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PAIR TRADING SYSTEM AND METHOD
CROSS-REFERENCE TO RELATED
APPLICATIONS
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This application is a divisional application of U.S. patent application Ser. No. 10/206,549, entitled "Pair trading system and method", which was filed on Jul. 25, 2002 now U.S. Pat. No. 7,412,415, which claims priority to U.S. provisional patent application Ser. No. 60/334,163 entitled "Method and 10 System for Trading Pairs of Securities" that was filed on Nov. 29, 2001. The contents of both applications are herein incorporated by reference.
BACKGROUND 15
The following invention relates to a system and method for trading securities and, in particular, for a system and method of trading securities in pairs.
A recognized strategy for trading securities is known as 20 pair-trading. Pair-trading is a non-directional investment strategy in which the investor identifies two securities having similar characteristics and the securities are currently trading at a price relationship that is out of their historical trading range. The investor exploits the price relationship between 25 the securities by buying the undervalued security while shortselling the overvalued security. Because pair-trading is a market-neutral strategy, it is a particularly desirable strategy for investing in volatile markets.
One context in which pair trading is useful is where an 30 investor desires to take advantage of an arbitrage opportunity resulting from a merger between two companies. For example, Company A has announced a definitive agreement to acquire Company T in which case Company T shareholders will receive 0.5 shares of Company A stock for each share of 35 Company T stock they own. The investor desires to capture the "spread" between the offered consideration (0.5 shares of A) and the price of T stock. To do this, the investor buys shares in T stock and sells shares of A stock.
For instance, if stock T is trading at $28 per share and stock 40 A is trading at $60 per share, then the investor may execute a trade for 200,000 spreads by buying 200,000 shares of T stock and selling 100,000 shares of A stock. After the merger takes place, the investor will cover the short position in stock A with the 100,000 shares of A stock the investors receives in 45 exchange of the 200,000 shares the investor held of stock T. Thus, by executing the pair trade, the investor locks in a $400,000 profit (assuming that the merger goes through). The process of executing a pair trade thus includes executing individual trades directed to each leg of the pair trade request. 50 An example of a system for executing trades for filling a pair trade request is the Quantex system from ITG (http://www.itginc.com/products/quantex/quantex.html) of 380 Madison Avenue, New York, N.Y 10017.
A challenge in implementing a pair trade is to find a coun- 55 terparty for a particular position an investor desires to establish while minimizing "leg risk." Typically, a large pair trade is performed "off the market" as a private transaction negotiated by a financial institution that services large clients. For example, if an investor desires to execute a pair trade betting 60 that a proposed merger between two companies will go through, the investor would approach a financial institution seeking an investor that is willing to bet against the merger. The financial institution then acts as an intermediary between the two investors in which the investors establish equal and 65 opposite positions in the stock of the proposed merger partners thereby completing the pair trade. Thus by matching two
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pair trade requests so that the transactions associated with each of the pair trade legs are executed simultaneously, neither investor is exposed to leg risk that would otherwise result for the period of time between execution of the first leg and the second leg of the pair trade.
There are numerous drawbacks associated with the prevalent pair-trading practice. First, pair-trading is typically limited to clients of large financial institutions that have the ability to identify suitable counterparties for a particular pair trade. This is especially the case when the pair trade involves a large amount of stock or illiquid stocks in which the only way to execute the trade and minimize leg risk is via an "off the market" transaction negotiated by a financial institution. Also, because a pair-trade is typically negotiated by the parties with a financial institution as an intermediary, the process is often slow and inefficient. Furthermore, pair-trading under current practice is generally best suited for large clients seeking to establish large positions thereby providing the financial institutions with the economic incentive to execute the transaction. Smaller clients, however, must rely on the markets for executing pair trades, which is unsuitable for illiquid stocks and also results in increased leg risk.
Accordingly, it is desirable to provide a system and method for trading securities in pairs.
SUMMARY OF THE INVENTION
The present invention is directed to overcoming the drawbacks of the prior art pair trading practices. Under the present invention a method is provided for fulfilling a pair trade request and includes the steps of receiving a plurality of pair trade requests; executing a transaction for a first portion of one of the plurality of pair trade requests and matching a second portion of the one of the plurality of pair trade requests against another of the plurality of pair trade requests.
In an exemplary embodiment, the method includes the step of executing a transaction for a first portion of one of the plurality of pair trade requests in an external market.
In another exemplary embodiment, the method includes the step of executing a transaction for a first portion of one of the plurality of pair trade requests against the order inventory.
In yet another exemplary embodiment, the pair trade request includes a first security having a bid price and an ask price and a second security having a bid price and an ask price, and the method includes the steps of determining whether the bid price of the first security and the bid price of the second security meet a spread limit; determining an amount of the second security that can be sold based on a bid size associated with the second security; calculating an equivalent amount of the first security that can be bought based on the amount of the second security that can be sold; adjusting the equivalent amount of the first security based on adjustment criteria; calculating a purchase price for the adjusted equivalent amount of the first security based on the spread limit; executing an initiating order to buy the adjusted equivalent amount of the first security at the purchase price and executing a covering order to sell the amount of the second security.
In still yet another exemplary embodiment, the method includes the step of executing a covering order to sell the amount of the second security at the bid price of the second security.
In an exemplary embodiment, the method includes the steps of determining whether the ask price of the first security and the ask price of the second security and/or the bid price of the first security and the bid price of the second security meet a spread limit; determining an amount of the first security that
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can be bought based on an offer size associated with the first security; calculating an equivalent amount of the second security that can be sold based on the amount of the second security that can be bought; adjusting the equivalent amount of the second security based on adjustment criteria; calculat- 5 ing a selling price for the adjusted equivalent amount of the second security based on the spread limit; executing an initiating order to sell the adjusted equivalent amount of the second security at the selling price and executing a covering order to purchase the amount of the first security. 10
In another exemplary embodiment, the method includes the step of executing a covering order to purchase the amount of the first security at the ask price of the first security.
In yet another exemplary embodiment, the adjustment criteria include a minimum amount and a maximum amount. 15
In still yet another exemplary embodiment, the method includes the step of rounding the initiating order to a round lot size.
In an exemplary embodiment, the method includes the step of executing a first portion of one of the plurality of pair trade 20 requests in a plurality of tranches.
In another exemplary embodiment, the one of the plurality of pair trade requests and the another of the plurality of pair trade requests include a first security and a second security, the one of the plurality of pair trade requests has a first spread 25 limit and the another of said plurality of trade requests has a second spread limit and wherein the method includes the steps of determining that a range of the first spread limit and the second spread limit overlaps with a market spread; setting a spread level; calculating prices for the first security and the 30 second security that are within the market spread and based on the spread level and matching the second portion of the one of the plurality of pair trade requests against another of the plurality of pair trade requests based on the calculated prices.
In yet another exemplary embodiment, the method 35 includes the steps of calculating a mean between the first spread limit and the second spread limit and setting the spread level as the mean if the mean is within the market spread.
In still yet another exemplary embodiment, the method includes the step of identifying a spread amount that is closest 40 to the mean and within the market spread and setting the spread level as the spread amount if the mean is not within the market spread.
In an exemplary embodiment, the one of the plurality of pair trade requests and the another of the plurality of pair trade 45 requests include a first security and a second security, the one of the plurality of pair trade requests has a first spread limit, a buy ratio and a sell ratio, the another of the plurality of trade requests has a second spread limit, a buy ratio and a sell ratio and the method includes the steps of determining that the buy 50 ratio and the sell ratio associated with the one of the plurality of trade requests does not equal the buy ratio and the sell ratio of the another of the plurality of trade requests and that an overlap exists between range of the first spread limit and the second spread limit and a market spread; determining that 55 market prices exist that are within the overlap; determining a mismatch amount in the second security based on a difference between the buy ratio and the sell ratio associated with the one of the plurality of trade requests and the buy ratio and the sell ratio of the another of the plurality of trade requests; calcu- 60 lating a cross amount for the first security and the second security; selecting a crossing price for the first security and the second security that is within the overlap; determining that the mismatch amount is available at the crossing price for the second security; matching the second portion of the one of 65 the plurality of pair trade requests against another of the plurality of pair trade requests based on the calculated prices
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and executing a transaction for the mismatch amount of the second security at the crossing price for the second security.
In another exemplary embodiment, the method includes the step of determining that the mismatch amount is available in an external market at the crossing price for the second security.
In yet another exemplary embodiment, the method is performed by a financial institution having order inventory and includes the step of determining that the mismatch amount is available in the order inventory at the crossing price for the second security.
In still yet another exemplary embodiment, the one of the plurality of pair trade requests and the another of the plurality of pair trade requests indicate a number of spreads and the method includes the step of matching a second portion of the one of the plurality of pair trade requests against another of the plurality of pair trade requests if the number of spreads is greater than a minimum number of spreads.
In an exemplary embodiment, the method includes the step of receiving a preference for filling at least some of the plurality of trade requests via the step of executing a transaction for a first portion of one of the plurality of pair trade requests, described above.
In another exemplary embodiment, the method includes the step of receiving a preference for filling at least some of the plurality of trade requests via the step of matching a second portion of the one of the plurality of pair trade requests against another of the plurality of pair trade requests, described above.
Under the present invention, a method for fulfilling a pair trade request is provided and includes the steps of receiving a plurality of pair trade requests and matching at least a portion of one of the plurality of pair trade requests against another of the plurality of pair trade requests.
Under the present invention, a system for fulfilling a pair trade request is provided, the system receiving a plurality of pair trade requests and includes a pair trading engine for executing a transaction for a first portion of one of the plurality of pair trade requests. The system also includes a pair crossing network for matching a second portion of said one of the plurality of pair trade requests against another of the plurality of pair trade requests.
In an exemplary embodiment, the system includes a link to external markets and wherein the pair trading engine executes the transaction for the first portion of one of the plurality of pair trade requests in the external markets.
In another exemplary embodiment, the system includes a financial institution having an order inventory and wherein the pair trading engine executes the transaction for the first portion of one of the plurality of pair trade requests against the order inventory.
In yet another exemplary embodiment, the pair trade request includes a first security having a bid price and an ask price and a second security having a bid price and an ask price, and wherein the pair trading engine determines whether the bid price of the first security and the bid price of the second security meet a spread limit; determines an amount of the second security that can be sold based on a bid size associated with the second security; calculates an equivalent amount of the first security that can be bought based on the amount of the second security that can be sold; adjusts the equivalent amount of the first security based on adjustment criteria; calculates a purchase price for the adjusted equivalent amount of the first security based on the spread limit; executes an initiating order to buy said adjusted equivalent amount of the first security at the purchase price and executes a covering order to sell the amount of the second security.
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