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Trading Truths

Trading Truths

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Published by Wayne H Wagner

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Published by: Wayne H Wagner on May 05, 2009
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09/29/2010

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plexusry
BuildingBetlerPerf otmdnGeCOMMENTARY
80
APRIL
2OO4
TRADING
TRUTHS
How Mis-Measurement
of
Trading Costs
ls
Leading
lnvestors
Astray
Some
recentlypublisheddata argues
that
large capstocks
are
more expensiveto
trade
on theNYSE
than small caps.
In
this
Commentary,
we debunkthat theory
by
demonstratingthat
this
conclusion
results
from incomplete
data and
faulty
logic.
We also
show
that:
.
lmplementation costs aremuch
higher
thanthose reported
using
VWAP
measures;
.
So-called
"pennying"
only
accounts
for a
small
fraction
of
the cost
of
trading,
and
.
Damning
the
specialist-" and
floorbrckers
ie
nn!an appropriate nor
desen.,edresponse.
A
recent
maqazine
article'
states
in the
sub-title
that
'Bluechipsnowcostmore
to
tradeon
the
Big Board
than
small caps
do."
lt
goeson
to
state"Thehighercostof
tradinggiant-capstocks
at the
NYSE, compared
with
smaller
names, runs counter to
the
conventionalwisdom
thatlarge, actively traded stocks have
lower transactioncosts
than
smaller,
less
liquidones."
The author
provides
a
table,
(portions
of
which
are
reproduced
on thefollowing
page),
that shows
"Micro
Cap"
stocks
of
less than$250million
capitalizationcosting
0.5
cents
De.:r
shareon
the
NYSE
whi!a
"Giant
Cap"stocks
with
capitalizationsin excess
of
$25
billion
cost
1
.9
cents
per
sha,re The arliclegetsfairly breathless
about
how
'iransactioncosts
on theBig
Board
are
actually higher
for
big, actively tradedstocksthan
theyare
for small,
lightly
traded
stocks."
The
article
attributes
this
phenomenon
in
part
to
pennying;
....
NYSE
specialists' and
floor
brokersputative practice
of
bidding
a
stockup or
down
by
one
centand
trading
for
their own
accounts ahead
of
investors."
The author recognizes that the finding"runscounter
to
the
conventional wisdom
that
large, actively
traded
stockshave lowertransaction
costs."
Indeed,
it
is
counterintuitive; fortunately, the
finding
is
false.
And
it
is
dangerous:
it
may lead
to
mis-identification
of
themagnitude,
source and
relevance
of
transaction
costsand
thus
contribute
to
inferior
oerformance.We
will develop three important
points:
1.
Usingpennies pershare as
the
metric ignores thefact
thatsmall cap stockstrade
at
lower
prices
than
large
cap
stocks.
When expressed
in
economicterms
aspercentageofprincipal,thiskey finding
is
simply false:
liquid, large cap stocks
trade at
no
higher
impact
cost than
smaller
stocks.2.
f
he
actual costsof
implementing
investment
ideas
is in
factsignificantlyhigher thanthe
figuresnrrnted
hcre
Indced
thc
differences orrotedhere
are
vvrvv
trivial, while true implementationcosts are
egregiousand muchlarqer
than
canbeseen through
the
narrow
perspective
of
the
VolumeWeighted Average
Price(VWAP)comparison.
3.The
damning
of
specialistsand
floor
brokers
on
the
basis
of
thrs evidenceis
faulty
logic based
on
faulty
measurement.
Measu
ring Economic
Costs
Cents
per
share sounds
like a
simplemetric,
but it only
works
if
the share
prices
are
reasonably
similar.
For
example,
a
dime
cost
on a
$100
stock
is
0.1oh;
on
a
$10stock,
it
represents
1.0%--
a
big difference.
l
Schack,
Justin:
"TradingPlaces;"
Institutional
Investor Magazine,November
2003.
Po
B1-85.
 
The
share
price
for
NYSElistedstocks withcapitalizationlessthan$250million
is
about$7;forstocks in excess
of
$25
billion
the
averageprice
is
around
$35.
The
tablebelowadjusts
VWAP
impact
differences
in
stockprice.
lt
showstheexpected relationship:large,liquidstocks
aretraded
with
lessimpactthansmaller capitalizationstocks.
Thepicturehere
is
one of
impact
as a
percentof traded
dollarsrising
as
marketcap
falls.
Showing costs as
a
percent
of
principal
tradedshows
the
expected
relationship,even though
the
impactin centsper
sharedeclines.
The last
columnprovides
a
partial
explanation
of
tradesize
effects:
the
average
trade
in
the
largest cap
groupisalmost
19
times thedollar
size
in
the
Microcap
group.
Other
things
being equal,
weexpect
large
trades
to
cost
more
than
small
trades.
Things
are not
equal,
however,
since
large cap stocks
are
far
more
liquid
and
therefore
easier
to
trade.
Thus
the
interplayof trade size and
available
li^!i/.,1;+..,
/.r^+^-q;h^.,r.a
+r2^llro
.-.ncinl*eTencesi-liquidity
are
ignored
by the
VWAP
benchmark,
whichuses
thesame benchmark
irresoectiveof
trade
size.
The
RealCosfs
ofImplementing
lnvestment
Needs
andldeas
So
far we've
identified
cents
oer
share
measurement
as
leading
to
erroneous conclusionsbetween large cap
and
smallcap
stocks.
But
there are hidden costs of
tradingbeyond
the
impact.First
there'sthe
commission.
The
followingtable
shows
NYSEcommission
costsby
capitalization
group.
The
cents
persharecommissions are
fairly
steady.
Showing
the
cost
in
basispointshighlights
the
higher commissioncosts of
trading
lowerpricedstocks.
VWAPdefinesimpact
as
the
differencebetween
the
averageprice
in
thetrade
being executedand
the
averageprice
in
the
marketduringthe
day.
Noiethet
tho
VWAP impacts
in
theabovetable
do
not
net
tozero,
as
they would
be
if
the
game
wereone
that
pitted
institutionalbuyersagainstinstitutionalsellers.
Theinvestors
mustbe
losing
to
someone
else,
specifically
market
makers
and
speculators.Specialists,
market
makers,hedgefunds,day traders,speculators, etc.enter
the
marketopportunisticallysolely
to
garnershort
term
trading
profits.
In
the
process
they
provideliquidity
to
investors.
Institutional
tradersenter
the
market
to
implement
investment
decisions.Theycannot
be
opportunistictraders;they
have
an
agenda,
a
blotterof specific trades
to
complete.
Therefore
investorspayspeculators for the
provision
of
liquidity,leading
to
frictional
costs
in
therangeof
fivecentsper
hundreddollars
traded(5
bp.)
A
moreinclusive
alternative
to
the VWAPmeasure
is
called lmplementation
Shortfall.
lt
measures
the
change
in
price
fromthe starting
gate,
where
the
trader
receives
the
orcier,
to
ihe
finishiine
vyhen
tne eniifeiraoe
is
completed.lt
answers
thequestion:
How much
of
the
potentialreturn
did
I loseto
the cost of
implementingthetrades?
Thecosts below show figuresfor
all
buy and
sell trades
for
a
sample
of
89
investmentmanagersduring
thesecondquarter
of 2003.Giant
cap
($25B+)Large
cap
($SA
-$258)
Midcap($1B
-
$5B)Small
cap
($250M -
$18
Microcao
$250M or
less
12
15
2028
47
4.3+.2
A4-.
1
4.0
3.4
Another
hidden cost
of
trading
is
the cost
of
searching for
liquidity.
Liquiditysearch costs
are
real; they eat into the
research
advantage
for
stock
purchases,
andthey
cost
real
dollars
on
security
sales
when
orices
decline
before
finding
the
liquidity
to
comolete
the
trade.They occur
because
institutional
ordersVWAPlmpact
Measures
VWAP
lmpactPrice/shr
VWAP
lmpact
cap
f/shr
($)
(basis
points)Giant
cap
($2SA+;Large
cap
($se
-
$258)Midcap
($1B
-$58)Smallcap
($2SOw
-
$ta)
Microcap$250M
or
less
1A
t.o
t.J
u.o0.535
ZY
20
14
665.8
6.54.2
6.9
I
mplementation
Shortfall
lmpact
MeasureslmplShortlmpact:
Price/shr
.
lmplShortlmpact:Trade
Size:
cap
d/shr
($)
(basis
points)($thou;Giant
cap
($25B+)Large
cap
($5B-$25B)
Midcap($18
-$5B)
Small cap
($ZSOtttt
-
$1B)Microcap
$250M or
less
6.U
5.95.2
4.42.6
35
29
20
14
7
474
21.427.531.035.4
2,286
1,448744
119

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