Reading 34: Trade Strategy & Execution Flashcards
Scheduled Algorithms
Include percent-of-volume (POV), volume-weighted average price (VWAP), and time-weighted average price (TWAP) algorithms. These algorithms execute trades using rules driven by historical volume or specified periods and have the effect of receiving the average intraday price over a specified time period or volume pattern.
Four Categories of Trade Motivation
Profit seeking, looking to outperform benchmark, key consideration is alpha decay (acting before the market) and information leakage (avoid alerting market of mispricing, can be done through dark pools). Risk management and hedging needs with rebalancing or using derivatives. Cash flow needs with redemptions based on NAV using closing prices so selling at closing prices is favoured, cash drag from implementing illiquid holdings can be avoided with equitation strategies (ETFs or derivates while implementing). Corporate actions, margin calls and index reconstitution.
Dark Pools
Referred to as Alternative Trading Systems in US and Multilateral Trading Facilities (MTFs) bringing together buyers and sellers or Systematic Internalisers (SIs) that are single-dealer liquidity pools, in Europe.
Determining Optimal Trading Strategy
Order characteristics: include side (all one side have greater market risk), absolute size of order, relative size compared to ADV (average daily volume). Security characteristics: security type, short-term alpha (alpha decay urgency), price volatility (implies execution risk), security liquidity (more liquidity through tighter bid-ask spread and greater depth decreases both market impact cost and execution risk). Market conditions with volatility and liquidity. Individual risk aversion, high manager risk aversion leads to concern regarding adverse movements rather than market impact costs so they trade with more urgency.
Trader’s Dilemma
Market impact cost is the risk of the trade moving prices caused by trading too quickly (information leak). Execution risk is the risk of adverse price movements over a longer time horizon, caused by trading too slow. Alleviating market impact cost causes execution risk.
Reference Prices
These are used as a benchmark to determine trading costs and include: pre-trade benchmarks (decision price, previous close, opening price, arrival price to market); intraday benchmarks, used by managers who trade over day and may be rebalancing (VWAP or TWAP, where TWAP has equal weighting and removes outlier effects); post trade benchmarks which is the closing price (used by cash driven trading to get redemption aligned with NAV based on closing prices); price target benchmarks used by profit seeking managers aiming to earn short term alpha.
Trade Implementation
High touch approach: used for large trades or in illiquid markets where lots of human engagement is needed to find other side, principle trades include quote-driven, OTC, off exchange markets, or request for quote and broker assumes some or all of the risk, agency trades is where risk remains with portfolio manager.
Electronic trading: done via a computer, used in more liquid markets, order driven though central limit order book, involves direct market access (DMA portfolio managers access to order book of exchange directly) and/or also trading.
Trade Implementation 2
Algorithmic trading: programmed rules to trade orders electronically used for profit seeking (by electronic market makers, quantitative funds, and high frequency traders) and trade execution. Scheduled algorithms are percent of volume (POV), VWAP, and TWAP. POV send orders like 5% of traded volume and automatically exploit increased liquidity when available but continue to trade at any price (even adverse). VWAP and TWAP ensure a specified number of shares are executed in a specified time period but may force trades in times of low liquidity or trade too little in times of high liquidity.
Other strategies are liquidity seeking (opportunistic), arrival price (more aggressive), dark strategies/liquidity aggregators, or smart order routers (SOR) who determine best festinate (lit or dark).
Which Algorithm?
Scheduled algorithm: relatively small orders in liquid markets, for less urgency (greater risk tolerance to execution periods), minimising market impact.
Liquidity seeking: large orders in illiquid markets, higher urgency while mitigating market impact, concerned about displaying limit orders (info leakage), sporadic liquidity.
Arrival price: small orders in liquid markets, worried about price movements, aggressive trading, profit seeking.
Dark strategies: large orders in illiquid markets where arrival or scheduled methods would lead to high market impact, do not need to execute order fully.
SOR: small orders with low market impact, fast moving markets, low info leakage.
Clustering
Machine learning technique that deciphers which algorithm is best based on the characteristics of the trade.
High Frequency Market Forecasting
Models short term market direction but uses lots of variables that may need to be reduced by least absolute shrinkage and selection operator (LASSO), which reduces the number of explanatory variables.
Asset Classes & Implementation
Equities are most technologically advanced and use of algo’s are common place. Fixed income has limited algo trading (mainly with on the run treasuries), with request for quote becoming more common, high touch execution methods are common with urgent using principle broker and less urgent using broker agent. Electronic trading is common for exchange traded derivatives (more futures than options), usually use DMA. OTC derivatives usually use high touch approaches.
Implementation Shortfall
Total trading costs embedded in the transaction. Paper return less actual return, with paper return assuming the full trade went though at original decision price with zero cost. Includes execution cost which is made up of delay cost (time for broker to decide strategy and send to market) and trading cost (market impact), opportunity cost of remaining unsold shares, and fixed fees.
Trade Governance
Manager must write a formal trade policy outlining the following: meaning of best execution, not necessarily being best price and lowest cost but best result for client. Factors that ermine optimal execution approach (urgency, liquidity of security, characteristics of venues, reason for trade, investment strategy. List of eligible brokers and execution venues establishing a best execution monitoring committee (BEMC) evaluating based on competitive execution price or speed, financial stability, ethical reputation, willingness to commit capital to principle trades. Process for monitoring execution arrangements.
Market-Adjusted Cost
Subtracts the gain or loss in the index due to price movements when making a trade so the trader isn’t penalised or praised for general market movements, subtracting the index cost adjusted for security’s beta.
