We hear traders talking about icebergs a lot, but what do these orders do and how do they work?
What are Iceberg Orders?
An iceberg order is a type of trading strategy that involves breaking down large trades into smaller, more manageable chunks.
This approach allows investors to conceal the true size of their trade from the market, thereby minimizing its impact on prices. The term "iceberg" refers to the fact that only a small portion of the order is visible above the surface, while the majority remains hidden beneath the surface.
Iceberg orders are often used by institutional traders, such as hedge funds and pension funds, who seek to execute large trades without triggering market-moving events that work against the best execution for that order.
By breaking down their orders into smaller pieces, these investors can avoid sudden price movements that might occur if a large trade were executed all at once.
How Do Iceberg Orders Work?
Here's an example of how an iceberg order might work:
Suppose an investor wants to buy 100,000 shares of XYZ Inc. stock, but they don't want to reveal their true intentions to the market. Instead, they place an iceberg order with a broker that breaks down the trade into five chunks of 20,000 shares each.
The first chunk is executed immediately, and the trade is reported to the exchange as usual. However, only 20,000 shares are visible in the order book, giving the impression that there is relatively low demand for XYZ Inc. stock.
As the market continues to move, the second chunk of 20,000 shares becomes available, and it too is executed at a slightly higher price. Again, only 20,000 shares are reported to the exchange, maintaining the illusion that the order is smaller than it actually is.
This process continues until all five chunks have been executed, with each chunk being reported to the exchange as a separate trade. The investor has successfully hidden the true size of their trade from the market, avoiding any potential market-moving consequences.
The Impact on Market Price Discovery
So how do iceberg orders influence market price discovery? The answer lies in the way they affect the flow of trades and the subsequent pricing of securities.
When an investor places an iceberg order, it creates a series of small trades that are executed over time. Each trade is reported to the exchange as usual, but only a portion of the total trade size is visible at any given moment.
As these small trades accumulate, they can create the impression of increased demand or supply for a particular security. This, in turn, can influence market prices and shape price discovery, but to a much lesser extent than it would if the entire order was transmitted all at once.
Very large iceberg orders, particularly within equity futures, are worth watching as they can influence the three-way auction process. For example a very large iceberg sale (3,000) on ES into an exhaustive buyer stop out may lead to a price reversal, as you see larger institutional traders absorbing buyers aggressively as the smaller momentum traders that are more price sensitive are forced out of bets against price.
The Role of Passive Flows
While iceberg orders are often associated with institutional traders, investors can also play a role in influencing market price discovery through their indirect trading activities.
For example, a large pension fund may use an index fund to track a particular stock market index. As the fund grows or shrinks, it may need to buy or sell securities to maintain its target allocation. These trades can occur over time and be executed using iceberg orders, which can influence market prices and shape price discovery.
Similarly, individual investors who use automated trading strategies or robo-advisors may also employ iceberg orders as part of their investment approach. As these investors trade in large numbers, their collective activities can impact market prices and influence the flow of trades.
Closing Thoughts
Iceberg orders are a powerful tool that allows traders to execute large trades while minimizing their direct and near-term impact on market prices. By breaking down their orders into smaller chunks and reporting each chunk as a separate trade, investors can conceal the true size of their trade and avoid sudden price movements.
By recognizing the potential impact of these trades, traders seeing them take place can make more informed decisions and better navigate the complex world of financial markets.
Ultimately, iceberg orders are just one example of the many tools and strategies that traders use to shape market price discovery. As the landscape of trading continues to evolve, it is crucial for traders to stay up-to-date with the latest developments and adapt their approaches accordingly.