order-Driven Markets 10

Oral Auctions 11

Call Auctions 12

Quote-Driven Markets and Hybrid Markets 13

Chapter 2

Modern Financial Markets 15

The U.S. Equity Markets 15

The NYSE 15

Nasdaq 16

Alternative Trading Systems 17

European Equity Markets 18

Spot FX Market 19

The U.S. Fixed Income Markets 21

High-Frequency Trading 22

Chapter 3

Inventory Models 26

Risk-Neutral Models 26

The Garman’s Model 26

Amihud-Mendelson Model 29

Models with Risk Aversion 29

What Is Risk Aversion? 29

The Stoll’s Model 31

Chapter 4

Market Microstructure: Information-Based Models 35

Kyle’s Model 35

One-Period Model 35

Multi-Period and Multi-Insider Models 38

Glosten-Milgrom Model 39

Further Developments 41

Chapter 5

Models of the Limit-Order Markets 44

The CMSW Model 44

The Parlour Model 46

The Foucault Model 47

Equilibrium at Zero Volatility 48

Volatility Effect 49

New Developments 50

Chapter 6

Empirical Market Microstructure 53

Roll’s Model 53

The Glosten-Harris Model 55

Structural Models 56

Recent Empirical Findings 58

Equity Markets 58

Global FX Spot Market 60

Part Two

Market Dynamics 63

Chapter 7

Statistical Distributions and Dynamics of Returns 65

Prices and Returns 65

The Efficient Market Hypothesis 66

Random Walk and Predictability of Returns 68

Recent Empirical Findings 69

Fractals in Finance 72

Chapter 8

Volatility 75

Basic Notions 75

Conditional Heteroskedasticity 77

Realized Volatility 79

Market Risk Measurement 81

Chapter 9

Agent-Based Modeling of Financial Markets 86

Adaptive Equilibrium Models 87

Non-Equilibrium Price Models 89

The Observable-Variables Model 91

Modeling Efficiency of Technical Trading 94

Modeling the Birth of a Two-Sided Market 95

Part Three

Trading Strategies 101

Chapter 10

Technical Trading Strategies 103

Trend Strategies 105

Filter Rules 105

Moving-Average Rules 106

Channel Breakouts 107

Momentum and Oscillator Strategies 109

Complex Geometric Patterns 113

Chapter 11

Arbitrage Trading Strategies 117

Hedging Strategies 118

Pair Trading 120

Cointegration and Causality 121

Pair Selection 123

Arbitrage Risks 125

Chapter 12

Back-Testing of Trading Strategies 129

Performance Measures 131

Resampling Techniques 133

Bootstrap 133

Markov Chain Monte Carlo 135

Random Entry Protocol 136

Comparing Trading Strategies 137

Bootstrap Reality Check 138

New Developments 139

Chapter 13

Execution Strategies 142

Benchmark-Driven Schedules 143

Cost-Driven Schedules 145

Risk-Neutral Framework 145

Risk-Averse Framework 147

The Taker’s Dilemma 151

The Random Walk Model 153

Simulations of the Execution Costs 154

Appendix a Probability Distributions 156

Basic Notions 156

Frequently Used Distributions 159

The Uniform Distribution 159

The Binomial Distribution 159

The Poisson Distribution 160

The Normal Distribution 160

The Lognormal Distribution 161

The Cauchy Distribution 162

The Gamma Distribution 162

Stable Distributions and Scale Invariance 162

Appendix B Elements of Time Series Analysis 165

The Autoregressive Model 165

The Moving Average Model 167

The ARMA Model 168

Trends and Seasonality 170

Multivariate Time Series 172

Notes 174

References 180

About the Author 190

Index 191

DR. ANATOLY B. SCHMIDT holds a master of science and PhD in physics from University of Latvia. He has been working as a quantitative analyst in the financial industry since 1997. Dr. Schmidt has published several papers on agent-based modeling of financial markets, market microstructure, and algorithmic trading as well as a book entitled Quantitative Finance for Physicists: An Introduction. He also teaches in the Financial Engineering Program of Stevens Institute of Technology.

Financial Markets and Trading

Over the last decade, the financial landscape has undergone a significant transformation—shaped by the forces of technology, globalization, and market innovations to name a few. In order to operate effectively in today's markets, you need more than just the motivation to succeed, you need a firm understanding of how modern financial markets work and what professional trading is really about.

Nobody understands this better than author Anatoly Schmidt, and in his new book, he puts these topics in perspective by providing you with an informative overview of modern financial markets, and the theoretical concepts of market microstructure, as well as an engaging assessment of the methods used in deriving and back-testing trading strategies.

Divided into three comprehensive parts, this reliable resource offers a balance between the theoretical aspects of market microstructure and trading strategies that may be more relevant for practitioners.

Part One details the modern financial markets for equities, foreign exchange, and fixed income—starting with an introduction to various types of traders, orders, and market structures and then presenting the major market microstructure models. Some important empirical properties of modern equity and foreign exchange markets are also described.

Part Two addresses the basics of market dynamics, including statistical distributions, dynamics, and volatility of returns—discussing the efficient market hypothesis and possible predictability of returns as well as introducing the concepts of agent-based modeling of financial markets.

Part Three is devoted entirely to trading, and offers a summary of approaches used in technical analysis and statistical arbitrage as well as a more detailed description of trading performance criteria and back-testing strategies. Ideas used in optimal order execution, such as optimal order slicing and the taker's dilemma, are also examined.

Two appendices are also included to support the main material in this book. Appendix A provides reference material on basic statistical notions and statistical distributions that are frequently used in finance. And Appendix B describes the main concepts of time series analysis: autoregressive and moving average models, trends and seasonality, and multivariate models.

If you're unprepared to enter today's markets you will underperform. But with Financial Markets and Trading as your guide, you'll quickly discover what it takes to make it in this competitive field. "Anatoly Schmidt has written an extremely useful book that connects academic theories of market structure to their practical implementation on the trading floor. Both groups should benefit from this conversation. Traders will learn the latest theoretical models of dealer and order driven markets. Students will better understand the challenges of producing profitable trading strategies. Readers interested in learning more about the equity, bond, and foreign exchange markets are fortunate to have this comprehensive guide."
—Bruce Mizrach, Associate Professor, Department of Economics, Rutgers University

"I recommend Financial Markets and Trading as the insider's look at the structure, practices, and conventions of financial markets, especially within the OTC wholesale environment. Anatoly Schmidt does an excellent job in evaluating and applying various theoretical aspects of creating, testing, and implementing trading programs within several markets and asset classes. I plan to use his book in the curriculum of the Financial Engineering Program at Kent State University."
—John Donato, VP, ICAP PLC; Instructor, Kent State MSFE Program

"Alec Schmidt has written an excellent textbook that details the complex workings of 21st-century equity markets. His textbook is unique in combining the theory and practice of market microstructure with an extensive, practitioner-oriented treatment of trading strategies."
—Craig Holden, Professor of Finance, Indiana University