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January 1, 2003

Trading and Exchanges Market Microstructure for Practitioners

By Reviewed by Gregory Bresiger

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  • Trading and Exchanges Market Microstructure for Practitioners

(Oxford University Press, New York, 641 pages) $95

If you want to really understand markets, if you are confused by market

structure issues and the nuances of trading, you have to talk to Larry Harris."

This is what a longtime securities industry lobbyist recently told me. This is also what a number of influential people in this business have told me over the past few years. They were referring to the Securities and Exchange Commission's chief economist, who is the author of this much anticipated work. It is both a trading handbook and an exposition of various trading strategies.

Harris, an academic on assignment from the Marshall School of Business at the University of Southern California (USC), has established a reputation for knowing more about trading than many of its most famous practitioners. Harris' reputation is justly earned.

Delivers the Goods

This weighty book delivers the goods. It is must reading for just about everyone in the trading business and for those who aspire to be part of it. "Trading," Harris warns at the outset of the book to those who want to make a career of this often-difficult business, "is a zero-sum game in which some traders win and others lose. Traders who do not expect to win should refrain from trading." (page 4).

And those who must trade, and believe they will be winners by using value strategies, must avoid what Harris calls "the winner's curse." As described by Harris, these traders suffer from a professional affiliation that can affect almost anyone. They appear to be winners. But actually they are losers because the price of victory is too dear.

"Traders suffer the winner's curse when they win an auction and subsequently regret that they traded because they paid too much or sold for too little," Harris writes. "Everyone who competes with others to buy or sell faces the winner's curse. When you buy a house, when you trade on eBay, and when you bid on a job." (page 338).

Buyers, Harris says, avoid the winner's curse by doing certain things: First and foremost they must always consider the implications of being the highest bidder in an auction. The highest bidder must know that his value estimate is different, sometimes far too different, than others, an important piece of information.

"If he knew this value estimate beforehand," Harris writes, "he could have improved his estimate by lowering it toward the common mean." (page 341).

Harris' common sense approach to trading includes advising the trader to look for contradiction, for miscalculations that can be exploited. Still, he warns there are also times to be cautious; when values appear to be too good to be true. He writes: "The uncertainties in your estimates of value imply that you should not speculate unless you believe instruments are very mispriced. Of course, the greater the mispricing you believe you have identified, the more likely it is that you have made a mistake." (page 343).

Another example of the winners' curse, Harris writes, was the Internet group of stocks in the late 1990s. They were difficult to value. Therefore, traders, trying to protect themselves, would trade these securities only at very wide outside spreads, according to Harris.