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CFA Level 3 > Trading Strategy and Execution > Flashcards

Trading Strategy and Execution Flashcards

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1
Q

What characterizes a profit seeking trader?

A
  1. Information is not fully reflected - try to hide trades from information leakage - lit venues are cheaper though
    Trading urgency is often high when there are alpha opportunities
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2
Q

What characterizes a risk management/hedging trader?

A
  1. Use of derivatives for cost efficiency
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3
Q

What characterizes a cash flow needs trader?

A

Money comes and goes and you must adjust. Trading urgency can be high (margin calls), or low (redemptions). Inflows may involves using ETF proxies to minimize cash drag.
MF’s will trade very close to the close of markets to reduce redemption price risk.

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4
Q

What characterizes a corporate action trader?

A

This could be…

  1. Reinvesting dividends automatically
  2. Margin calls
  3. Index reconstitutions
  4. Active managers rebalancing when index reconsitutes.
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5
Q

What are the inputs to a trading strategy?

A
  1. What side of the trade are we on?
    If we are buying into an upwards or selling down, execution may be longer - trading urgency increases
  2. Size of the order - large orders create impact. Large orders take longer. Large orders will be spread out and will have lower urgency.
  3. What type of security?
  4. Will we look for short term alpha? Trade faster
  5. How volatile is the price?
  6. How liquid is the security? Spreads and depth
  7. What is the market condition? - Crises cause vol and low liquidity
  8. Individual risk aversion
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6
Q

What is the difference between short term and long term market impact?

A

Short term is moving the market prices because of volume, long term is when your trade signals new information. We must hide orders to minimize this.

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7
Q

What is the trade off between market impact and execution risk?

A

Trading too fast minimizes execution but increases market impact.

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8
Q

What are pre-trade benchmarks we can use to evaluate performance?

A
  1. Decision price
  2. Previous close - often for quants
  3. Opening price - no overnight price risk - used by fundamental PMs
  4. Arrival price - what is the price when we entered the order - used by short term traders
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9
Q

What are intra-trade benchmarks we can use to evaluate performance?

A

These are typically used for liquidity seekers, rebalancers, and passive management. They are not concerned with short term price momentum
1. VWAP - volume * price for the entire day/# of shares traded
This is used when we want to trade based on volume. It works best when you are buying and selling
2. TWAP - average price over the horizon - this corrects for issues created when you make large trades at bad times as VWAP would be skewed

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10
Q

What are post-trade benchmarks we can use to evaluate performance?

A

This is for funds who trade on the close.

1. Closing price to minimze tracking error

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11
Q

What factors determine the type of trading strategy you should use?

A
  1. What is your motivation to trade?
  2. How risk averse are you?
  3. How urgent are the trades?
  4. What are the market conditions?
  5. What is the order size?
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12
Q

When does a human trader make sense?

A
  1. Large principal trades with the dealer
  2. Large non urgent or illiquid trades - this involves brokers actually looking for buyers, requesting quotes, trading over time, etc.
  3. Liquid, standardize securities (non-large)
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13
Q

What are the primary purposes of algorithmic trading and how does it accomplish it?

A
  1. Execution - get the best price
  2. Profit seeking - algo makes decisions
    Algo trading splits orders across venues and time.
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14
Q

What is a scheduled POV algo?

A

This is an algo where trading increases with volume as specified by a %

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15
Q

Why would you use scheduled algos to trade?

A
  1. No expectations of momentum
  2. Greater risk tolerance for long execution
  3. You want to minimze market impact
  4. You have small orders
  5. You have high liquidity and there are balanced orders
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16
Q

What is a scheduled VWAP and TWAP algo?

A

A VWAP will trade more on the open and close and bases volume off of historical volumes. A TWAP trades over time regardless of volume.

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17
Q

Why would you use a liquidity seeking algo?

A
  1. You want to trade faster when liquidity shows up
  2. Will use exchanges, dark pools, ATS
    This is good for large orders with high urgency
    When you don’t want to reveal information
    When something is thinly traded
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18
Q

Why would you use an arrival price algo?

A

this will front load trades and is used when expected momentum is high. Trade urgency is high. you are likely risk averse. volume can’t be huge

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19
Q

Why would you use an dark strategy or liquidity aggregator algo?

A
  1. Avoid info leakage
  2. high order size and high market impact
  3. Low liquidity
  4. Low urgency
20
Q

Why would you use a smart order router algo?

A

This is simply an algo that determines the highest prob of executing a limit order. You do it when delaying makes no sense, trades are small, securities are traded on multiple markets.

21
Q

What is implementation shortfall? What is the basic calculation?

A

This is the total cost associated with implementing. This is the paper portfolio return - actual return. This is based on decision prices. Paper return is calculated by:
Current Price - Decision Price * Ordered shares.
Actual Return is the shares executed * Price now - average price* shares - Fees.

22
Q

How do you decompose total implementation costs to execution and opportunity cost?

A

Execution is cost of position - cost of paper portfolio. Opp cost is the difference between what we wanted as far as shares vs what we got.
Execution costs = Sharesexecution price - shares * decision price
Opportunity cost = (Shares wanted-shares got(Execution-Decision)

23
Q

How do you break down execution cost between delay and trading cost?

A

Delay is the difference between price when you place the order and the decision price. Trading cost is the difference between the execution costs and the price when the order is placed.

24
Q

How do you improve execution performance?

A
  1. Develop performance metrics
  2. Post trade anlaysis
  3. Determine proper order sizes for markets
25
Q

How do we calculate the market adjusted cost?

A

MAC = Arrival cost in bps - Beta* index cost in bps

Index cost is = (Index benchmark - index arrival price)/Arrival price

26
Q

What should be the objective of a trading policy?

A

You have a duty of care for best execution. Therefore, you must have a procedure to demonstrate you are doing this.

27
Q

What does best execution mean?

A

Identifying tradeoffs between

  1. Price
  2. Speed
  3. Costs
  4. Likelihood of execution
  5. Nature of trade
  6. Size
28
Q

What should a trade policy document include?

A
  1. Definition of best execution
  2. Factors determining optimal execution
  3. List of eligible brokers and venues
  4. Process used to monitor execution arrangements - you must monitor your brokers - use of a best exeuction monitoring committee
29
Q

What are the differences between measurement, attribution, and appraisal?

A

Measurement is answering what, attribution is measuring how, appraisal is evaluating why (luck vs skill)

30
Q

What are the four types of traders?

A
  1. Profit seeking - active managers
  2. Risk management/hedging
  3. Cash Flow needs
  4. Corporate actions
31
Q

What are the two main factors on how quickly you want to trade?

A
  1. Trades over shorter time horizons

2. Trades with high alpha decay

32
Q

What are the key inputs for trade strategy selection?

A
  1. Order characteristics (Size and side):
    What is market momentum? How big is the trade?
  2. Security characteristics
    Increased volatility increases execution risk, liquidity will affect how quickly something can be traded and the price impacts of trades, as well as costs.
  3. Market conditions
    What does volume look like? How big are spreads?
  4. Individual risk aversion - lower risk tolerance often has lower trade urgency, but not always
33
Q

What are the different types of reference prices for trades?

A
  1. Pre-trade
  2. Intraday benchmarks
  3. Post trade
  4. Price target benchmarks
34
Q

What are the various types of pre-trade benchmarks and why would you use them?

A
  1. Decision price - the price at the time that you make the decision. Often used in quant models
  2. Previous close - can be a proxy for decision price - quants use previous day closing price in models
  3. Opening price - for those who begin trading upon market open, usually long term holders, does not have overnight risk. If you’re trading at the in an open auction, not the best as you influence price.
  4. Arrival price - price when you enter the order. This is used when you’re seeking short term alpha, or don’t want to incur a lot of trading costs.
35
Q

What are the various types of intra-day trading benchmarks and why would you use them?

A
  1. VWAP - volume weighted average price of all trades executed over the day. You would typically want to use this if you have both buy and sell orders through rebalancing within the day
  2. TWAP - time weighted average price is an equal weighted of the average price across times. This excludes outliers. You would use this if there is high volume uncertainty.
36
Q

What are the various types of post trading benchmarks and why would you use them?

A
  1. Closing price - used for fund managers
37
Q

What strategy would one trade for a short term alpha trade?

A
  1. Want to ensure full execution - unlikely to go to dark pools
  2. Typically a price target, so pre trade benchmark
  3. Unlikely to use an intra day target
38
Q

What strategy would one trade for a long term alpha trade?

A
  1. Execution risk is lower and trades can be spread as needed
  2. If you are trading a high volume, you probably won’t want to take the hit in trading all at once
39
Q

What features make it more likely for a trade to be executed as a principal trade?

A

Principal trades are broker risk trades typically made from broker inventory. The larger the block, the more likely to use a principal trade. The less active the security, the more likely.

40
Q

When it is more likely to have a high touch approach to trading?

A

If there are large, illiquid trades that may need to be sliced across other counterparties

41
Q

How do you calculate the market-adjusted cost?

A

First you find the Index cost
Index for benchmark method - Index arrival price/Index arrival price.
You subtract the index cost * Beta from the arrival cost
This is used to remove the stock movement that would have already happened

42
Q

How do you calculate the trade value-added?

A

Arrival cost - estimated pre trade cost

43
Q

How do you calculate the arrival cost?

A

Arrival cost = Average execution price - Arrival price/Arrival price

44
Q

How do you calculate delay costs? Trading costs?

A

Delay costs = Price entered - Price decided * filled shares

Trading Costs = Price received - Price entered * Shares received

45
Q

What type of trading system should you use for a large, non-urgent OTC derivative trade?

A

High touch agency

CFA Level 3 (28 decks)

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