Trading, Monitoring, and Rebalancing Flashcards
Effective Spread
ES for buy = 2 * (execution price - midquote)
ES for sell = 2 * (midquote - execution price)
ES reflects price movement and price impact
Example: bid 11.50, ask 11.56, buy executed price 11.55
midquote = 11.53
ES buy = 2 * (11.55-11.53) = 0.04
This is less than 11.56 means execution was superior (lower cost)
Types of Market Structures
-
Quote-Driven: trade with dealers
- Offers liquidity
- Good for bond markets
-
Order-Driven: trade directly with each other
- Results in competition (better prices)
- Liquidity may be poor
- Brokered markets: use brokers to locate counterparty
- Hybrid market
Types of Order-Driven Markets
- ECN - Institutions
- Low costs
- Don’t pay bid-ask spreads
- Don’t know counter party
- Auction Markets
- Traders compete for orders
- Have price discovery
- Automated Auctions
- Trades based on rules
- Have price discovery
- Don’t know counter-party
Brokers and Dealers
Dealers are matchmakers earning a profit (provides liquidity)
Brokers are hired by the investor. They can:
- Represent the order
- Find counterparties to the trade
- Provide secrecy
Market Quality
- High liquidity
- narrow spreads
- lots of buyers/sellers (depth)
- High transparency
- Good trade settlement
Execution Costs
Explicit
Implicit
VWAP
Explicit: commissions, taxes, fees
Implicit: spread, opportunity costs, delay costs
VWAP - just average costs
Advantages/Disadvantages of VWAP
Advantages Disadvantages
Easily understood Not good for large trades
Can be applied quickly Can be manipulated
Best for small trades Ignores delay and missed trade costs
Implementation Shortfall (IS)
Measures difference between actual and theoretical portfolio
4 Types:
- *Delay (slippage):** cost for slow execution
- *Price impact (RGL):** costs after delay
- *Missed trade opportunity (UGL):** any portion not traded
- *Explicit costs:** commissions, etc.
Example: Limit order for 1000 shares at 47.39, closing price 47.30
500 sold at 47.44, 500 at 47.39, commission of 50
Hypothetical portfolio = 1000 * 47.39 = 47,300
actual portfolio = (500 * 47.44) + (500 * 47.39) - 50 = 47,365
IS = 47,300 - 47,365 = -65 Per share: -65/1000 = -0.065
bps = -65/47,300 = -.14% or 14 bps
Components of IS
Missed trade opportunity
Its the unrealized profit/loss
[(CP - DP)/DP] * (% canceled)
Components of IS
Delay/slippage costs
Only applies to day that order went unfilled
[(BP - BP)/DP] * % executed
benchmark price = the NEXT daily closing price
Components of IS
Price/market impact
This is the realized gain/loss
[(EP - BP)/DP] * % executed
Advantages/Disadvantages of Implementation Shortfall(IS)
Advantages
Can see full cost of an idea
Can see market impact vs execution
Cannot be “gamed”
Disadvantages
Requires lots of data and analysis
Trading costs should be lower when?
Based on Econometric Models
- in liquid markets
- less volatility
- smaller trades
- buying in a falling market
Types of Traders
Types Motivation Time/Price Order Type
Information time-sensitive time market
value misvaluations price limit
liquidity reallocation time market
Passive reallocation price limit
Types of Trading Tactics
Tactic Strength Weakness
Trustworthy agent low advertising uncertain exec.
Advertise liquidity good on large trades front running
Low cost low trading costs uncertain timing
Liquidty-at-cost quick execution info leakage
Costs-dont-matter quick execution high trade cost
Types of Algorithmic Trading
-
Logical participation
- Simple - best for small trades
- VWAP, TWAP, % of volume
- IS - best for urgency (front loads trades)
-
Opportunistic
- reacting to changing market volume
-
Specialized
- Hunter - wait until favorable conditions
- Target closing price (trade at end of day)
Trading Procedures
- Process documented
- Disclosure to clients
- Record keeping
What is adverse selection risk?
A dealer faces adverse selection risk because a trader has more information and can profit at the dealer’s expense
Calendar vs % Rebalancing (PoPR)
Calendar
On specific date rebalance to weights.
Drawback: deviation between dates unknown
PoPR
Once asset class out of bands, rebalance all asset classes
Benefit: lower transaction costs
Drawback: requires daily monitoring
Can combine both
Factors in Setting a Tolerance Band
Factors positively correlated:
- Transaction costs: ↑ costs ↑ band
- Risk tolerance: ↑ risk ↑ band
- Correlation: ↑ correlation ↑ band
Factors negatively correlated:
- Volatility on asset class: ↑ volatility ↓ band (to control risk)
- Volatility of other asset classes: ↑ volatility ↓ band
Managers Must Monitor Changes in:
- Client circumstances
- Capital market expecations
- Portfolio (change in allocations)
Types of Rebalancing Strategies
- Buy and Hold
- Constant Mix
- Constant Porportion
Buy and Hold Rebalance
- Do nothing, let assets grow
- Middle results between CM and CPPI
- Risk tolerance goes up/down with risky assets
- Floor = amount in Rf
Good when:
- risk tolerance is correlated to wealth and return
- Tax and transaction cost efficient (no trades)
Constant Mix Rebalance
AKA contrarian strategy
- Does well in mean reverting environment (concave payoff)
- Good for investors with constant risk tolerance
- Dimished upside
- Floor is $0
- Less tax and transaction cost efficient
Constant Proportion Rebalance
AKA momentum (double-down)
- Good for investors with risk tolerance up/down rapidly with wealth
- Accelerates updside
- Floor value > % in Rf
- Formula: Multiplier * (total assets - floor)
Best Rebalance Strategy per Market
- Up/down trending
- Best: CPPI (buy winners and sell losers)
- Mean Reverting
- Best: Constant mix (selling high and buying low)
- Remember BH is most tax and transaction efficient
When do use what type of trade execution tactic?
VWAP: low volume, not urgent, narrow bid/ask
IS: low volume, urgent, narrow bid/ask
