Trading Mechanics & Microstructure

Definition

Auctions are periodic trading sessions used at the start and end of the trading day—and sometimes during volatility halts—to determine a single clearing price for a stock where the maximum volume can be matched.

Types

• Opening Auction (Opening Cross): Sets the day’s first official trading price.
• Closing Auction: Determines the official closing price, which is critical for index funds, ETFs, and NAV calculations.

Example

Before the market opens, orders for Stock ABC are collected. The auction mechanism finds the equilibrium price (e.g., $100.50) that allows the maximum number of shares to trade, and all matching orders execute simultaneously at that single price.

Definition

After the opening auction, markets enter a continuous trading phase where orders are matched in real-time by an electronic matching engine based on price-time priority (highest bid, lowest ask).

Mechanism

A central limit order book (LOB) is continuously updated. Trades occur instantly when a buy order's price is greater than or equal to a sell order's price.

Example

The order book shows a bid for 1,000 shares at $50.10 and an ask for 500 shares at $50.12. A market order to buy 500 shares would execute immediately against the ask at $50.12.

Definition

The order book is the real-time list of all outstanding buy and sell orders for a security at various price levels.

• Level 1: Shows only the best bid and best ask (the "top of the book").
• Level 2: Shows the full depth of the order book, with multiple price levels and the size of orders at each level.
• Level 3: Includes trader-specific data, typically only available to market makers.

Example (Order Book Snapshot)

Definitions

• Bid: The highest price a buyer is willing to pay.
• Ask: The lowest price a seller is willing to accept.
• Spread: The difference between the ask and the bid, indicating liquidity and trading cost.

Market Impact

When a large order consumes all the liquidity at the best price level and moves on to worse prices, it moves the market against the trader.

Example

A liquid stock might have a tight spread of $100.00 / $100.01. An illiquid stock might have a wide spread of $100.00 / $100.20, indicating a higher cost to trade.

Definitions

• Slippage: The difference between the expected execution price of a trade and the actual price at which it was executed.
• Implementation Shortfall: The total performance difference between an ideal "paper" portfolio and the real-world execution after all costs, slippage, and market impact are accounted for.

Example

You intend to buy 10,000 shares when the price is $100. By the time your order is filled, the average price is $100.20. Your slippage is $0.20 per share, or $2,000 in total.

Definition

HFT involves ultra-fast algorithmic trading strategies that operate in microseconds to exploit tiny price inefficiencies and market structure dynamics, often using co-located servers placed physically near exchange matching engines.

Example (Arbitrage)

An HFT algorithm sees Apple stock trading at $150.00 on Nasdaq and $150.02 on the BATS exchange. It instantly buys on Nasdaq and sells on BATS, profiting $0.02 per share with minimal risk.

Interview Tip: HFT is credited with adding liquidity to markets but is controversial for potential advantages like front-running and latency arbitrage.

Definitions

• Dark Pools: Private trading venues with no pre-trade transparency, allowing institutions to execute large orders anonymously without causing significant market impact.
• Lit Markets: Public exchanges with full order book visibility.
• Hidden Liquidity: Liquidity that is available for matching but not visible to the public, such as the hidden portion of an iceberg order or orders resting in dark pools.

Definition

These are exchange mechanisms designed to pause trading during periods of extreme volatility to prevent panic selling and ensure orderly markets.

• Circuit Breakers: Triggered by significant percentage drops in major indices (e.g., S&P 500), leading to market-wide trading halts.
• Limit Up/Down (LULD): Prevents individual stocks from trading outside a specified price band based on their recent average price.

Definition

Short selling is the practice of selling borrowed shares in the hope that the price will decline, allowing the seller to buy them back at a lower price to return to the lender.

Mechanism

1. Borrow shares from a lender (via a prime broker).
2. Sell the borrowed shares on the open market.
3. Later, repurchase the same number of shares ("cover" the short).
4. Return the shares to the lender. The profit is the difference between the initial sale price and the repurchase price.

Example

You short 100 shares of XYZ at $100 per share. The price drops to $80, and you buy back 100 shares to cover your position. Your gross profit is ($100 - $80) × 100 = $2,000.

Definition

Margin trading involves borrowing money from a broker to purchase securities, which amplifies both potential gains and losses.

Mechanism

An investor deposits an initial margin (e.g., 50% of the purchase price). The broker lends the remaining amount. If the portfolio value drops below a certain level (the maintenance margin), the broker issues a "margin call," requiring the investor to deposit more funds or sell securities.

Example

You buy $100,000 worth of stock using $50,000 of your own cash and $50,000 borrowed on margin. If the stock rises 20% to $120,000, your equity becomes $70,000 ($120k - $50k loan), a 40% return on your initial cash. If it falls 20%, your equity becomes $30,000, a 40% loss.

Summary Table

Final Interview Tips

Expect questions like: “Walk me through how a short sale works.”, “What’s slippage and how do you minimize it?”, “Why do dark pools exist and what are their pros/cons?”, and “How does margin trading amplify returns—and risks?”