Market - Strategies, Orders, Costs, etc. Flashcards
Market Orders
- Immediate execution at the best possible price
- Start at lowest ask, then next lowest… until filled
- Execution is the top priority
- Price is a secondary concern, so price uncertainty is a risk
Limit Orders
- Trade at the best possible price, but only if it is at least as attractive as the limit price
- Order is filled immediately in increments until completed
- Price is top priority
- Execution is a secondary concern, so execution uncertainty is a risk
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Effective Spreads
Quoted Spreads
Trading Costs
Average Effective Spread
Price Improvement
Market Impact
Market Liquidity
Price improvement
Trading Cost
Securities Market Structures
Three main Market Structures
Order Driven Market`
Hybrids Markets
Upstairs Market (Brokered)
Quote-Driven (Dealer)
Order-Driven (Direct Exchange)
Order - ECN
Order: Auction
Order: Automated Auction
Roles of Brokers
Roles of Dealers
Market Quality
liquidity
transparency
execution
“the criteria of market quality”?
components of execution costs
evaluate a trade in terms of these cost
Explicit Transaction Fees
Market Impact Costs
Occur whenever an order is executed at a price other than the currently quoted bid or ask
What are implicit Execution Costs?
Why can’t people just buy at the ask or sell at the bid?
Missing Trade Opportunity Costs
- This is the gain that you miss out on (or loss you avoid) if your order does not get completely filled.
- This typically happens with limit orders, which have execution uncertainty.
- This is measured using the difference between some closing price and the benchmark price, which is the price at which the manager decided he wanted to buy it (or sell, but on the exam, it will almost certainly be a buying scenario).
How do you decide when to an opportunity ends?
What is the fourth component of execution costs?
Delay/Slippage costs
Implementation Shortfall
Unlike pre-trade costs, Implementation Shortfall (and especially Market-Adjusted Implementation Shortfall) can be negative, which means that these costs can actually end up
being a net benefit to you
Market-Adjusted Implementation Shortfall
How to estimate implicit costs?
Multiply the difference between the trade price and the benchmark price by the number of shares traded.
(Actual transaction price - Benchmark price) x # of shares traded
What are the prices that we need to know to calculate implementation shortfall?
- Benchmark price (BP): The price that the manager sees and decides to buy/sell at (assume that it’s the closing price on the first day of a case/question set).
- Decision price (DP): This is the closing price on the day before any part of the order gets filled, so it will be different for parts of the order that are filled on different days.
- Execution price (EP): The actual transaction price (for the portion of the order that actually gets filled).
- Cancellation price (CP): The closing price on the day that the order is cancelled and the remaining portion is unfilled
what formulas do we use once we know these prices?
Explicit cost (Fee/share / BP) x total shares in order
Delay/Slippage cost [(DP - BP) / BP] x % of order filled
Realized profit/loss [(EP - DP) / BP] x % of order filled
Missed opportunity cost [(CP - BP) / BP] x % of order NOT filled
Better understanding of above formulas:
- Start with the denominator, which is always the benchmark price.
- Next, note that delay costs and realized profit/loss are multiplied by the % of the order that is actually filled - not the entire order size and not the % that goes unfilled.
- Missed opportunity costs are multiplied by only the % of the order that does NOT get filled, which makes sense.
- Explicit costs, by contrast, are applied to the entire order - so $20 trading fee on an order for 1,000 shares is $0.02/share - even if the order does not get completely filled.
- Those are all logical, but the prices used in the numerator are trickier:
* Delay/Slippage costs start with DP - BP (think “Delay
means use DP”)
* Missed opportunity costs start with CP - BP, which
makes sense because then you pretty much admit
you’ve lost the opportunity when you cancel the rest of
your order (although remember that there is no set rule
on what actually is the “cancellation price”).
* Realized profit/loss starts with EC - DP, which actually
makes sense - just remember that the DP is used in the
numerator, but it is still the BP that is used in the
denominator.
example of implementation shortfall?
Mon (close) Tues (close) Wed (intra-day) Wed (close)
$10.00 $10.05 $10.10 $10.15
Benchmark Decision Execution Cancellation
Order placed for 1,000 shares, but only 60% of the order was filled.
Explicit cost = [($20 fee / 1,000 shares) x $10.00] x 100% = 0.2%
Delay/Slippage cost = [($10.05 - $10.00) / $10.00] x 60% = 0.3%
Realized profit/loss = [($10.10 - $10.05) / $10.00] x 60% = 0.3%
Missed opportunity cost = [($10.15 - $10.00) / $10.00] x 40% = 0.6%
0.2% + 0.3% + 0.3% + 0.6% = 1.4%
1.4% x (1,000 shares x $10.00) = $140
Explicit Trading Costs
VWAP vs. Implementation shortfall
Contrast volume weighted average price (VWAP) and implementation shortfall as measures of transaction costs
Volume-Weighted Average Price (VWAP)
- Volume-weighted average price, or VWAP, is a measure that is used when you can’t complete a transaction at a single price.
- For example, you buy 100 shares at $20.00, 250 at $20.01, 500 at $20.02, etc.
- WAP gives you the “true” price of the transaction by weighting the portions sold at various prices.
Advantages of Volume-Weighted Average Price
- It is easy to calculate and easy to understand.
- It’s useful for small trades, especially in “trending” markets that have much underlying movement (no market-adjustment required)
How can VWAP be “gamed” by traders?
how is Implementation Shortfall better than VWAP?
Pre-trade analysis and econometric methods
Explain the use of econometric methods in pre-trade analysis to estimate implicit transaction costs?
“Econometric methods”
What are the major types of traders, based on their motivation to trade
What are the major types of traders, based on their time versus price preferences
What are the major types of traders, based on their preferred order type
Describe the suitable uses of major trading tactics
evaluate their relative costs, advantages, and weaknesses?
