Biais et al. (1995) suggest a complex relationship exists between trader order strategy and a number of factors, including transmission of information to the market, the cost of trading and the nature of the liquidity available to the market. One of the most effective ways traders can maximise their portfolio return is through the management of their trading strategy. By optimising their trading strategy, traders can minimise their transaction costs compared to those who do not (Harris, 1998). When placing an order, a trader will need to choose between submitting a market or a limit order.13 If the trader decides to submit a limit order, he will also have to decide the limit price. If the limit order does not execute, he will then need to choose between cancelling and amending the order.14
13 Market orders are instructions to buy (sell) a fixed quantity of shares at the best available price
offered by the standing limit orders on the sell (buy) side of the market. Limit orders are instructions to buy (sell) at or up to the fixed quantity of shares at the limit order price set by the trader. An important difference in the two types of order is that a market order guarantees execution (assuming sufficient opposing limit orders exist) but does not provide price certainty (especially if market prices are changing quickly) while a limit order guarantees price certainty but does not guarantee execution. If no opposing orders exist, market orders cannot be placed. The ASX trading platform, for example, generates an error message when this occurs.
14 Another decision the trader faces when submitting an order is the order size. Order size and order
A number of papers have examined the factors that influence the choice between a market and a limit order (Foucault, 1999; Lo and Sapp, 2003; Ranaldo, 2004; Verhoeven et al., 2004). While the study of the dichotomous choice of market versus limit order provides a good preliminary examination of trader strategy, it does not cover the full range of order strategy options available to a trader. The use of a market order involves accepting the best price on the opposing side, allowing the order to be executed immediately. In comparison, the use of a limit order is more involved as it requires the trader to set the price at which he is willing to trade. The limit order price could be in-the-market, at-the-market or behind-the-market.15
Harris and Hasbrouck (1996), one of the first papers to examine order placement strategy or aggressiveness of an order, define the latter as the extent to which it betters the existing quote. A number of subsequent papers (Griffiths et al., 2000; Hedvall et al., 1997; Ranaldo, 2004) have examined the concept of aggressiveness and its interaction with the state of the limit order book. Griffiths et al. (2000) categorise orders into six categories: (1) market orders; (2) marketable limit orders for quantities greater than the depth at the best opposing bid/ask; (3) marketable limit orders for quantities equal to the depth at the best opposing bid/ask; (4) limit orders that are in-the-market; (5) limit orders at-the-market; and (6) limit orders behind-the- market.
By definition, market orders consume liquidity while limit orders provide it. While the price of liquidity is the bid-ask spread, the use of limit orders does not come without a cost. Limit order traders face both the risks of non-execution and adverse selection. Harris (1998) suggests the strategy a trader selects reflects the trading problems they are attempting to solve. In the modelling of stylised trading strategies, Harris analyses three different types of traders, of which two are informed. The first informed trader has private information that may be short-lived. In his stylised model of trader strategy, Harris assumes the informed trader’s informational advantage decays exponentially with time. As a result, the informed trader uses a market or a
15 In-the-market orders have order price between the best bid and best ask. At-the-market orders have
order price at the best available price on the same side as the order. For example, a bid (ask) order that is placed at-the-market has the same order price as the highest bid (lowest ask) on the schedule. Behind-the-market bid (ask) orders have order price less (more) than the best bid (ask) price available on the schedule.
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more aggressively priced limit order to trade more quickly. However, if the bid-ask spread is wide and there is no time constraint on the informed trader, he is likely to submit a more passive limit order to minimise his transaction cost, or not trade at all. Harris also suggests another class of informed trader exists. They are the value motivated traders who receive private information that is long-lived and are likely to use working orders or limit orders that are placed behind-the-market. Limit orders allow them to trade discreetly and prolong their ability to trade profitably. The above discussion suggests that the study of order aggressiveness may not provide conclusive evidence on the informativeness of the different trader types as informed traders can use a mixture of order types depending on their beliefs about the longevity of their private information.
Keim and Madhavan (1995) examine the use of market and limit orders by institutional traders. They find a strong preference for market orders (90.1%) and that the choice of order type was asymmetrical across the different trading strategies. While 76.2% (77.6%) of the bid (ask) orders placed by value traders were market orders, traders adopting technical and index strategies used an even greater proportion (88-92%). The findings are supported by Campbell et al. (2004) who report that institutions on average demanded liquidity from other traders. It is debatable whether the traders following technical and index strategies examined by Keim and Madhavan should have been classified as informed. The placement of more aggressive orders may not be a reflection of whether a trader is informed so much as his desire to complete the trade, for whatever reason.
Given the findings from Keim and Madhavan (1995) and Campbell et al. (2004), we expect to find similar results in the Australian share market environment. Institutional traders are likely to demand immediacy due to the perceived short term nature of their private information about the underlying value, their “information” derived from technical analysis or their desire to track an index. Besides the demand for greater immediacy, the ability to monitor market conditions and react accordingly may result in the greater use of market orders (Dupont, 1998). Institutional traders are likely to monitor the market and place an order only when they judge the market to be favourable. This is akin to the “pre-considered” trader discussed in Harris
(2003).16 The act of placing a limit order provides the market with the ability to trade, similar to granting the market a trading option (Copeland and Galai, 1983). Limit orders are also exposed to the possibility of being quote-matched (Aitken et al., 2001a; Harris, 1996).
Consider an institutional broker who has instructions from a client to buy at a price lower than the current best bid. If the broker submits the order to the trading system, the order would be classified as a passive order. The limit order runs the risk of being quote-matched by other traders placing another limit order at a price marginally higher. If the limit order is hit and share price increases, the quote-matcher will benefit from the price rise. However, if the price falls, the quote matcher may be able to limit his losses by selling to the institutional trader. Thus, the institutional broker may not submit the order immediately but would monitor the market and place the order only when the market moves towards the client’s indicated price. Subsequently, the order would be classified as aggressive.
Due to the preference of institutional traders for immediacy and their ability to monitor the market, orders placed by these traders are likely to differ from those placed by retail traders. Hypothesis H3 predicts that, ceteris paribus, orders placed by retail traders are less aggressive compared to those placed by institutional traders.
H3: Orders from retail traders are less aggressive than orders from institutional traders.