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December 1, 1998

What Should The Next Trade Cost? How the Pros Will Set OptiMark Profiles

By John A. Byrne

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  • What Should The Next Trade Cost? How the Pros Will Set OptiMark Profiles
  • Page 2

The OptiMark Trading System is set to debut as a facility of the Pacific Exchange next month. Wayne H. Wagner, chairman of the Plexus Group, a Los Angeles-based consultant on trading costs to investment managers and brokerage firms, writes about setting profiles on OptiMark, and gives an analysis on cost.

Conversations with buy-side traders reveal a strong curiosity about OptiMark, nothwithstanding a skepticism about how successful it actually will be. Traders, to be sure, fully understand the concepts behind OptiMark, and the potential benefits of the system developed by OptiMark Technologies in Durango, Colo. They are uncomfortable, however, about how to apply their trading experience.

In today's markets, buy-side traders act as price takers: the broker states a price for a stock and the volume it wants to trade, and the trader accepts or declines. Using OptiMark, though, the buy-side trader has to set his or her own price for different fill rates. And that requires a new skill for buy-side traders.

OptiMark is said to have three dimensions: price, size and satisfaction. Trades are specified in the form of a profile, indicating how much traders are willing to pay to complete trades in given numbers of shares. A profile is drawn on a chart, indicating cost-versus-trade size. The white areas of the OptiMark profile is for prices the trader is willing to pay to complete the trade for various-sized fills. A trader's willingness to trade at each price and size point is indicated across a spectrum ranging from a one (completely willing to trade) to a zero (unwilling to trade).

But how exactly does a trader determine an acceptable price? Perhaps the portfolio manager has some top price in mind. Alternatively, the cost of the stock can be separated from the cost of immediacy. The cost of immediacy will help in the setting of profiles. In contrast, a trader who is uncomfortable about what the next trade should cost is not going to use OptiMark aggressively.

For example, if the price of Dell Computers is $66 a share, and the seller offers stock at $67 while the buyer offers to buy at $65, no trade will occur. Alternatively, a buyer and seller might show a willingness to trade at $66, but they only offer 10,000 shares. Since OptiMark is designed to bring traders together to trade large blocks of shares, trading small pieces adds little value over the existing process.

The Cost of Immediacy

The value of OptiMark comes from coaxing out the larger orders of portfolio managers underlying the moment-to-moment activity.

To gauge the frequency of these large trades, Plexus took seven very large money managers who each trade a minimum of $8 billion each quarter, comparing trading in giant trades (that is, trades of more than 250,000 shares) to trading in more conventional institutional trades of between 10,000 shares to 100,000 shares.

The bulk of trade dollars are in the large orders. The heavy costs of these orders are in the hidden categories of trading delays and missed opportunities. These same costs result from the refusal to pay the costs of immediacy. The giant orders are those for which the use of OptiMark should be most productive.