TRADE STRATEGY AND EXECUTION Flashcards
Explain what is alpha decay and what it incurred for managers.
alpha decay is the deterioration of alpha once an investment decision has been made. Managers with high alpha decay (like managers that trades on daily news) have high alpha decay. They have a high trade urgency.
Identify the four categories that motivates a manager of executing a trade.
- Profit Seeking
- Risk Management and hedging needs
- Cash flow needs
- Corporate actions, margin calls, and index reconstitution
what is information leakage and how can we mitigate it.
Information leakage is when we alert the market that the security is mispriced through trading activities. Manager should execute their trade in multiple venues (that can include dark pools) to remove the risk.
Describe how the following factors affects the market impact cost of the trade : order size, security liquidity, and rate of alpha decay
A larger order size will most likely lead to a higher market impact cost; the trader will have to trade at more adverse prices to execute a larger transaction.
Higher liquidity results in narrower bid-ask spreads and higher market depth, both contributing to lower market impact cost; the trader will likely be able to execute the trade close to current market prices.
Higher alpha decay prompts traders to trade quickly, leading to a higher market impact cost.
What is included in a pre-trade benchmarks (reference prices)
1- Decision price : price at the time the manager made the investment decision
2- Previous close : Price at the previous market close.
3- Opening price : opening price of the day
4 - arrival price : Price when the manager submitted the trade.
What is included in a intraday benchmarks (reference prices) and described.
Volume weighted average price : average price weighted by volume over the trading horizon.
Time weighted average price : Equal weighted average price of all trade executed over the trading horizon.
What is included in a post trade benchmarks
Determined after the trade has been completd. Usually we take the closing price, for manager who want to minimize the tracking error of the fund.
What is included in a price target benchmarks
Prices used by profit seeking managers aiming to generate short term alpha, related to manager’s view of fair value of the market price. Example, if the managers thinks that a stock is worth 10.50$ and is now price at 10$, that manager could use a strategy to purchase a many shares possible below that threshold.
What type of reference prices would be appropriate for the following trade types : Short-term alpha, long term alpha risk rebalance, cash flow driven
Short term alpha : price target benchmarks
Long term Alpha : Difficult to use
Risk rebalance : time weighted average
Cash-Flow : Closing price
What execution method would be appropriate for the following trade types : Short-term alpha, long term alpha risk rebalance, cash flow driven
Short term alpha : Computer algorithm
Long term alpha : sell securities over a few weeks in small parts to avoid information leakage
risk rebalance : Algorithmically target TWAP over the next couple of days.
Cash flow (client redemption) : Execute a reasonable amount of liquidity in the closing auction. the remainder will be execute before the close of trading day.
Cash flow (new trade mandate) : obtain immediate exposure to index through a long position in index future to remove cash drag effect.
Explain the trade implementation approach : High-touch approaches
Involve high levels of human involment.
Required for large trades.
Inlcudes:
-Principal trades : Where dealer or market makers assume assume all or some of the risk related to executing the trade.
Quote driven OTC
Agency trades : this is whre the broker finds the other side of the trade.
Identify types of trade execution algorithmic trading
Scheduled algorithms : Includes POV, VWAP, TWAP algorithms
Liquidity seeking algorithm : aim to take advantage of favorable liquidity conditions
Arrival price algorithm : Seek to trade close to market prices prevailing at the time the order is entered.
Dark strategies/Liquidity aggregators : Execute trade in dark pools
Smart order routers : algorithms that determines the best destination for the trade (lit or dark pools) to get the best results.
what type of algorithms is appropriate for relatively small order in liquid market with less urgency :
Scheduled algorithms
What type of algorithms are appropriate for larger trades in less liquid market with higher urgency
Liquidity seeking algorithms
What type of algorithms is appropriate when a manager is concerned that displaying limit orders may lead to information leakage
Liquidity seeking algorithms
What type of algorithms is appropriate for relatively small orders in liquid markets for managers who believe prices are likely to move against them during the trade horizon
Arrival price
What type of algorithms is appropriate for large orders in illiquid markets, and that arrival price or scheduled algorithms would likely lead to high market impact.
Dark strategies- liquidity aggregators
What type of algorithms is appropriate for small market orders with low market impact where the market can move quickly, or for small limit orders with low information leakage where there are multiple potential execution venues.
Smart order routers
Identify the decomposition of implementation shortfall (IS)
Execution Cost : Trade got executed at a less favorable price than the original decision price. Can be broken down into delay cost and trading cost.
Delay cost : price movements in the time between the portfolio manager submitting the order to the trader and the time the trader releases it to the market. This delay is usually due to the time it takes the trading desk to determine the optimal execution strategy for the trade.
Trading cost : due to the market impact of executing the trade.
Opportunity cost : cost of not trading any unfilled part of the order
fixed fees : any explicit commissions or fees
How do we calculate absolute cost of a trade againts the benchmark
Absolute Cost = (side) * (execution price - benchmark price) * # shares
If you want in basis point value : (side) * ((execution price - benchmark price) / benchmark price)) * 10 000
How can we remove the impact of market movements on trade cost ?
Market-adjusted cost
Index cost (bps) : (side) ((VWAP index - index arrival price) / index arrival price )) * 10 000
Market-adjusted cost : Arrival cost - Beta * index costs
What are the key areas that should be specify in the trade policy of the asset manager.
- Meaning of Best Execution
- Factor that determine the optimal execution approach
- List of eligible broker and execution venues
- Process for monitoring execution arrangements
What are the factors that determine best execution when it comes to an asset manager’s trading
-Execution price
-Trading cost
-Speed and likelihood of execution and settlement
-Order size and liquidity
-Nature of the trade
What are the factors that determine the optimal execution approach needed to be communicated in the trade policy.
-Urgency and size of order
-Liquidity of security and nature of security
-Characteristics of available execution venues
-Investment strategy objectives
-Reason for the trade
