VOLUME NO. 8
`
`IMPROVING TRADE EXECUTION WITH
`ORDERS
`Placing execution orders with your
`bank’s FX, bond or derivatives trading
`desk is a good way to improve hedging
`and investment performance without
`increasing transaction costs.
`
`To use orders effectively, it is important
`to understand how the order process
`works and the characteristics that
`differentiate one type of order from
`another. This issue of Derivations will
`focus on why, when and how to use
`orders to execute OTC transactions.
`
`THE CHALLENGE
`
`Investors and hedgers use orders to buy or sell a wide variety of financial instruments—
`exchange-traded instruments like stocks and futures contracts, as well as OTC
`instruments such as interest rate swaps or currency options. They leave orders for several
`reasons:
`
`l To protect unhedged exposures against adverse price and rate movements
`l To reap benefits from rapid and sometimes temporary changes in the market
`prices or rates
`l To take special advantage of the reach and expertise of market professionals
`
`Orders allow investors and hedgers to benefit from market volatility, locking in better
`transaction pricing than might be available any other way. They are also an efficient way
`to set hedges or reduce exposure in fast moving markets and to execute transactions when
`local markets are illiquid or closed altogether.
`
`WHAT DOES IT MEAN TO LEAVE AN ORDER?
`An order is a directive given to a dealer to execute a trade with the client, when certain
`price or other market conditions are met. Most financial managers cannot afford to take
`time away from other activities to scan markets continuously for the perfect execution
`window. Continuous market scanning, on the other hand, is fundamental to what dealers
`do every day.
`
`l MARKET ORDER
`A market order directs the dealer to execute a transaction at the prevailing market price or
`rate. In OTC markets most trades are implicitly done on this basis. Market orders are
`regularly used in global markets like swaps or FX to facilitate out-of-time zone
`transactions.
`
`l LIMIT ORDER
`A limit order directs the dealer to execute (or fill) a transaction only at a specified price
`or better. A limit order is best used when the actual price at which the trade is done is
`more important than the time at which it is done. Since a limit order is always entered
`away from the current market price, it is almost never executed immediately. A party that
`leaves a limit order trades off the certainty of immediate execution (and risks not getting
`it filled at all) in exchange for the expectation of getting an improved price in the future.
`
`l STOP ORDER
`A stop order becomes a market-order when a certain price level (the stop) is penetrated.
`Unlike the limit order it does not define the actual price at which the trade will be
`executed, but rather the price that will cause the trade to be initiated. While a stop order
`does not guarantee the price of execution, it ensures that the trade will be executed if the
`price level is breached. This is very useful in fast moving markets when locking in an
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`GAIN CAPITAL - EXHIBIT 1029
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`0001
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`exact price is less important than just getting the trade done. Traders often use stop orders
`to protect profitable positions against unexpected market reversals.
`
`l STOP LIMIT ORDER
`A slightly more complex order strategy is the stop limit order, in which a limit order is
`activated when market prices move through a stop level. The stop (or trigger) can be set
`at the same price as the limit order price or it can be at an entirely different price. The stop
`limit order effectively establishes a worst case trade price. If the limit price cannot be
`traded after the stop is penetrated, the order will not be filled. This eliminates the risk of
`a fill at a worse-than-expected price. The stop limit order is most useful in markets where
`the price movements are choppy and unpredictable.
`
`l DAY ORDER
`Day orders are good until the close of business on the day given. These type of orders
`leave room for ambiguity unless “close of business” is explicitly defined, and will not get
`executed through the overnight market. Day orders do not guarantee that trade execution
`will take place.
`
`l GOOD UNTIL CANCELLED ORDER
`Good until cancelled specifies an order which is active until the client specifically revokes
`it. This type of order allows for price movement to a target level to take place over a longer
`period of time. It works best in situations where there is latitude in execution timing and
`a definitive target price. It is active until actually cancelled. If the client’s objectives
`change and the dealer is not advised, then an undesired trade may occur.
`
`Even though brokers serve to concentrate price information in OTC markets, there is no
`“official” OTC price. For this reason orders are most often executed on a best efforts or
`“not-held” basis. This means that while the dealer will do his best to fill the order, he is
`not compelled to execute it at the specified level.
`
`USING ORDERS TO TAKE ADVANTAGE OF INTRA-DAY VOLATILITY
`One of the most significant advantages of leaving an order is that it creates an
`opportunity to take advantage of short-term price/rate movements. Many markets are
`surprisingly volatile over short periods of time. Limit orders placed a reasonable distance
`from the current market price or rate provide a way to exploit this unpredictability in price
`behavior.
`
`The chart below tracks the yield of a 10-year U.S. Treasury note between March 24 and
`April 15, 1998.
`
`1
`
`2
`
`3
`
`4
`
`5
`
`6
`
`7
`
`8
`
`9
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`10
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`1 1
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`12
`
`13
`
`1 4
`
`15
`
`16
`
`1 7
`
`18
`
`19
`
`2 0
`
`Time (days)
`
`5 .7 5
`
`5 .7 0
`
`5 .6 5
`
`5 .6 0
`
`5 .5 5
`
`5 .5 0
`
`5 .4 5
`
`5 .4 0
`
`Yield 10 - yr. U.S.T.
`
`Even over this short period interest rates exhibited roller-coaster-like volatility. Over one
`5 day period yields rose by 20 basis points. Over the next 5 days yields fell more than 25
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`basis points. The trend reversed again over the next 7 days, taking yields up by almost the
`same amount as the prior week’s decline. Interest rate swap limit orders set 15-20 basis
`points away from the market in this rate environment were quite likely to be filled,
`creating the potential for significant savings for hedgers.
`
`Rates can move substantially even within a single day. Violent intra-day price/rate
`movements are sometimes triggered by surprises in closely watched economic releases
`like monthly payroll data or official crop forecasts. Orders give hedgers and investors the
`ability to position to take advantage of these rapid oscillations.
`
`The circled areas on the chart show how yields responded to surprising new economic
`information. In the first instance, rates spiked lower on a weak durable goods number,
`then an hour later bounced sharply higher on a stronger-than-expected home sales
`statistic. The same pattern emerged a week later with the release of monthly payroll
`data—a knee-jerk overshoot reaction when the data was made public, then a rebound as
`the data was analyzed more closely. A day limit order placed ahead of the information
`releases would have had a good chance of getting filled, even though rates quickly
`bounced back in both instances.
`
`SUMMING UP
`
`Execution orders are underused but extremely useful financial tools that enable
`financial managers to make market price movements work to their advantage. Orders can
`be used to prevent erosion in the value of unhedged positions caused by a market move in
`the wrong direction. Orders can also free managers from the time needed to monitor
`market movements on a minute to minute basis to ensure best execution.
`
`This material is for general information purposes only and is not to be relied on as investment
`advice. The reader should consult their own financial advisors before making any investment
`decisions.
`
`© Copyright of Bank of Montreal 1998
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`0003
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