Trading strategy: Iceberg orders

False face must hide what the false heart doth know

(Macbeth Act I Scene VII)

Sometimes a client may wish to write off a certain stock off his books, which he had heavily invested in. Such a client may call up his broker and ask to sell say 1M shares of IBM. Now, the most primitive approach the broker could have used is to just place one large sell order with a quantity of 1M (market or limit based on client preferences). However, the disadvantage of doing this is that, if some trader X is actively trading IBM and he suddenly sees this huge order, he may have a doubt that someones got some insider information on IBM stock falling down and is trying to write it off. So he too may follow suit and this may in turn trigger a chain of such transactions. The law of demand-supply commands that IBM stock price will fall in this scenario. This eccentric price shift was not backed by any fundamentals but instead just by the whim of a few traders thinking that IBM is going to fall. So in all this, our poor client who wished to write off IBM is left to face the brunt of selling at a low price. To avoid such situations, his broker may chose to just show a small part of the total order onto the market (before its execution) and hide the rest. Such an order is like an iceberg, tip above the water surface, rest is deep down the water. Thus its called as an "Iceberg order". The broker will slice and dice the original order and time it using some algorithm like VWAP, TWAP etc. Slicing is done to disintegrate the original order while timing is done to make sure it gets the best execution price. The client may specify some slicing parameters like -

• Total size of the order
• Maximum size to be displayed at any given point (know as "Disclosed quantity")
• Actual "Displayed quantity" (this is NOT specified by client but instead calculated based upon the executions received on the "Disclosed quantity".

Note that some exchanges support Iceberg orders by themselves while some dont. For the latter types, the brokers (Investment banks) use sophisticated proprietary algorithms and infrastructure to simulate this.

Operational semantics:
Consider this hypothetical case:

• Iceberg order - total-qty=300 , Disclosed-qty=50
• Two other pure limit orders O1, O2 - qty=50, price=100
• One pure limit order O3 - qty=50, price=99.5

Lets say the broker determines that he should break up the Iceberg into 2 "visible" slices of 50 each(V1, V2) and 4 "invisible" slices of 50 each.  (I1,  I2, I3, I4)
Initially, the broker sends first visible slice. This gets queued up on the exchange as per the price/time priority rules. This order is seen to outside world. This new order will then enter below the already existing pure limit orders queued up on the exchange. A new visible order is sent only when the previous one is completely executed.No invisible slice is sent till ALL visible slices get completely executed. Once all visible slices are executed, invisible slices assume positions below the already existing pure limit order of same qty. So in our case, at three discrete time intervals t1 < t2 < t3, we might have a possible scenario as -
                                    t1: V1, O1, O2
                                    t2: O1, O2, V2, O3
                                    t3: O3, I1, I2, I3, I4
(above listing is in decreasing priority from left to right)
Obviously, the client would wish his total order to get executed ASAP. The repeated lessening of priority on each new slice of the iceberg order, may act as an impediment to this. So brokers often try to somehow ensure that new slices do not enter at low priority, by techniques like revising the "Disclosed quantity" and thus amending a previously partially filled visible slice with an increased quantity or something like that. This ensures minimum delay between different slices of the same iceberg order. Note that brokers may also route these slices to different exchanges in order to bring more randomness to the identity of the original iceberg order, to avoid getting tracked down by sniffers.

To summarize..
Icebergs offer - 

1. Ability to reduce market impact on the prices of the stock.
2. Control the liquidity in the market.
3. Convenience to the original client, by not having him to manually slice-and-dice, but instead having a formalised notion of an iceberg order.