2018 Study Session # 16, Reading # 31 “EXECUTION OF PORTFOLIO DECISIONS” MV = Market Value IV = Intrinsic Value TMG = Trade Management Guidelines THE CONTEXT OF TRADING: MARKET MICROSTRUCTURE Market microstructure ⇒ process that affects how trades are executed 2.1 Order Types Market Order Limit Order Requires prompt execution Price uncertainty Specific limit price for execution Execution uncertainty Additional Order Types Market-Not-Held Order Market on Open Order Variation of the market order Not held means not to trade at any specific price or time interval Executed at the opening of the market Market on close order ⇒ executed at market close Participate (don’t Initiate) Order To capture a better price, broker waits for & responds to initiate more active trades Best Effort Order Undisclosed Limit Order/Reserve/ Hidden Iceberg Order Gives the trader’s agent even more discretion to work the order Variation of a limit order Instruction not to show more than some maximum unfilled order quantity Types of Trades Principal Trades Broker commits capital for the prompt execution of the trader’s order Suitable when order size is large & more urgent Portfolio Trades Order to trade a specific basket of securities Low cost strategy on a relative basis Copyright © FinQuiz.com All rights reserved 2018 Study Session # 16, Reading # 31 2.2 Types of Markets 2.2.1 Quote-Driven (Dealer) Markets Trades are executed with a dealer Inside bid (ask) is the highest (lowest) bid (ask) Closed-book market ⇒ where limit order book is not visible to the public Dealer’s role: Ensure market continuity Immediacy or bridge liquidity Suitable in markets requiring negotiation Some measures of trade costs: Quoted bid-ask spread Effective spread Better representative of true cost because it captures both price improvement & market impact 2.2.2 Order-Driven Markets Public limit orders establish transaction prices Trade may be delayed or unexecuted (absence of a dealer) Traders can’t choose with whom they trade 2.2.3 Brokered Markets 2.2.4 Hybrid Markets Transactions take place through brokers away from public markets These markets are suitable where: Public markets are small Illiquidity Block transactions take place Combinations of the previously described market types Example ⇒ NYSE (elements of batch auction, continuous auction & quote driven markets) Types of Order-Driven Markets Electronic Crossing Networks Auction Markets Buy & sell orders are batched & crossed at a specific point in time Benefits Avoid costs of dealers Avoid market impact Prevent information leakage Anonymity Low commissions Drawbacks: Execution uncertainty No price discovery Orders of multiple buyers compete for execution Provide price discovery The problem of partial fill Batch action markets ⇒ trade occurs at a single price pre specified point in time Continuous auction markets ⇒ trades occur at any time during the day Electronic Limit-Order Markets Computer based auctions that operate continuously within the day In contrast to crossing networks these: Operate continuously Provide price discovery Like crossing networks, these: Provide anonymity Are computer based Copyright © FinQuiz.com All rights reserved 2018 Study Session # 16, Reading # 31 2.3 The Roles of Brokers and Dealers Brokers Dealers Agent of the investor who works for commission Provides following services: Represents the order Find the opposite side of trade Supply market information Provide discretion & secrecy Supporting investment services Supports the market mechanism Adversarial relationship b/w the trader & a dealer: Difference in bid-ask spread preferences Adverse selection risk ⇒ risk of trading with a more informed trader Buy side traders are often strongly influenced by sell side trade 2.4 Evaluating Market Quality Liquidity Transparency Characteristics of a liquid market: Low bid-ask spread Market depth ⇒ big trades not tend to cause large price movements Resilient market ⇒ small & quickly correctable discrepancies b/w MV & IV Factors that contribute to a liquid market: Many buyers & sellers Different types of market participants Convenience Market integrity Liquidity advantages: Less price impact Suitable for information motivated traders Easy capital raised by corporations Pre-trade transparency ⇒ quick, easy, inexpensive & accurate information about quotes & trades Post trade transparency ⇒quick & accurate details on completed trades Assurity of Completion All parties to trades will honor their commitments Clearing entities can help ensure assurity of completion Copyright © FinQuiz.com All rights reserved 2018 Study Session # 16, Reading # 31 THE COSTS OF TRADING 3.1 Transaction Cost Components Explicit Costs Implicit Costs Direct costs of trading These include commission, taxes, stamp duties & fees paid to exchanges Bid ask spread Market impact ⇒effect of the trade on transaction prices Missed trade opportunity costs ⇒arise from failure to trade in a timely manner Delay costs ⇒ inability to trade immediately due to size & liquidity Measurement of Costs Implicit costs are measured against some price benchmark: One benchmark is the time-of-trade mid quote Opening & closing prices (less satisfactory) VWAP (when price information is lacking) Most exact approach ⇒ implementation shortfall VWAP Volume weighted Average price at which the security traded during the day Advantages Disadvantages Easy to compute & understand Best for comparing smaller trades in nontrending markets Can be computed quickly Ignores slippage & missed trade opportunity costs Subject to gaming by delaying trades Can be misleading Not sensitive to trade size or market conditions Implementation Shortfall Approach Definition Advantages/Disadvantages Difference b/w money return on a paper portfolio & actual portfolio’s return Decision price is used for paper portfolio Captures explicit & implicit elements of transaction costs Four components: Explicit costs Realized profit/loss Slippage cots Missed trade opportunity costs Implementation shortfall is adjusted for market movement through market model Advantages Relate cost to the value of ideas Recognizes tradeoff b/w immediacy & price Allows attribution of costs Not subject to gaming Copyright © FinQuiz.com All rights reserved Disadvantages Require extensive data Unfamiliar evaluation framework for traders 2018 Study Session # 16, Reading # 31 3.2 Pre-trade Analysis: Econometric Models for Costs Used to build reliable pre-trade estimates According to market microstructure theory, trading costs are non-linearly related to these factors: Stock liquidity characteristics Risk Trade size relative to available liquidity Momentum Trading style Estimated cost function can be used: To assess execution quality Appropriate trade size to order TYPES OF TRADERS ANDTHEIR PREFERRED ORDER TYPES 4.1 The Types of Traders Information-Motivated Traders Act on information that has limited value if delayed Focus on liquidity & speed of execution Market orders & large block trades Value-Motivated Traders Act on value judgments based on research Price focus & infrequent trading Use limit orders Sometimes act as a dealer’s dealer Liquidity-Motivated Traders Counterparties to more knowledgeable traders Do not want to reap information advantage Time preference Use market, market not held, best efforts, participate, principal traders, portfolio trades & orders on ECNs & crossing networks Passive Traders Much more concerned with cost of trading Price preference Use limit orders, portfolio trades & crossing networks Avoid large as well as heavily concentrated orders TRADE EXECUTION DECISIONS AND TACTICS 5.1 Decisions Related to the Handling of a Trade Small, liquidity trades ⇒ executed via direct market access & algorithmic trading Large information laden trades ⇒ executed via skills of senior traders Copyright © FinQuiz.com All rights reserved 2018 Study Session # 16, Reading # 31 5.2 Objectives in Trading and Trading Tactics 5.2.1 Liquidity-at-Any-Cost Trading Focus Used by information traders who trade in large block sizes & demand immediacy Attract high commission rate brokers Use expensive methods for timely execution 5.2.3 Need-Trustworthy-Agent Trading Focus To execute large orders in thinly traded issues Use of skillful brokers by placing a best effort, market not held or participate order Trader loses control of the trade 5.2.2 Costs-Are-Not-Important Trading Market orders Ordinary spreads & commission for speed of execution 5.2.4 Advertise-to-Draw-Liquidity Trading Focus Used for IPOs, secondary offerings & sunshine traders Risk of front running Little or no market impact if sufficient number of traders 5.2.5 Low-Cost-Whatever-the-Liquidity Trading Focus Best suited for passive & value motivated investors Limit orders Traders may end up chasing the market 5.3 Automated Trading 5.3.1 The Algorithmic Revolution 5.3.2 Classification of Algorithmic &Execution Systems Logic behind algorithmic trading ⇒ break large orders into smaller orders to moderate price impact Constant monitoring required Meat-grinder effect ⇒ in order to get done, large equity orders are broken up into smaller orders Opportunistic Participation Strategies Passive trading combined with the opportunistic seizing of liquidity Trading over time Logical Participation Strategies Simple Logical Participation VWAP strategy, TWAP strategy (order in proportion to time) & % of-volume strategy Implementation Shortfall Strategies Optimal trading strategy that minimizes trading costs Specialized Strategies These are: Hunter strategies Market on close algorithms Smart routing Other specialized strategies Copyright © FinQuiz.com All rights reserved 2018 Study Session # 16, Reading # 31 5.3.3 The Reasoning behind Logical Participation Algorithmic Strategies Simple Logical Participation Strategies Breaking up the order into smaller sub-blocks yields a lower average market or price impact Implementation Shortfall Strategies To minimize market impact & missed trade opportunity costs Trade heavily early in the trading day Use an objective function that minimizes expected total cost & variance Ideal for small, highly urgent orders SERVING THE CLIENT'S INTERESTS 6.1 CFA Institute Trade Management Guidelines Guidelines define best execution as: To maximize the value of a client’s portfolio within stated objectives & constraints Four characteristics of best execution: Can’t be determined independently Can’t be known with certainty ex-ante Measured on ex-post basis Process, not an outcome TMG are divided into the three areas: Processes Disclosures Record keeping 6.2 The Importance of an Ethical Focus Over time markets become adversarial& implicit costs Interest of clients must be honored & fiduciary duties must be met appropriately by traders Copyright © FinQuiz.com All rights reserved ... 2018 Study Session # 16, Reading # 31 5.2 Objectives in Trading and Trading Tactics 5.2.1 Liquidity-at-Any-Cost Trading Focus Used by information traders who trade in large block sizes & demand... Copyright © FinQuiz. com All rights reserved 2018 Study Session # 16, Reading # 31 THE COSTS OF TRADING 3. 1 Transaction Cost Components Explicit Costs Implicit Costs Direct costs of trading These... continuously Provide price discovery Like crossing networks, these: Provide anonymity Are computer based Copyright © FinQuiz. com All rights reserved 2018 Study Session # 16, Reading # 31 2 .3 The Roles