1R. Almgren,‘Optimalexecution withnonlinear impactfunctions andtrading-enhancedrisk, AppliedMathematicalFinance 10’(2003), 1-18.2R. Almgren and N.Chriss, ‘Optimalexecution of portfoliotransactions’, J.Risk 3 (Winter2000/2001) 5-39.3A. Freyre-Sanders,R. Guobuzaite, K.Byrne, ‘A reviewof trading costmodels: reducingtransaction costs, J. Investing’(Fall2004), 93-115.
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Chapter 10Emerging trends and future direction
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ALGORITHMICTRADING
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ABUY
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SIDEHANDBOOK
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THETRADE
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Efficient trading frontier –single stock
The breakthrough paper ‘Optimalexecution ofportfolio transactions’by Robert Almgren and Neil Chriss
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quantifies the relationship betweentwo important components oftrad-ing costs – market impact and tim-ing risk.Any attempt to devise astrategy with low timing risk leadsto aggressive trading and aninevitable increase in market impactcosts.Conversely,the decision tominimise market impact necessi-tates passive trading,and a highdegree oftiming risk.These ideas become easier tograsp ifa simple example is used toillustrate the concepts.Consider asell order of78,000 shares ofXYZ tobe completed by the end ofthe day.The difficulty ofthis trade dependson the expected trading volume forXYZ.As a proxy for expected vol-ume,it is common to use a 20-day average daily volume (ADV).IfADVis 650,000 shares then the positionconstitutes 12% ofthe ADV.Clearly,there are many ways tocomplete this trade within a day.One possibility is to use a VWAPstrategy.Ideally,this approach willmaintain a steady participationrate of12% throughout the day.There are,however,severalassumptions which need to be sat-isfied for a smooth execution:(a)650,000 shares ofXYZ is an accu-rate volume forecast;(b) the intra-day volume distribution (U-curve)is consistent with the historic aver-ages;and (c) the trading strategy isable to maintain the indicated par-ticipation rate at all times.The market reality may invali-date these assumptions.For exam-ple,U-curves can be quite unpre-dictable,and on any given day may vary from historic averages.Forsimplicity,assume XYZ has a per-fectly flat intra-day volume profile– with 50,000 shares traded in each30-minute bin (in the UnitedStates the stock markets are openfor six and a halfhours,from 9:30to 16:00,giving thirteen 30-minbins).In this simplified example,maintaining a steady 12% partici-pation rate by trading 6,000 sharesper bin completes the order.In this example the trading ispassive,thus minimising tempo-rary market impact oftrades.Market impact in general is very difficult to measure or estimate (cf.
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).The existing pre-trade analysistools (TIE™ from Miletus Trading)apply advanced statistical tech-niques to large trade databases inorder to estimate market impactfor any pre-selected executionstrategy.In this example,a pre-trade engine may produce a marketimpact estimate of30 bps.Any other trading strategy is likely tolead to a higher impact estimate.On the other hand,for VWAPexecution the timing risk is relative-
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