What Are Iceberg Orders & How Do Large Institutional Investors Conduct Them?

2022-07-01, 06:06

[TL; DR]

There are two significant forces in any market: demand and supply. These market forces apply to the capital market too. The prices of stocks tend to either surge or decline as a direct reaction to the level of demand and supply present in the market.

Large institutional investors whose one-time purchase can demonstrate significant market change by the numbers try to avoid a distortion of the actual demand and supply forces in the stock market by "hiding" what they buy and sell in smaller unit orders. This strategy is relatively popular and is termed "iceberg orders".

This article seeks to demystify iceberg orders and how large institutional investors execute them.

Keywords: Iceberg order, limit order, Institutional investor, market order, invest.

Iceberg Orders

An Iceberg order, sometimes known as a reserve order, refers to a large, single order broken down into smaller orders to be carried out over a set period. This breakdown is usually automated by a program built for this purpose.

The word "Iceberg" stemmed from the fact that each smaller lot is the "tip of the iceberg" with regards to the overall large number of orders that are to be placed. Iceberg orders hid the original quantity that was or will be ordered.

These orders are mainly employed by large institutional investors looking to buy and sell a significant amount of securities without distorting the market. They mask the size of the order and reduce the movement of prices in the market, which could result from a significant change in a stock's demand and supply.

Institutional Investors

An institutional investor can either be a firm or an organization seeking to invest money on behalf of several other individuals. Examples abound in our modern globe, such as insurance companies, mutual funds, pensions, etc.

These companies tend to buy massive chunks of security portfolios like stocks, bonds, or otherwise- which earned them the nickname. The large size of their purchases earned them the name "the whales of Wall Street".

Generally speaking, there are six (6) types of institutional investors. They include:

Endowment funds;
Mutual funds;
Hedge funds;
Commercial banks;
Pension funds; and
Insurance companies.

These sophisticated investors are subjected to fewer restrictive laws than the average investor because it is generally assumed that an institutional firm encompasses more knowledge to protect itself against market forces.

Market Orders And Limit Orders

Iceberg orders are carried out using limit orders. These are pretty different from the regular market orders.

Limit orders

Limit orders are orders where a maximum acceptable price for sale or purchase of the security is set before the purchase order. Here, the minimum acceptable prices are always indicated on the sales orders.

Limit orders allow investors to gain control over the buying and selling of their trades. With limit orders:

There is an assurance that the specified price will not deviate too far away from the market entry or exit point of the trade. In essence, if a particular security value is outside the limits of the order, the transaction does not occur.
In cases of low-volume stocks that are not listed on major exchanges, limit orders are a viable option, as difficulties may arise when attempting to figure the actual price of the security.

However, limit orders have their downsides. For instance:

In cases where the actual market price never declines to the order guidelines, such a transaction may never be executed.
It is also possible to meet the desired target price, but as at the time the price is desirable, liquidity may have declined, which results in having a partially filled order or even an empty order.

Market Orders

Market orders, on the other hand, emphasize the speed at which the trade is completed over the price of the security traded. They are the more conventional orders: a broker collects a trade order for security and then processes such security at the current market price.

It is noteworthy that even though it is more likely for a market order to be executed, this does not mean that all market orders go through.

All market order transactions are determined upon the availability of the preferred stocks. Due to the execution timing, liquidity, and other factors that affect stocks, market orders can vary significantly.
Market fluctuations usually threaten the price of orders, mainly when orders occur between the time the broker receives the order and the actual time the order is executed. This effect of market fluctuations usually affects large orders, which are time-consuming. For instance, a market order placed after the trading hours will be filled in at the opening market price of the next trading day.

Market orders can shift the position of the market.

Why Do Large Institutional Investors Execute Iceberg Orders?

There are a plethora of reasons for iceberg orders:

One valid reason is the avoidance of panic buying in the market. Buying such a vast amount of securities in disguisable, smaller amounts masks the selling pressure such an order may cause.
Iceberg orders also reduce the impact cost of execution. Impact cost is the difference between the actual price at which the security was traded in comparison to the price of the security when the order was placed.
Additionally, institutional investors may aim to buy such shares at the lowest possible prices. Therefore, they would avoid buying large orders that would signal other traders to skyrocket the prices of stocks.

Research has even indicated that individual traders also place orders that resemble iceberg orders to minimize the effect of such an order in the overall market and further increase liquidity in the market.

An Example Of Iceberg Orders

After assessing a company and its stock in the capital market, a mutual fund intends to buy about 300,000 shares of this particular company's stock.

Daily, the average trading volume on the company's stock is 50,000 shares. This is the total amount of this company's shares bought and sold daily.

Taking a critical look at this scenario, this institutional investor (the mutual fund) wants to buy six times the total volume of the company's shares sold and bought daily. For emphasis, the amount the mutual fund seeks to buy is more than the sum of shares bought and shares sold daily.

The mutual fund can decide to put in a single order, purchasing all 300,000 shares at once. But, this will send the market into a frenzy:

Other traders will notice the order in the stock market and assume the mutual fund is aware of insider information that will cause an increase in the company's stock price in the market.
Due to the price increase, in subsequent orders, the price per share would be significantly higher, and the institutional investor will have to buy smaller units at larger prices.

To avoid this, the mutual fund manager could decide to fill the order of 300,000 shares in installments of 6,000.

Once a limit order of 6,000 shares is completed, the next limit order to buy 6,000 shares is triggered. This cycle will continue for 48 more times, spreading over many trading days, weeks, and months until the desired number of shares is bought.

Identifying Iceberg Orders

For individual traders, it is possible to identify an iceberg order that stems from a single market maker. This limit continues to recur during trades. For instance, in cases where an institutional investor wants to buy 1,000,000 shares in ten orders of 100,000 shares each, the traders have to observe the pattern and trend of such shares to discover that such orders are being filled.

For those who want to capitalize on such trends, they begin to buy shares that are just higher than the average level, with an understanding that the iceberg orders based on limit orders create strong support for such trades. Identifying iceberg orders creates an opportunity for the trader to scalp profits.

Conclusion

Iceberg orders provide a structured, seamless route of a transaction, where substantial changes in the market are avoided, and the forces of demand and supply are not distorted. It is a method large institutional investors use to avoid triggering panic buying in the market, as it would ultimately not favor their work with clients' funds in the long run. It is carried out by limit orders and preserves the market conditions that sustain limit orders.