L3 - Trade Strategy and Execution

What are the four most commong motivations to trade?

Profit seeking, risk management, cash flow needs, corporate action

what are features of transparent, illuminated or lit markets?

they report pre and post trade price, volume and depth

what are features of dark pools?

they only provide post trade data

what are some common cash flow needs for which trading is required?

pursue other opportunities, meet margin requirements, invest and distribute client funds, or for other operational needs

why can a manager use an ETF when receiving or distributing cash?

to equitize uninvested cash in a rising market until the manager can trade the underlying or until the next rebalance in order to minimize underperformance due to cash drag

what is alpha decay and what does it determine?

the decrease in potential alpha after making an investment decision and determines the trade urgency

what are value strategies and what is their trade urgency?

they involve undervalued companies regaining a position or improvement based on slower-developing factors that drive earnings. Such strategies may take months or years to mature, result in less short-term trading, and have less trade urgency

what are three considerations in trading the underlying or a derivative?

the mandate, risks being hedged or managed, security liquidity

how can PMs adjust a volatility target to a mandate?

take a position in volatility futures

what is a long straddle?

long in both call and put with same strike and underlying to profit from higher volatility

how does trading relate to portfolio risk and leverage?

as portfolio risk and leverage are higher, trading increases. Trading must be quick and frequent

On which measure are investor redemptions in mutual funds based and how can they deal with such requests?

on net asset value (NAV) at the close of the day the request is made, if requested before the market close. Mutual funds may then sell derivatives at the market close to fund the redemption request, thereby avoiding a mismatch between the value delivered in redemption and the value securities can be sold for when the fund trades the redemption value of securities

Why would a manager raise cash from derivatives instead of selling the underlying?

this may allow the manager to trade securities that capture optimal cost and risk/return considerations. These costs could relate to illiquidity, opportunity costs and tax impacts, as well as other costs of trade

how can PMs trade index reconstituents to minimize TE?

funds may trade the necessary securities at closing NAV on the day announced to minimize tracking error. This generally results in significant market impact costs.

why does a margin call inspire high trade urgency?

Funds may initially need to trade into government bonds to use as collateral for derivatives positions.

Covering a subsequent margin call will inspire high trade urgency as the manager either adjusts the

position or provides the additional margin

what are the two key factors for trading strategies?

order side and order size

explain order side as a key factor in trading

Execution times may be lengthened for buyers (sellers) if rising prices result in longer execution times and negative market impacts as they wait for sellers (buyers). A list of buys and sells may have a mismatch and require more time to sell on one side or another.

explain order size as a key factor in trading

Market impact describes adverse price movements that result from trading an order; larger orders often result in greater market impact due to supply/demand imbalances. To reduce market impact, traders will attempt to trade with less urgency. Market impact costs tend to rise as relative order size, % of average daily volume (%ADV), increases. Managers may also limit order size relative to %ADV for that security

what is short term or trade alpha?

st alpha represents investment price movement over the period between the investment decision and trade execution. Alpha decay is erosion of short-term alpha until the trade is executed or abandoned. The rate of alpha decay also affects trading urgency.

what is execution risk in trading?

the risk of not being able to execute a trade at the desired price, due to price volatility, which may be caused by changes in perceived value or by the market impact of trades

what is security liquidity in trading?

the speed of execution and degree of price impacts. Greater liquidity lowers execution risk and market impact of trades

what are bid ask spreads and what do they indicate?

b-a spreads describe round-trip costs for trades of a maximum quantity indicated, therefore indicating market depth—the quantity of a security that can be traded at any time—and trading costs. Market depth informs whether and how a trade must be divided into smaller orders

when does market liquidity become constrained and what is the impact on trading costs?

Market liquidity can become constrained when all participants attempt to sell at the same time and correlation increases between all securities except safe havens. Decreasing liquidity in turn increases market impact, which, along with greater trading during the crisis, increases trading costs.

what is the distiction between short term and long term market impact?

Portfolio managers should be aware that trading costs are a short-term component of market impact, while the information content of the trade often leads to long-term or permanent market impact. Security prices tend to increase with excess demand and fall with excess supply. Market participants will follow the direction of the imbalance when they learn the information, especially when the information comes via trades from an astute individual or institution.

describe the dilemma between execution risk and alpha decay?

Greater trading urgency decreases execution risk and alpha decay, whereas less trading urgency—slicing an order into smaller orders and more patiently executing it—decreases market impact but increases the risk of alpha decay. In other words: “Trading too fast increases market risk, but trading too slowly increases execution risk.

what are reference prices?

Reference prices refer to specified prices, price targets, or price-based calculations used as a benchmark that the portfolio manager can use to strategically minimize costs or optimize client outcomes.

what are the four benchmark classification for benchmark prices?

pre-trade, intraday, post-trade, and price target benchmarks

describe pre trade benchmarks

Pre-trade benchmarks include:

Decision price: The price at which the manager decides to trade (buy/sell); may be the previous open or close if the manager has no record of the decision price, which is often the case in quantitative approaches.

Previous close: A security’s closing price on the day before the trade.

Opening price: A security’s opening price on the day of the trade.

Arrival price: A security’s price when a trade arrives in the market; managers basing a trade on mispricing (i.e., alpha trade) or attempting to minimize trading costs often specify the arrival price as a pre-trade benchmark.

describe intraday benchmarks

Volume-weighted average price (VWAP): Managers with both buy and sell orders may specify VWAP as a benchmark in order to trade with market order flow. Managers may use VWAP to ensure they have cash from sell orders to fund purchases.

Time-weighted average price (TWAP): Managers use TWAP when they do not wish to participate during price spikes (e.g., opening or closing prices). TWAP helps evaluate performance against reasonable trading prices rather than volume spikes.

describe post trade benchmarks

Post-trade benchmarks include the closing price, commonly used when managers want to minimize tracking error with a benchmark price, which is usually marked at the end of the trading day. Managers using this approach, however, do not know how they are doing relative to the benchmark until the market closes.

describe price target benchmarks

Price target benchmarks are likely to be used by portfolio managers seeking alpha, who usually use the price perceived as fair value. The manager purchases as many shares as possible below the target price.

describe the short term alpha trading strategy

A high-urgency trade typically designed to capture gains due to mispricing. Less obvious mispricing leading to less urgent trading benefits will offset the possible market price risk. This approach leads to higher market impact costs in illiquid markets

describe the long term alpha trading strategy

Alpha decay is expected to take a long time. Less urgent trading benefits will offset the possible market price risk. This approach leads to lower market impact costs in illiquid markets.

describe the risk rebalance trading strategy

May be used when the fund’s actual risk becomes higher/lower than the target risk. Trades with balanced or hedged risk exposure will tend to have lower trade urgency than trades that have direct market exposure.

describe a cashflow driven client redemption trade

A portfolio manager may decide to redeem assets as a certain percentage across all holdings on close of business day. In this case, the client receives the fund NAV regardless of trade execution success. A closing price reference is appropriate in this situation because the trader bears the risk of executing at lower-than-closing price.

describe a cashflow driven new mandate trade

he portfolio manager receiving a large new mandate who does not wish the initial orders to have adverse market impact may establish a comparable position using appropriate futures trades (equitizing the cash) and replace them with the underlying securities over time. Funds not allowed to use derivatives may choose to use an ETF to equitize a new cash position.

describe order driven markets

Many orders in a liquid market may be transacted on automated execution menus with varying levels of transparency or through a dealer network that establishes a bid price to buy and an offer price to sell. Such order-driven markets may be run by exchanges, brokers, and alternative trading systems that cross- trade and provide rules-based matching

describe request for quote markets

dealers and market makers provide quotes upon request rather than continuously

describe agency trades

a portfolio manager engages an “agent” to find the other side of a trade but retains risks associated with the trade

describe principal trades or broker risk trades

market makers and dealers buy or sell securities in their own portfolios to absorb temporary supply or demand imbalances. In some cases, this may simply mean a cross-trade within their own book. If not, they may have to disclose themselves to their clients’ counterparties and find the best price execution.

describe the percentage of volume scheduled algorithm and describe advantages and disadvantages

Percentage of volume (POV) algorithms use a manager-specified percentage of volume currently traded to place an order. For example, a 10% POV would buy or sell up to only 10% of current book orders. The number of shares traded increases or decreases with the market volume, although the percentage traded remains constant. While this has the advantage of trading into liquidity, it also can incur high trading costs by continuing to buy/sell as prices increase/decrease. POV algorithms may also fail to complete an order if market liquidity diminishes.

describe the VWAP scheduled algorithm

VWAP uses historical intraday volume to slice an order into amounts less likely to incur negative market impact. For example, larger purchases and sales would be completed during times of day when more trading occurs (e.g., open or close) and fewer units are transacted when less liquidity is likely to occur.

describe the TWAP scheduled algorithm

TWAP sends an equal percentage of the order at different times throughout the day in order to minimize market impact.

when are scheduled algorithms appropriate?

Scheduled execution algorithms are appropriate when portfolio managers do not expect adverse market moves or quickly decaying alpha, and therefore have less urgency. They are also used by managers with greater risk tolerance who are more concerned with minimizing market impact. In addition to being appropriate for relatively small trades or relatively liquid securities, these algorithms are also appropriate when trading orders at a similar pace will maintain a risk-balanced basket of securities.

describe liquidity seeking algorithms and when are they appropriate

Liquidity-seeking algorithms, also called opportunistic algorithms, seek high-liquidity markets with a favorable price. These algorithms may use a process called “liquidity sweeping” or “sweeping the book” which crosses venues, including the use of dark pools, to execute the trade at minimum cost. These algorithms typically make greater use of market orders than limit orders in order to assure execution and not end up over-buying or selling. They run the risk of incomplete execution. These algorithms are appropriate for large orders when the portfolio manager wishes to avoid market price impact—especially as the result of information leakage—or when liquidity is low or episodic

what is arrival price execution

Arrival price execution strategies front-load to ensure trading as close as possible to market prices at order arrival. These algorithms are typically time-based but may also be volume-based and are typically used for orders constituting less than 15% of market volume.

when are dark strategies/liquidity aggregators strategies used?

These strategies transact in dark pools and away from “lit” venues with pre- and post-trade transparency.

These strategies are used when %ADV would be high and using arrival price or scheduled execution could have considerable market impact. They are appropriate for securities trading with wide bid–ask spreads or low liquidity, for low-urgency trades, or when the manager can accept greater execution risk

what are smart order routers and when are they best appropriate?

For market orders, smart order routers (SORs) find the best market price (i.e., national best bid and offer, or NBBO, in the United States). Market order SORs are appropriate when the market moves quickly, the manager is concerned about execution risk, or when the order is relatively small and will have little market impact (e.g., when the order is less than the best bid or offer)

what is an alternative trading system (ATS)

Alternative trading systems (ATS) may operate as a broker-dealer or may in some cases apply with regulatory authorities to become an exchange

distinguish systematic internalizers versus multi-lateral factilities in ats

Globally, there are many dark pools/ATS. In Europe, these are known as systematic internalizers (SI) and multi-lateral trading facilities (MTF). SI typically involve a single dealer; MTF involve multiple investment firms or market operators that bring together multiple market participants. Trading book data, where allowed by the ATS, may be expensive or restricted to certain market participants.

what are two features that make fixed income markets different from equity markets?

Fixed-income markets vary by the availability of information and its availability to market participants.

which part of the fixed income market is traded algorithmatically?

Only on-the-run Treasury securities, and bond and interest rate futures

describe some aspects of the ETF trading market

large, very liquid market with high market transparency. most of the trading volume and most algorithmix trading occur in futures.

describe some aspects of OTC trading markets

largely opaque. Regulatory authorities in some countries increase pressure to make the markets report data to the public.

describe some aspects of the foreign exchange currency markets

almost entirely OTC, with very little regulation across countries; trading takes place across many electronic and broker markets. international banks and large financials make up the interbank market, first tier. Smaller banks and institutions is second tier. Commercial companies and retail is third tier.

what is the trade horizon?

the period from the portfolio manager’s investment decision to the trader’s completion of the trade

what are trade costs?

Trade costs represent the value paid by buyers or sellers but not received by the counterparty. Trade costs for buyers are the price paid above the decision price and for sellers are the price received below the decision price

what is implementation shortfall?

Implementation shortfall (IS) measures the total cost of executing the trade in excess of the decision price; that is, the manager’s paper return less the actual return.

describe the parts of the implementation shortfall formula?

The first two terms are the execution costs and the second two terms are the opportunity costs. Execution cost relates to shares transacted in the market and corresponds to price drift from buying (which can increase the market price) or selling (which can decrease the market price). Opportunity cost relates either to unexecuted shares and adverse movement that prevent executing the entire order or to general market illiquidity. Opportunity cost helps managers understand what would have happened had they been able to fully implement their idea.

what are delay costs?

Delay cost results from price movement allowed by a lag that arises when the order is not delivered in a timely manner; a lag that often results from not selecting which broker or algorithm to use. Brokers can reduce delay cost by having better performance procedures in place. Delay costs increase as expected alpha or market movement increases; that is, a lower decision price relative to potential gain or fast adverse market movements cause a higher delay cost.

Distinguish positive and negative values in trade costs

For trade cost calculations, positive values indicate additional cost and underperformance relative to the benchmark. Negative values indicate a savings and outperformance relative to the benchmark

why could one use market adjusted price in trade cost analysis?

market-adjusted price may be used to separate market movement effects the trader has little control over from market impact that could have been controlled

How to determine the added value of a trade in terms of trading costs?

Expected trading costs are formed using a pre-trade model that includes order size, volatility, market liquidity, investor risk aversion, urgency level, and underlying market conditions. Subtracting this expectation from actual arrival cost determines the added value from the trade.

what are the four factors to consider in a trade policy?

Factors to consider in a trade policy include:

Best execution: This is typically described in the applicable regulatory framework but may involve achieving the best outcome given competing objectives rather than as the best execution price at the lowest cost.

Optimal execution approach: This can depend on the manager’s investment process, asset class, liquidity, and market type.

Eligible brokers and venues: Due diligence should ensure that portfolio managers and traders use reputable brokers and venues to ensure reliable, efficient order execution. Venues should provide simultaneous quotes for price discovery and market transparency in order to provide best execution.

Monitoring: This is done to continually ensure that current arrangements meet or are expected to exceed requirements.

what should best execution include from a governance perspective?

best execution should consider cost, speed, likelihood of execution, likelihood of settlement, and any other relevant factors. MiFID II in Europe prohibits combining the cost of broker-provided research with trading commissions (soft dollar arrangements), so such arrangements should not be part of trading costs. MiFID II in Europe requires investment managers to pay for broker research costs or levy a special charge to clients for a research payment account