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Shares: Trading strategies with Direct Market Access

Created:
23 April 2008
Updated:
24 April 2008
Written by:
Rakesh Shah

The simplest way to interpret a direct market access (DMA) screen is to use the total bid and offer size as a measurement of the strength of supply and demand. Often, though, this can encourage novice buyers and sellers to make false assumptions about the current supply and demand prospects for a share. Take a look at Image 1 (below): E*Trade’s Level 2 screen for Carphone Warehouse.

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The daily range of Carphone Warehouse's shares has been 30p-40p in the most recent quarter. In today's market, with little share- or sector-specific news, the share price can be expected to move in line with the broader market, barring an unexpected announcement or event.

Image 1

Realistically, then, the daily range will be 20p-30p. Any orders outside this range are unlikely to get executed. 'Unlikely' is the key word here, as anything is possible in the short term. A large order to sell outside this range at 370p or 375p would have a low probability of getting filled, but would give the impression of selling supply in the stock. The investor behind the order might have a number of motivations, such as selling because they feel the shares are overvalued at this price, or maybe they wish to accumulate a short position. Maybe they have no motivation at all and are simply testing the level of supply and demand in the market at that price. As an investor you will never know.

In any event, you must be able to calculate very quickly the probabilities of the market trading at that price. If the probability is low, then you can ignore those orders when deciding whether the order book structure is bullish or bearish. To do so, you will need to apply a number of techniques to evaluate the strength of the market, which we will look at in this article. It is important to note that all orders are real orders – there is no such thing as a fake order.

Buying shares – in an imaginary company – at better prices using DMA

Shortly after the market opens, shares in ABC are trading at a bid-offer spread of 32.50-33.00. You wish to buy £10,000-worth of ABC shares, which is equivalent to 30,303 shares at the offer price.

In a stock such as ABC, the spread – the difference between the bid and offer prices – typically varies from 0.25p to 0.50p.

Using a DMA platform, a buyer has the ability to place an order directly into the market. This means that you, as the buyer, have the opportunity to purchase shares at three distinct price points shown as reference points: ∂, ∑ & ∏ on the table below. You can enter a buy order for 30,303 shares at three different price levels:

By entering an order at points 1 or 2, it is possible for another participant in the market (a seller of ABC shares) to transact with you, and fill your buy order.

This can result in the saving of between 0.25p and 0.50p in the purchase price of a stock. In percentage terms, that amounts to 0.75 per cent and 1.52 per cent. This benefit must be weighed up against the possibility that the share price may move against you and move higher. The greatest savings are achieved in shares with wider spreads.

Using this method of trading, there are a number of variables that will dictate how much can be saved. It is worth giving careful consideration to :

• Tick increments. Shares have different increments in which they trade. This can be as tight as 0.1p and as wide as 1p.

• The size of your trade. Is the trade small or large when compared with the orders currently displayed on the Level 2 screen?

• Time of day. Liquidity can often improve significantly after the first half-hour of trading.

• Liquidity. This is the total number of buy and sell orders ahead of your order, and how fast they are replenished.

• Market capitalisation. Generally speaking, larger capitalisation stocks have tighter spreads.

• Will the order get executed? In other words, how active the market is on that day.

Trading the spread.

The simplest strategy is to become a market maker. In the trading world, this is called 'trading the spread'. To do this you will have to place orders to 'buy at the bid' and enter an order to 'sell at the offer'. You can do this simultaneously or wait for one side to be filled before entering the other side. This will depend on the strategy you are using, the trading volumes in the stock, and most importantly, the directional bias that is placed on the trade. Is the stock trending higher or lower?

Trading the spread is only worthwhile if the profit factor – the buying price less the selling price – is large enough to offset commissions and losing trades. Often, this strategy is over-looked by professional traders, who simply do not have the time or patience to trade in the smaller capitalised shares where liquidity may be limited to a few hundred shares, resulting in profit potential of only a few hundred pounds.

Let's look at an example. In Northern Rock 's shares – see image 2, below – the spread is 1p, with the bid at 78.1 and offer at 79.1. You can place a trade to buy 20,000 shares at 78.2 and at the same time place a trade to sell 20,000 shares at 79.0. This will result in a profit of 20,000 x 0.8p = £160, minus transaction costs. Total cash required will be 20,000 x 0.782p = £15,640. Assuming you were not leveraged on this trade, your return will be 1.02 per cent.

Image 2

Not bad, but at the end of the day, it is only 1 per cent. How can you increase your returns? First, you can leverage your transactions using contracts for difference (CFDs), where you will only have to put up from 5 per cent to 25 per cent of the capital normally required. Every broker has different margining policies. If a broker was offering 10 per cent margin on our transaction here, you would only have to put up £1,564 of the £15,640 value of your total position. So, your return will be £160/£1,564 = 10.23 per cent. Now things are starting to look interesting.

Of course, you can repeat this process many times over the course of a day. And you can hedge your risk by taking positions in uncorrelated shares. If you are looking for a more advanced strategy, you can take a pairs position where you buy and sell two shares from the same sector simultaneously to hedge out any general market movement risk.

You need to be aware that there are some trading factors that can quickly turn that profit into a loss. First, new orders may be placed into the market that reduce the spread, resulting in a smaller profit. Second, the market must trade at your specified price levels for you to get a fill at that price level. That is to say, another market participant must come into the market and either buy or sell 20,000 shares at the prevailing bid or offer, respectively. Third, your order may not get filled at all at your desired price, with another investor jumping in front of your order, so that you will be pushed to the back of the queue until the order in front is filled.

It can also happen that you manage to get a fill on the bid – you buy some shares – and the market begins to head lower before you can get a fill on your offer. This will cause you to either take a loss immediately by selling your shares at the next available bid on the order book, or you will have to swiftly move your offer to the top of the order book, putting you next in line for any buyers in the market that will buy your shares. Either way, you are now managing a losing trade. A good way to find your feet here is to practice with the London Stock Exchange's (LSE) DMA simulator.

Of course, this process goes on all day long and it is your overall performance that matters. It's important not to get disheartened by individual losses. Making profits comes with discipline and experience. You also need an edge when it comes to working out the market's direction. This can come from technical analysis or anticipating newsflow. The bottom line is that, whatever your approach, your edge has to make you enough to cover losing trades and commissions comfortably.

When starting out with trading the spread, it is best to take a position by placing a bid in the market for a share that you would normally buy for the short term because you are bullish, so that the positive momentum works in your favour. The decimalisation of a number of larger capitalised shares in the last year also requires this strategy to be adapted to take into account tighter spreads. You need to focus more on short-term position trading by taking a view on the direction of the share in the next few minutes. Shares such as Vodafone were previously traded in half- and quarter-penny increments. Now, it is traded in hundredth of a penny. The benefit here is that it reduces entry and exit costs for investors but, on the flipside, there may be fewer traders providing liquidity in that particular share at every price point. Brokerage charges have also been reduced significantly due to competition and this helps to offset tighter spreads.

After observing a number of DMA spread trading opportunities, it will become more apparent that the majority of these rapid trading opportunities exist at the very start of the day while the liquidity of the share is building up.

Trading gaps in the order book

Level 2 screens can allow you to see gaps in the order book, where there are fewer orders between certain price points. Using DMA can enable you to place orders to these price points. That said, there is no guarantee that placing orders at these price levels may trigger new orders to be entered into the market in these areas. A number of professional investors have computer programmes set up to identify these points and potential trading opportunities based on momentum principles. The idea here is to place your trade only when you see a large order being filled and, by using DMA access, take one of the last bites of that order before the gap opens up.

Looking at image 2 (above), suppose you wish to take advantage of the gap between 79.1p and 80p in Northern Rock. Say there are 29,969 shares on the offer; you must wait until there are approximately only 20,000 shares on the offer. You can then buy the shares and, at the same time, put a sell order for 20,000 in at 79.9p. Now there is one order on the books at 79.5p for 2,000 shares. This is pretty typical of such a trade. You simply have to manage the risk and the trading process as the numbers you wish to trade may not match up with what is available in the market. Every form of trading comes with risks and the risk here is that new orders will be entered into the market to fill those gaps before you are able to exit with a profit.

Jumping the queue: using DMA to get your order filled at better prices

Level 2 shows the entire order book, which can help you determine where to place your order relative to others. For example, you may decide to transact ahead of a larger order. Perhaps you have previously bought shares at 150p and you wish to take profits at 200p. You can see an exceptionally large order to sell at 199.5p, which has not moved for the majority of the day. In this case, you may make up your mind to sell at 199.25p and take your profits slightly earlier, in the knowledge that there is a large seller just above the price you sold. The share may have run out of steam, or 200p may be a key technical level. Whatever is the case, having DMA access will certainly give you an advantage in your decision-making process.

Using technical analysis with DMA

DMA trading strategies often work well when you have a particular technique or level at which you would like to trade. A good look at the Level 2 order book gives you an indication of interest in the same trading strategies that you are looking at.

Consider the order book for Blue Bay Asset Management image 3 below. There is a technical level offering some support as shown in the image by the red box. The red box indicates that there may be some buying interest at the price point shown from other like-minded technical traders who may have the same idea.

How can you validate the idea before the price level is tested again? By using a Level 2 screen, you can see the current bids in the market at that price. Now, if you know the order book well – because you have been observing a particular share for some time – you may see a cluster of buy orders at that price (highlighted in the red box).

At this point, your skill and judgment come into play in deciding if you still wish to participate in the trade based on that particular level, and with DMA you can position your order wherever you feel it is best suited, depending on how aggressive an entry you wish to make. In addition, watching the price behaviour at a given level may provide you with some clues as to the type of investor that is participating at that level. In recent years, this has become harder to do, because of the growth of programme and algorithmic trading, where a computer executes orders in various sizes in an effort to conceal the actions of professional investors when they enter or exit in equity markets in large sizes.

An aggressive DMA entry will place your order well above the current orders at around 353p and aims to get you in before that level is reached. A conservative DMA order may place you in between some of those orders. This is less risky but your trade may not get filled. The benefit is that you will be closer to your stop-loss level that is set below 348p. At every stage you can see how the market is responding to this level that has been tested five times before. Note here that the momentum coming into this level is extreme. So, you must have a tight stop-loss in place to trade here, and be aware that this is a low-probability trade from a charting perspective.

In fast-moving markets, some investors will sit on the sidelines and wait for the markets to settle at a level before committing to trade. Others will enter into positions and simply ride out of the storm and see where prices land at the end of the period. DMA allows you to participate at these turbulent times with a better degree of accuracy for technical traders.

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