R30 execution of portfolio decisions

The Context of Trading: Market MicrostructureEmphasize immediacy Some degree of price uncertainty... Effective Spread = 2 x deviation of the actual execution price from the midpoint of t

Reading 30

Execution of Portfolio Decisions

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1 Introduction

2 The Context of Trading: Market Microstructure

3 The Costs of Trading

4 Types of Traders and their Preferred Order Types

5 Trade Execution Decisions and Tactics

6 Serving the Client’s Interests

1 Introduction

2 The Context of Trading: Market Microstructure

Emphasize immediacy

Some degree of price uncertainty

Emphasize price

Bid-Ask Spread

Dealer vs Trader

Inside Bid Or Market Bid

Inside Ask or Market Ask

Market Bid-Ask Spread

Effective Spread = 2 x deviation of the actual execution price from the midpoint of the

market quote at the time an order is entered

Effective spread is a better representation of actual transaction cost because it captures both:

1 Price Movement: execution within quoted spread

Bid-Ask Spread Versus Effective Spread as a Measure of Trading Cost

Bid-Ask Spread = 0.06 Midquote = 20.00

Effective Spread:

2 x (20.01 – 20.00)

= 0.02

Average effective spread is the

mean effective spread over alltransactions in the stock in the

1 For each of these market orders, compute the quoted spread Also, compute the average quoted spread for the stock for the day.

2 For each order, compute the effective spread Also, compute the average effective spread and the share-volume-weighted effective spread for the stock for the day.

3 Discuss the relative magnitudes of quoted and effective spreads for each of the three orders.

2

3

Factors like price and time determine which

orders are executed

Crossing networks provide no price discovery

Partial fill

Block order is an order to sell or buy in a quantity that is large relative to the liquidity

ordinarily available from dealers

Broker is an agent of the investor (trader) Receives a commission and provides various

execution services, such as:

1 Representing the order

2 Finding the opposite side of the trade

3 Supplying market information

4 Providing discretion and secrecy

5 Providing other supporting investment services

6 Supporting the market mechanism

Dealer is a counterparty to the investor (trader) There is an inherent conflict of interest.

Dealer faces adverse selection risk: the risk of trading with a more informed trader

Liquid markets have the following characteristics:

1) Low bid-ask spread

2) Market is deep

3) Market is resilient (efficient)

Advantages of high liquidity:

1 Traders can trade rapidly without impacting price

2 Lower cost of capital for corporations

Factors contributing to market liquidity:

1 Many buyers and sellers

2 Diversity of opinion, information and investment

needs among market participants

3 Convenience

4 Market integrity

Participants can easily, quickly andinexpensively obtain information about

quotes and trades (pre-trade transparency)

and details on completed trades are quicklyreported to the public (post-trade

transparency).

Low transparency compromises marketintegrity

Buyers and sellers confident that trade will

be completed Brokers or clearing entitiesmight provide guarantees

Assurity of Completion

3 The Cost of Trading

• Trading costs represent negative performance

• Understand trading costs

• Transaction cost components

 Bid-ask spread

 Market impact

 Missed trade opportunity costs

 Delay costs

Traders measure implicit costs (i.e., costs excluding commissions) with reference to a

benchmark

Time-of-trade midquote

Volume weighted average price (VWAP): weighted average price at which the security

traded during the day

Less informative for relatively large trades

Can be gamed

Implementation shortfall is possibly the best cost measurement approach

Calculation of implementation shortfall: paper portfolio return – actual return

Say market has gone up by 1% over trading period and stock beta = 1  predicted return on share =1%

Read Example 6 and Example 7

Many people focus on commission costs because these are

observable

We should recognize that major parts of transaction costs are unobservable

Estimated cost function can be used in two ways:

Example 8: An Econometric Model for Transaction Costs

4 Types of Traders and Their Preferred Order Types

Preferred Order Type

MarketLimitMarket, other order typesalso used

5 Trade Execution Decisions and Tactics

Decisions Related to Handling of a Trade

Objectives in Trading and Trading Tactics

Automated Trading

Decisions Related to Handling of a Trade

• Small, liquidity-oriented trades can be packaged up and executed via direct

market access (DMA) and algorithmic trading

 DMAs are broker-sponsored platforms which allow buy-side traders to directly access

securities

• Large, information laden trades demand immediate skilled attention

• Traders should be aware of client trading restrictions, cash balances and

brokerage allocations

Objectives in Trading and Trading Tactics

Automated (Algorithmic) Trading

• Algorithmic trading refers to automated electronic trading subject to

quantitative rules and user-specified benchmarks and constraints

• Exploit market patterns of trading volume so as to execute orders with

controlled risk and costs

• Example 9 and Example 10: Break large order into small pieces

• Several types of algorithmic trading

 Simple logical participation strategies

Algorithmic Trading Classification

• Simple logical participation strategies

 Volume-weighted average price (VWAP) strategy:

match or improve upon VWAP for the day Typically

the trader attempts to match the expected volume

pattern over the day

 Time-weighted average price (TWAP) strategy is a

simple variant of the VWAP strategy that assumes a

flat volume profile

• Implementation shortfall strategies

 Minimize trading costs as measured by

implementation shortfall method

 Concerned about opportunity cost related to

adverse price movement  transactions are

front-loaded

Summary output from a trader’s order management system or trade blotter

What tactics are appropriate for each order?

6 Serving the Client’s Interests

• CFA Institute’s Trade Management Guidelines offer investment managers

“a framework from which to make consistently good trade execution

suggestions…”

 Best execution: the trading process investment management firms apply that seeks

to maximize the value of the client’s portfolio

 Trade Management Guidelines are divided into three areas: processes, disclosures

and record keeping

• Ethical focus for portfolio manager and buy-side trader must be the

interests of the client

 Buy-side trader acts in a fiduciary capacity, with access to the client’s assets

 Code of both buy-side and sell-side traders is that verbal agreements will be

• Market Microstructure

 Order Types

 Market Types and Market Quality

• The Costs of Trading

 Cost components

 Cost benchmarks: VWAP, Implementation Shortfall (Exhibit 6)

• Types of Traders and their Preferred Order Types

• Trade Execution Decisions and Tactics

 Exhibit 9

 Algorithmic Trading