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What's the rationale behind an inverted market?


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What's the rationale behind an inverted market?

  #1 (permalink)
 
Jura's Avatar
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I was reading through LMAX's Trading Manual and came across the following section (p. 5-6):


Quoting 
3.1.7 Inverted Markets

Where the MTF [multilateral trading facility] ask price is lower than the MTF bid price (an “Inverted Market”), the price at the mid point between the MTF ask price and MTF bid price will be shown to you on both sides of the order book. However, you will still trade at the actual MTF bid or ask price, which will be no less advantageous than the price shown.

With the following example:



I did some Googling but didn't came across any forex related information. Apparently, in futures an inverted market is..

Quoting 
In the context of options and futures, this is when the current (or short-term) contract prices are higher than the long-term contracts.

This usually occurs because a good is currently in short supply, which drives up prices in the short term.


Though I understand why an inverted market may happen in theory in futures, I don't understand why it happens in practice:
  • Shouldn't these price differences be arbitraged away immediately?
  • How can such a situation occur on a MTF where the bid and ask prices are for the same instrument with the exact same terms (as delivery date etc.)?
  • What does it say about the underlying market if these inverted markets happen apparently frequent enough to explain these in a trading manual?
  • And, as the above example shows, what's the rational for LMAX to "hide" these inverted prices but quote 1.46280 vs 1.46280?

Who can shed more light on this?

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  #3 (permalink)
 
Fat Tails's Avatar
 Fat Tails 
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Jura View Post
I was reading through LMAX's Trading Manual and came across the following section (p. 5-6):



With the following example:



I did some Googling but didn't came across any forex related information. Apparently, in futures an inverted market is..



Though I understand why an inverted market may happen in theory in futures, I don't understand why it happens in practice:
  • Shouldn't these price differences be arbitraged away immediately?
  • How can such a situation occur on a MTF where the bid and ask prices are for the same instrument with the exact same terms (as delivery date etc.)?
  • What does it say about the underlying market if these inverted markets happen apparently frequent enough to explain these in a trading manual?
  • And, as the above example shows, what's the rational for LMAX to "hide" these inverted prices but quote 1.46280 vs 1.46280?

Who can shed more light on this?


@Jura: In an inverted market bid and ask orders are crossed, but cannot be matched.

The explanation is pretty easy and depends

-> on the order types allowed by the exchange
-> the matching rules used by the matching engine

The example that you have posted shows a buy limit order for 500 lots at bid 1.46280 and a sell limit order for 7 lots at ask 1.46280. If those cannot be matched, the explanation can likely be found with the order type of the buy limit order.

You might have heard about Fill-or-kill orders, which must be executed immediately or will be removed from the order book otherwise. As the buy order is still sitting on the book, it cannot have been a Fill-or-kill order, but we need to look for other order types:

All-or-none: An order type requiring that the entire order is filled.

Minimum-volume: This order type allows large participants to avoid that their order is crossed with an odd lot order. If you want to buy 10,000 shares, would you be happy, if you end up with 7?

Uncommited orders: This order type requires confirmation prior to execution.


The example shows that it is important to know

-> which order types are available on the exchange that you intend to trade
-> how the matching algorithm works (time price priority, pro-rata-allocation etc.)

This information can be usually downloaded from the exchange.

For a brief introduction to order types see Barry Johnson: Algorithmic Trading and DMA, 4Myeloma Press, 2010, Chapter 4: Orders, pp 83-113.

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Fat Tails View Post
In an inverted market bid and ask orders are crossed, but cannot be matched.

The explanation is pretty easy and depends

-> on the order types allowed by the exchange
-> the matching rules used by the matching engine

Thanks for your clear explanation Fat Tails. I failed to take these two things in consideration.


Fat Tails View Post
The example shows that it is important to know

-> which order types are available on the exchange that you intend to trade
-> how the matching algorithm works (time price priority, pro-rata-allocation etc.)

This information can be usually downloaded from the exchange.

Good advice. I already found one possible explanation in the rule book:


Quoting 
4.3.6 No Order entered by a General Member shall be matched with an Order
entered by another General Member. Orders that are entered by General
Members may only be matched with Orders entered by Broker Members, but
an Order entered by a Broker Member may be matched with an Order entered
by another Broker Member.

(Also thanks for the book suggestion).

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  #5 (permalink)
 
Fat Tails's Avatar
 Fat Tails 
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Jura View Post
4.3.6 No Order entered by a General Member shall be matched with an Order
entered by another General Member. Orders that are entered by General
Members may only be matched with Orders entered by Broker Members, but
an Order entered by a Broker Member may be matched with an Order entered
by another Broker Member.

General members are not allowed to trade among them, but have to deal with a broker. I did not think about the possibility that some animals are more equal than others ....

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Last Updated on January 17, 2013


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