Abstract

In this paper, we discuss the issues a trader should consider when trading in and around the closing auction. Specifically, we describe the auction mechanisms used by the exchanges, including the order types offered and pre-auction information that the exchanges publish.  We then provide an empirical analysis of trading volume, auction imbalances, and price reactions to imbalances, and discuss how a trader should use these findings to execute orders “optimally”. Our results suggest that algorithms meant to target the close should focus much of their open market trading to the period prior to the imbalance announcement, as opposed to just prior to the close itself.  We also show that these algorithms should trade differently depending on whether the trade is a rebalance trade or a flow trade.  As an example, we discuss our new ITG Dynamic Close algorithm, which utilizes the research contained in this paper to implement rebalance and flow trades more effectively.

Introduction

The close of trading is generally the most actively traded period of the day. Institutional traders in particular often trade around the close either because they are benchmarked to the close (e.g., indexers) or because they are drawn to the increased liquidity around this time. Traders have the option of trading in the closing auctions to ensure they receive the closing price.  Alternatively, traders may opt to trade part of their order in the open market to limit their impact on the closing price and potentially capture some of the price impact caused by their own auction trading. The actual trading strategy a trader should follow depends on both the market dynamics (e.g., how his trading impacts prices) as well as on the motivation behind the trade (e.g., implementation of a flow trade).

In this paper, we discuss the issues a trader should consider when trading in and around the closing auction. Specifically, we describe the auction mechanisms used by the exchanges, including the order types offered and pre-auction information that the exchanges publish.  We then provide an empirical analysis of trading volume, auction imbalances, and price reactions to imbalances, and discuss how a trader should use these findings to execute orders “optimally”. And lastly, we discuss our new ITG Dynamic Close algorithm, which utilizes the research contained in this paper to implement rebalance and flow trades most effectively.

Our results show that prices react to imbalances at the time of the first imbalance announcement. Traders and algorithms executing large orders in the closing auction should consider trading a portion of their order in advance of the imbalance announcement to capture the price impact caused by their own closing auction orders.  We also show that the optimal trading strategy in light of our findings depends on the objective behind the trade, i.e., rebalance trade versus flow trade.  For both large rebalance and flow orders, the optimal strategy involves executing a fraction of the order in the closing auction and a fraction in the open market prior to the initial imbalance announcement. The key strategy difference between rebalance and flow trades is that rebalance trades will generally continue to trade in the open market up until the close.  Flow trades, on the other hand, will often do little or no open market trading after the initial imbalance announcement.  This finding is in stark contrast to how most “close algorithms” work, as they typically concentrate their open market trading to just prior to the close.  Our research suggests that Close Algorithms should concentrate more of their open market trading prior to the initial imbalance announcement and should trade flow trades differently than rebalance trades.

NYSE & NASDAQ Close Auction Mechanics

1. A Brief Review

NASDAQ

NASDAQ provides two special order types to participate in the closing auction: “On-Close” orders, i.e., Market-on-Close (MOC) and Limit-On-Close (LOC), and “Imbalance-Only” (IO) orders.  On-Close orders allow traders to participate in the closing auction directly, regardless of whether any imbalance exists at the time of the auction.  Imbalance-Only orders, on the other hand, execute only when there is an opposite side imbalance and serve as a tool for traders to specifically offset imbalances without amplifying the imbalance when trading on the same side as the imbalance.  MOC/LOC and Imbalance-Only orders can be cancelled and modified until 3:50 PM.  After that only Imbalance Only (IO) orders can be submitted, but neither on-close orders nor IO orders can be canceled or modified.[1]