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Trading strategy & execution (Motivations to trade (Profit seeking …
Trading strategy & execution
Motivations to trade
Profit seeking
active managers
trading based on info not fully reflected in prices (secret and dark)
short term -> trade urgency is high, execute prices near market, alpha decay is high, only possible for liquid
Risk management/hedging needs
use derivatives or just trades underlying
liquid derivatives more cost efficient
Cash flow needs
can be high or low urgency
client redemption -> low
NAV based on closing prices this reduces redemption price risk
Corporate actions/index reconstitution/margin calls
cash dividends need to reinvested
margin or collateral have high urgency
index tracking portfolio trades to min tracking error
Trade strategy inputs
affects trade urgency, expected costs and risk of the trade
trade too fast -> increase market impact
trade too slow -> increase execution risk/market risk
Order characteristics
Side of the order
buying in rising market or selling in falling market -> market risk exposure which will take longer to execute or cost more
Size of the order
larger orders take longer to trade
low urgency to reduce market impact
Security characteristics
Type - liquidity and trading costs will vary by exchange
short term alpha - expected movement
Price volatility - affects execution risk
Security liquidity = greater liquidity -> lower execution risk and trading costs
Market conditions
market events increases vol and liquidity decreases
low liquid -> longer trading horizon
Investor risk aversion
high level aversion trades with more urgency -> higher costs and market impact
Reference prices
Pre-trade benchmark
known before the start of trading
Decision price = price at time PM made to decision
Previous close
Opening price
Arrival price = price at the time the order is ENTERED into market
Intraday benchmarks
VWAP
trades executed over the day/horizon
TWAP
average price of trades executed over the trading day/horizon
Post trade benchmark
funds valued at NAV
Price target benchmark
Execution
High touch approach
involves human interaction
large trade trades -> Urgent
large block -> non-urgent or illiquid that arranged with broker to attempt a cross
liquid, standardized securities with order-driven markets
quote-driven, OTC or office exchange markets
Algo trading
slices orders into smaller pieces and trade across venues and over time to reduce impact
execution and profit seeking
Scheduled/WAP/TWAP
follows volume to trade.
used when PM has no expectations of momentum, greater risk tolerance for a longer execution
smaller order size
liquid orders
Liquidity seeking
trade faster when liquidity shows in different venues
Used for high trade urgency but avoid market impact
less liquid, thin traded
Arrival price
trade aggressively at beginning of order,
Used when PM wants reduce execution risk and risk adverse
liquid
Dark strategies
to avoid info leakage
large order, illiquid, and low urgency
smart order routers
small order, determine destination with highest probability to execute
Trade cost measurement
Implementation shortfall
measures total costs associated with implementing the investment decision
IS = paper return - actual return
Execution cost
Opportunity costs (unexecuted shares)
Could have use missed shares into something else
Fixed fees/explicit fees
Expanded IS
Execution cost is expanded into:
delay cost (which can be address to reduce)
and trading cost
Evaluate trade execution
Market adjusted cost = arrival cost - B*(index cost)
Added value = arrival cost - estimate pre-trade costs
Arrival cost = buy/sell side x (avg ex price - ref price/ref price) x 10,000