Following are the two major types of orders that traders use: Market Order A market order is an instruction to execute an order promptly in the public market at the best price available.
Trang 1Reading 31 Execution of Portfolio Decisions
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The portfolio manager needs to be familiar with market
microstructure: the market structures and processes that
affect how trades are executed (represented by trade
prices and volumes)
Following are the two major types of orders that traders
use:
Market Order
A market order is an instruction to execute an order
promptly in the public market at the best price
available A market order:
(uncertainty about the price at which the order will
be executed)
NOTE:
In today’s market, most market orders are effectively
automated
Limit Order
A limit order is an instruction to trade at a price that is at
least as good as the limit price specified in the order For
buy orders, the trade price must not exceed the limit
price, and for sell orders, the trade price must be at least
as high as the limit price A limit order:
NOTE:
The order also specifies an expiry date
A few additional order types that represent variations on
the market and limit orders are as follows:
Market-not-held order
the agent greater discretion than a simple market
order ‘Not held’ means the broker is not required
to trade at any specific price or in any specific
time interval, as would be required with a simple
market order
Participate (do not initiate) order
broker waits for and responds to initiatives of more
active traders, in the hope of capturing a better
price
Best efforts order
more discretion to work the order
Undisclosed limit order/reserve/hidden/iceberg order
• This is a limit order that includes an instruction not
to show more than some maximum quantity of the unfilled order
Market on open order
opening of the market Similarly a market on close order is a market order to be executed at market close
Types of Trades Principal trades
A principal trade is a trade with a broker in which the broker commits capital to facilitate the prompt execution of the trader’s order Such trades are used most when the order:
• Is larger and/or
the normal flow of trading
Portfolio trades
A portfolio trade involves an order to trade in a specific basket (list) of securities Portfolio trades are:
by multiple security issues) reduces the risk to the other side of the trade
2.2.1) Quote-Driven (Dealer) Markets Quote-driven markets are markets in which trades are executed with a dealer—a business entity that is ready
to take the other side of an order to buy or sell an asset
at established firm prices
will buy a security, and the ask price is the price at which he/she will sell a security The quantities associated with the bid and ask price are known
as the bid size and ask size respectively
Trang 2bid The inside ask or market ask is the lowest or
best ask The market bid and ask prices make up
the inside quote or market quote and the
difference between them is the inside or market
bid-ask spread (inside ask less inside bid) The
midquote is halfway between the market bid and
ask prices
limit order book is not visible to the public, and
traders rely on brokers to locate the best price
• In a ‘pure’ dealer market, a dealer is a
counterparty to every trade and public traders’
limit orders do not compete with dealers’ bids and
asks
Dealers’ Role
Dealers can help in the following ways:
being ready to the opposite side of the trade
(especially in markets that lack natural liquidity)
liquidity, the price of which is the bid-ask spread
(they sometimes also take an active role in price
setting to turn over inventory)
negotiation of the terms of the instrument, such as
forward and swap markets
Trade Costs
The following are measures of trade costs:
proportion of the quote midpoint
trader actually transacts Sometimes a dealer steps
in front of an order to improve on the prior best ask
or bid price to take an incoming market order The
price improvement will result in an effective spread
that is lower than the quoted spread
o The effective spread is a better representation of
the true cost of a transaction because it
captures both price improvement and market
impact
NOTE:
effective spread of over all transactions in the
stock in the period under study
• Spreads are wider for riskier and less liquid
securities
2.2.2) Order-Driven Markets Order driven markets are markets in which trades take place between public investors, usually without intermediation by designated dealers Public limit orders establish transaction prices In order-driven markets:
at all because a dealer is not present (execution uncertainty)
because a pre-specified set of rules governs the execution of orders
Examples:
Toronto Stock Exchange for equities, International Securities Exchange for options, and Hotspot FX for foreign exchange
Types of Order-Driven Markets
1 Electronic Crossing Networks These are markets in which buy and sell orders are batched and crossed at a specific point in time
Crossing networks mainly serve institutional investors Some benefits are as follows:
services
on execution prices (market impact)
Some drawbacks are as follows:
trades will find an opposing match (execution uncertainty)
adjustment of prices to equilibrate supply and demand)
2 Auction Markets These are markets in which the orders of multiple buyers compete for execution Auction markets can further be categorized into:
occurs at a single price at a pre-specified point in time) An example is the reopening of the Tokyo Stock Exchange after the lunch break
executed at any time during the day)
In contrast to electronic crossing networks, auction markets:
Practice: Example 1
Volume 6, Reading 31
Trang 3• Lessen the problem of partial fills
3 Automated Auctions (Electronic Limit-Order
Markets)
These are computer-based auctions that operate
continuously within the day using a specified set of rules
to execute orders Electronic communications networks
(ECNs), such as Paris Bourse in France, are an example
of automated auctions for equities
In contrast to crossing networks, ECNs:
Like crossing networks, ECNs:
2.2.3) Brokered Markets Brokered markets are markets in which transactions take
place through brokers, away from public markets The
brokers collect commission for representation of the
trade These markets are important:
• Where it is difficult to find liquidity
• For block transactions (a block order is large
relative to the liquidity ordinarily available from
dealers or other markets), in which a broker might
occasionally position a portion of the block (act as
a principal with capital at risk)
NOTE:
Many parties can and do perform parts of dealer
functions Hence market classifications are
simplifications
2.2.4) Hybrid Markets Hybrid markets are combinations of the previously
described market types An example is the NYSE, which
offers elements of batch auction market, continuous
auction markets and quote-driven markets
Brokers
A broker is an agent of the investor In return for a
commission, the broker provides services including the
following:
• Representing the order: The broker’s primary task is
to represent the order to the market
• Finding the opposite side of a trade: The broker
locates the buyer or seller for the trade and may, in
return for compensation, act as a dealer by buying
and selling shares for his own account
provided by the broker can be valuable, including information about the identity of traders and the strength of trading interest
preserving the anonymity of the traders’ trading intentions Such secrecy does not extend to the selected broker
broker may provide a range of other services including providing financing, record keeping, cash management, and safekeeping of securities (such services and more are provided in relationships known as prime brokerage)
commissions indirectly assure the continuance of the needed market facilities
Dealers The relationship between the trader and a dealer is adversarial
the trader gains from narrower bid-ask spreads
how informed traders are, and how urgent their interest in transacting with the dealer is, in order to manage profits and adverse selection risk (the risk
of trading with a more informed trader) The trader does not want the dealer to know these facts
sell-side traders such as dealers The buy-side trader should manage the relationships with dealers, remembering that his first allegiance is to his clients
Markets quality can be judged by the degree to which it provides:
• Liquidity
• Assurity of completion
1 Liquidity
A liquid market has the following characteristics:
Such a market is called ‘tight’ Quoted and effective spreads are low
tend not to cause large price movements Deep markets have high quoted depth (quantity available for trading) Costs of trading large amounts of an asset are relatively small
market price and intrinsic value tend to be small and corrected quickly
Trang 4Following factors contribute to making a market liquid:
of locating the opposite side of a trade at a
competitive price
needs among market participants: If investors are
alike, they will make similar trades Diversity in the
factors described above increases the chance
that a buyer of a security can find a seller In
general, a large pool of investors enhances
diversity
location or a well thought out electronic platform
attracts investors
• Market Integrity: Ethical rules set by market
operatives and effective regulation play a major
role in increasing public confidence in the
market’s integrity
The advantages of liquidity include the following:
on price
bringing their insights into security prices
will pay a premium for securities that possess
liquidity Higher security prices will enhance
corporate value and lower the cost of capital
2 Transparency Transparency ensures that:
obtain accurate information about quotes and trades pretrade transparency
accurately reported to the public—post-trade transparency
3 Assurity of Completion Traders need to be sure that all parties to a trade will honor their commitments Assurity of completion depends on assurity of the contract (the parties to trades are held to fulfilling their obligations) Clearing entities that guarantee both sides of the trade can help ensure assurity of
completion
Trading costs have two major components:
Explicit costs are direct costs of trading, such as broker
commission costs, taxes, stamp duties, and fees paid to
exchanges
Implicit costs represent indirect trading costs They
include the following:
trade on transaction prices (for example, a large
buy order may push the market ask price of a
stock up, so that the remaining order is executed
at a higher ask)
failure to execute a trade in a timely manner If a
trader places a limit order to buy a stock at a price
of 99.00 but the ask is 99.04 the order will not
execute Suppose the stock closes at 99.80 The
difference (99.80-99.04= $0.76) reflects the missed
trade opportunity cost This estimate could be
quite sensitive to the time frame chosen for
measurement
inability to complete the desired trade immediately due to its size and the liquidity of markets While a trade is delayed, information is leaked into the market
Measurement of Costs Implicit costs are measured against some price benchmark
which is used to calculate the effective spread
benchmark is sometimes taken to be the volume-weighted average price (VWAP)
alternative benchmarks which use less information about prices and are less satisfactory (opening price is much easier to game)
the implementation shortfall approach
Volume-weighted average price The VWAP of a security is the average price at which the security traded during the day, where each trade price
Practice: Example 3 & 4, Volume 6, Reading 31
Trang 5is weighted by the fraction of the day’s volume
associated with the trade
Examples:
If a buy order for 500 shares was executed at $157.25
and the VWAP for the stock for the day was $156.00, the
estimated implicit cost of the order would be
500($157.25-$156.00) = $625
large fraction of volume
trading approaches and the VWAP estimate’s
accuracy increases To address this, VWAP could
be measured over multiple days
Implementation Shortfall Approach
Implementation shortfall is defined as the difference
between the money return on a notional or paper
portfolio in which positions are established at the
prevailing price when the decision to trade is made
(called the decision price, the arrival price, or the strike
price) and the actual portfolio’s return It correctly
captures all elements of transaction costs (both explicit
and implicit)
Implementation shortfall can be analyzed into four
components:
• Realized profit/loss: reflects the difference
between the execution price and the relevant
decision price (usually taken to be the previous
day’s close) The calculation is based on the
amount of order actually filled
(close-to-close price movement) over the day an
order is placed if the order is not executed that
day The calculation is based on the amount of
the order actually filled
profit/loss): reflects the price difference between
the trade cancellation price and the original
benchmark price based on the amount of the
order that was not filled
NOTE:
Market movement is a component of the last three of
these costs
NOTE:
selling—the return on the paper portfolio is subtracted from the return on the actual portfolio
The application of the implementation shortfall approach is hampered when:
price is then hard to determine
and/or quote information)
Adjustment for Market Movements Suppose the implementation cost is 87 bps and the market has risen by 100 bps over the period of trading If the beta of the security is 1, then the market model predicts that the return on the asset equals:
Ri =αi + βiRM Hence, the predicted return will be 1(1%) = 1% (given that, with daily returns, α will be close to zero) The market-adjusted implementation shortfall would be 0.87%-1.0% = -0.13%
NOTE:
Some managers measure shortfall with respect to a portfolio in which component costs are at expected levels
Comparison of VWAP and Implementation Shortfall
Volume Weighted Average Price
Implementation Shortfall
compute
• Easy to understand
computed quickly
• Works best for comparing smaller trades
in nontrending markets
• Links trading to portfolio manager activity; can relate cost to the value of ideas
tradeoff between immediacy and price
• Allows attribution
of costs
• Can be built into portfolio
optimizers to reduce turnover and increase realized performance
gamed
Practice: Illustration of the
calculation of implementation
shortfall,
Volume 6, Reading 31
Trang 6Volume Weighted Average Price
Implementation Shortfall
account for costs of trades delayed or canceled
misleading when trade is
a substantial proportion of trading volume
• Not sensitive to thes trade size
or market conditions
gamed by delaying trades
extensive data collection and interpretation
unfamiliar evaluation framework on traders
Source: Exhibit 6 Volume 6, Reading 31
Costs Econometric models can be used to build reliable
pre-trade estimates The theory of market microstructure
suggests that trading costs are nonlinearly related to
certain factors, including the following:
• Stock liquidity characteristics (e.g market
capitalization, price level, volume, trading frequency, bid-ask spread, index membership);
• Risk (e.g the volatility of the stock’s returns);
• Trade size relative to available liquidity (e.g order size divided by average daily volume);
market than in a down market);
associated with higher costs)
Regression analysis can be used to determine the relationships of the above factors with cost
Uses The estimated cost function can be used:
which can then be compared to actual realized costs to assess execution quality
trade size to order (for example if expected excess return is 5%, but round-trip transaction costs are also 5%, the excess return would be eroded The optimal trade size should be decreased)
Traders can be classified by their motivation to trade, as
follows:
that has limited value if not quickly acted upon They:
securing a better price
• are likely to use market orders (to hide their
intentions) and rely on market makers
based on research and trade only when the price
moves into their value range Value traders:
price
patient to secure a better price
profit from an information advantage They transact
to release cash proceeds, adjust market exposure, or fund cash needs, and tend to be counterparties to more knowledgeable traders
4 Passive traders seek liquidity in their rebalancing transactions and are much more concerned with the cost of trading
Some other trader types are as follows:
have short trading time horizons
of execution
Practice: Example 8 Volume 6, Reading 31
Trang 7• Day traders rapidly buy and sell stocks, and like
dealers, often seek to profitably accommodate
the trading demands of others
NOTE:
This classification of traders is relevant to both equity and
fixed-income markets
SUMMARY
Trading Time Horizon
Time versus Price Preference
Minutes to
Value-motivated
Perceived valuation errors
Days to
Liquidity-motivated
Invest cash or divest securities
Minutes to
Passive
Rebalancing, investing/
divesting cash
Days to
Dealers and
Minutes to hours
Passive, indifferent
Source: Exhibit 8 Volume 6, Reading 31
4.2.1) Information-Motivated Traders
Information traders believe that they need to trade
immediately and often trade large quantities in specific
names These traders:
• may use fast action principal trades
• use less obvious orders, such as market orders, to
disguise their trading intentions in order to prevent their information edge from diminishing
4.2.2) Value-Motivated Traders The value motivated trader develops an estimate of value and waits for market prices to fall in the range of that estimate These traders:
buying stock when dealers want to sell
4.2.3) Liquidity-Motivated Traders The commitment or release of cash is the primary objective These traders:
participate, principal traders, portfolio trades, and orders on ECNs and crossing networks
tolerate some execution uncertainty
4.2.4) Passive Traders Low-cost trading is the mains objective These traders:
• Use limit orders, portfolio trades, and crossing networks
of bid-ask spreads
• Use orders that are best suited to trading that is neither large nor heavily concentrated
Considerations include the following:
direct market access (DMA) and algorithmic trading
using the skills of senior traders
restrictions, cash balances, and brokerage
allocations, if any
Following are various types of trading techniques: 5.2.1) Liquidity-at-Any-Cost Trading Focus This technique is used by information traders who trade
in large block sizes and demand immediacy Traders with such a focus:
commission rate
Trang 8• Usually recognize that the methods they use are
expensive but pay the price for timely execution
NOTE:
Sometimes, urgency will place a normally nonaggressive
trader into this category
5.2.2 Costs-Are-Not-Important Trading Focus
Traders with such a focus use market orders (and its
variations) since they trust the market to generate a fair
price They pay ordinary spreads and commissions for
speed of execution Market orders:
5.2.3) Need-Trustworthy-Agent Trading Focus
This technique is used to execute large orders,
particularly in thinly traded issues
• Traders with such a focus use brokers to skillfully
work such orders by placing a best efforts,
market-not-held, or participate order
• Such a focus is less useful for
information-motivated traders
know whether the broker would act in his/her best
interests
5.2.4) Advertise-to-Draw-Liquidity Trading Focus
This technique is used for IPOs, secondary offerings and
sunshine traders If publicity attracts enough traders,
there may be little or no market impact Such orders
bear the risk of trading in front of the order
5.2.5) Low-Cost-Whatever-the-Liquidity Trading Focus
Limit orders are the chief example of this type of order
This type of order:
investors
and possible elimination of dealer spread
• Has execution uncertainty, and if the limit price
becomes stale, the order may be executed at an
unrevised, undesirable price
5.2.6) Trading Technique Summary
Source: Exhibit 9 Volume 6, Reading 31.
• Algorithmic trading refers to electronic trading
subject to quantitative rules and user-specified
benchmarks and constraints
• Related, but distinct, trading strategies include using portfolio trades and smart routing (use of algorithms
to route an order to the most liquid venue)
5.3.1) The Algorithmic Revolution The underlying logic behind algorithmic trading is to break large orders into smaller orders that blend into the normal trading volume in order to moderate price impact
to avoid taking unintentional risk (e.g an unbalanced portfolio)
NOTE:
tacticians, whereas in the past, their primary task was managing broker relationships
large equity order to get done, it must often be broken up into smaller orders
5.3.2) Classification of Algorithmic Execution Systems Logical Participation
Strategies
Opportunistic Strategies
Specialized Strategies
Participation Strategies
Shortfall Strategies Simple Logical Participation Strategies This is the most common class of algorithms in use Following are its types:
breaks up an order over time to match or improve upon the VWAP for the day It can either use historical volume data or forward-looking volume predictors
breaks up the order in proportion to time to match
or beat a time weighted or equal weighted average price The strategy is useful in thinly traded assets whose volume patterns might be erratic and can be reactive or proactive
which trading takes place in proportion to overall market volume until the order is completed
Implementation Shortfall Strategies These strategies solve for the optimal trading strategy that minimizes trading costs as measured by the implementation shortfall method
Trang 9Opportunistic Participation Strategies
These strategies also involve trading over time: passive
trading combined with the opportunistic seizing of
liquidity This liquidity strategy is not a true participation
strategy Examples include pegging and discretion
strategies (that use reserve or hidden orders and
crossing)
Specialized Strategies
These include passive order strategies, hunter strategies
(that seek liquidity), market-on-close algorithms, smart
routing, and other specialized strategies
5.3.3) The Reasoning behind Logical Participation
Algorithmic Strategies
on the premise that breaking up the order into
smaller sub-blocks yields a lower average market
or price impact
minimizing a weighted average of market impact
costs and missed trade opportunity costs Since
the volatility of trade value or trade cost increases
with trading horizon, these strategies are typically
front-loaded (trade heavily early in the trading day) The implementation shortfall algorithm solves for an objective function that minimizes expected total cost and variance of possible cost outcomes This is consistent with the portfolio optimization problem
Important: Generally:
volume, have low urgency and low spreads are ideal for VWAP algorithms
ideal for implementation shortfall algorithms
broker or crossing system to mitigate large spreads
The Guidelines define best execution as:
maximize the value of a client’s portfolio within the
client’s stated investment objectives and
constraints”
The definition identifies four characteristics:
independently
• Best execution is a prospective, statistical, and
qualitative concept that cannot be known with
certainty ex ante
basis, even though such measurement on a
trade-by-trade basis may not be meaningful in isolation
interwoven into repetitive and continuing
relationships
The Trade Management Guidelines are divided into
three areas:
1 Processes: Firms should establish formal policies and
procedures that have the goal of maximizing asset
value of client portfolios through best execution and
that provide guidance to measure and manage the quality of trade decisions
2 Disclosures: Firms should disclose to clients and prospects:
venues and agents
• Actual or potential trading related conflicts of interest
that supports:
• Disclosures provided to clients
NOTE:
The records may also support a firm’s broker selection practices
NOTE: These guidelines are a compilation of recommended practices and not standards
The code of both buy-side and sell-side traders is that verbal agreements will be honored Over time, the disappearance of commissions has caused costs to
Practice: Example under Exhibit 12 Volume 6, Reading 31
Trang 10become implicit and markets to become more
adversarial However, in every case, the ethical focus of
the portfolio manager and the buy-side trader must be
the interests of the client and all actions should be
consistent with the trader’s fiduciary responsibilities
Practice: End of Chapter Practice
Problems for Reading 31 & FinQuiz
Item-set ID# 13345