Formula.
Effective spread for a sell order
= 2 x ( Midquote - Execution price)
Formula.
Effective Spread for a buy order
Effective Spread for buy order
= 2 x (Execution price - Midquote)
Midquote is average of inside bid and inside ask
What is an Effective Spread?
The true cost of a round-trip transaction (supposedly a better measure than the quoted bid-ask spread).
If lower than the quoted spread, indicates better liquidity for a security or superior (i.e. lower cost) execution
Purpose of securities markets
Provide liquidity, transparency and assurity of completion
4 types of securities markets
- Quote driven market
- Order driven market
- Brokered market
- Hybrid market
3 Types of Order-Driven Market
Characteristics of each
- Electronic crossing network
- institutional trades
- guarantees anonymity
- no price discovery so prices can’t adjust according to supply and demand
- low liquidity so leads to unfilled orders
- trades at one point in time - Auction market
- trades at one moment or throughout day
- provides price discovery so more filled orders - Automated auction market (i.e. electronic communication network or electronic limit-order market)
- provides anonymity
- provides price discovery
- trades throughout day
Characteristics of Broker’s agency relationship (fiduciary duty) with Trader
- Represent order and advise trader
- Find counterparty to trade
- Provide market information
- Provide anonymity
- Other services like safe keeping of security and cash management (but not liquidity)
- Support market (i.e. helps market function)
3 characteristics of liquid market
- small bid-ask spread (lets traders find capital cheaply and quickly)
- depth (market can accept large volume trades without much price impact)
- resilience (deviations from intrinsic prices are minimized quickly)
Factors necessary to have a liquid market
- Abundance of buyers and sellers
- Diverse investor base with diverse needs and information
- Convenient place to trade
- Market integrity which means all investors are treated fairly
Components of execution costs: explicit and implicit
- explicit cost
- implicit cost
- market impact cost
- delay cost
- opportunity cost
- bid-ask spread
Potential benchmarks for implicit costs
- midquote
- VWAP
- opening and closing prices
What is VWAP
Formula
Weighted average of execution prices during a day where weights are proportion of day’s trading volume (% of number of shares traded that day)
4 Advantages of VWAP
- easily understood
- computationally simple
- can be applied quickly to make trading decisions
- most appropriate for comparing small trades in nontrending markets
4 disadvantages of VWAP
- not informative for traders that dominate trading volume
- can be gamed by traders
- doesn’t evaluate delayed or unfilled orders
- doesn’t account for market movements or trade volume
5 advantages of Implementation Shortfall
- not subject to gaming by traders
- decomposes and identifies costs
- can see cost of implementing ideas
- shows trade off between quick execution and market impact
- can use to optimize trading costs and performance
2 disadvantages of Implementation Shortfall
- unfamiliar to some traders
- requires considerable data and analysis
Describe 4 components of Implementation Shortfall
Include formulas
- Explicit cost = commissions or fees
- Market impact cost = I EP - DP or BP*I x shares executed = impact on market of seeking quick execution
- Opportunity cost aka missed trade aka unrealized profit/loss = I CP - DP I x shares cancelled = change in market price on any part of order never executed
- Delay cost = I BP* - DP I x shares later executed = change in market price if order is not executed quickly on shares later executed
What is Market-adjusted implementation shortfall?
Formula
IS removed of the effect of the return on the market, i.e., post-trade IS
= IS - expected return on market
If negative, it’s a benefit to the portfolio and the shortfall is actually negative
What is an econometric model?
A model used to forecast transaction costs using market microstructure theory
Based on the Econometric model, trading costs are nonlinearly related to 5 factors:
- security’s liquidity
- risk
- trading style (more aggressive trading results in higher cost)
- size of trade relative to liquidity
- momentum (e.g. it’s more costly to buy when market is trending up)
4 types of traders based on motivation to trade, time vs price preferences and preferred order types
1 information-motivated traders (time-sensitive info, time preference, market order)
- have time sensitive information so need to trade quickly before value of info expires
- prefer quick trades and large block size with guarantee of execution, so willing to bear higher trading cost
- timing cost low but market impact cost high
2 value motivated traders (security misvaluations, price preference, limit order)
- uncovered mispricings through research and analysis
- prefer to parcel out large block trade and wait for market to come to them
- market impact cost low but timing cost high - may take a long time to execute
3 liquidity motivated traders (realloc & liquidity, market order, crossing networks and electronic communication networks)
- need to convert securities to cash or reallocate portfolio from cash
- often are counterparts to information motivated or value motivated traders
- ant to execute within a day
- timing cost low but market impact cost high
4 passive traders (realloc & liquidity, limit order, crossing networks)
- trading to convert to cash or allocate cash
- similar to liquidity motivated traders but more focused on reducing costs so can afford to be patient
5 trading tactics
- strengths
- weaknesses
- usual trade motivation
Liquidity-at-any-cost
- quick, certain execution
- high cost and leakage of information
- information
Costs-are-not-important
- quick, certain execution at market price
- loss of control of trade costs
- variety of motivations
Need-trustworthy-agent
- broker uses skill and time to obtain lower price
- higher commission and potential leakage of trade intention
- not information
Advertise-to-draw-liquidity
- market-determined price
- higher admin costs and possible front running
- not information
Low-cost-whatever-the-liquidity
- lower trading costs
- uncertain timing of trade and possibly trading into weakness
- passive and value
