Hi all, I came across this trade a while ago and was a little bit confused by the arrangement.So on one of the index rebalancing day, the trading desk did a trade with a client on stock A where the desk is guaranting to buy from the client at say, 2bps outperformance of the closing price on that day. Stock A is being taken out of the index that day so obviously you would expect the price to drop. Its share price did drop slightly to close at $Y, and the trading desk cross-traded a block amount of shares with the client at the closing price of $Y, but in effect paid the client $(Y*1.0002) to ensure the 2bps outperformance. Now I am just wondering, is this sort of arrangement common practice? By guarating the outperformance the desk is bound to lose mone y on this trade (alone). Maybe there are some other information I am not aware of, could anyone shed any lights?Thanks!Fish

Why is the desk bound to lose money on the trade? In this kind of arrangement, the desk will not wait until the close to sell the shares. It will try to sell as many shares as possible at price levels above the closing price, throughout the day. In the situation you described, if the stock is expected to drop, probably they will try to sell a large chunk of the order in the morning to get the better prices. They may or may not achieve an average price > $(Y*1.0002) by the end of the day. If they do, they have made money.I believe deals based on the VWAP are more common than deals based on the closing price.

Yes that made sense and would be a very likely scenario. But what if we know for a fact that the desk did not sell that much earlier during the day, what other explanation could there be ?

QuoteOriginally posted by: fishfilletYes that made sense and would be a very likely scenario. But what if we know for a fact that the desk did not sell that much earlier during the day, what other explanation could there be ?There is another approach that the desk can take, but it pretty much means screwing the customer. Keeping good relationships with mutual/pension funds is important for brokerage houses, so probably they won't do this in this setting. However, they do what I'm about to explain for situations where they have a position in a derivative instrument that is based on the closing price of a stock:If the order size is really really large with respect to the stock's current liquidity, the desk can wait the whole day, and a just a few minutes before closing time, can start dumping the whole load onto the market. The stock with collapse, and the closing price will be very near the low of the day. The desk's average selling price will be necessarily higher than the closing price, and the desk will make easy money. However, the customer will not be pleased, and won't do business with them again after such behaviour. This is also why it is dangerous to make deals based on the closing price. This approach IS used frequently when the desk has a derivatives position and enough capital to move the cash market temporarily...