Execution of Portfolio Decisions

4.1. The Types of Traders • Passive traders

, acting on behalf of passive or index fund portfolio managers, similarly seek liquidity in their rebalancing transactions, but they are much more concerned with the cost of trading. They tend to use time-insensitive techniques in the hope of exchanging a lack of urgency for lower-cost execution. Passive traders have the flexibility to use lower-cost trading techniques. Because of the types of orders and markets they use, these traders resemble dealers in the sense that they allow the opposing party to determine the timing of the trade in exchange for determining the acceptable trade price.

The following describe special types of trades: • Principal trade.

A principal trade is a trade with a broker in which the broker commits capital to facilitate the prompt execution of the trader's order to buy or sell. Principal trades are used most frequently when the order is larger and/or more urgent than can be accommodated within the normal ebb and flow of exchange trading. A price concession provides an incentive for the broker acting as a principal in the trade.

Example of effective spread

A trader wants to buy 500 shares with minimal delay enters and it enters a market order for 500 shares.

2.4. Evaluating Market Quality Markets are organized to provide: 1. Liquidity 2. Transparency 3. Assurity of completion (x)

ASSURITY OF COMPLETION depends on assurity of the contract (the parties to trades are held to fulfilling their obligations). To ensure the certainty of trade completion, participating brokers or clearing entities may guarantee the trade to both buyer and seller and be subject to standards of financial strength to ensure that the guarantee has "BITE."

5.2.4. Advertise-to-Draw-Liquidity Trading Focus

Advertising is an explicit liquidity-enhancing technique used with initial public offerings (IPOs), secondary offerings, and sunshine trades, which publicly display the trading interest in advance of the actual order. If publicity attracts enough traders taking the opposite side, the trade may execute with little or no market impact. Implied in agency orders is an authorization to do some low-level advertising on the exchange floor. Advertising lets the market know that a willing buyer or seller is around. That presence may draw out the other side of the trade. However, such an order may also bear the risk of trading in front of the order. For example, if a large block purchase order is announced, traders may take long positions in the security in the hope of realizing a profit by selling the stock at a higher price.

Opportunistic Participation Strategies

Also involve trading over time. Involves PASSIVE trading combined with the opportunistic seizing of liquidity. The most common examples are PEGGING and DISCRETION strategies, in which the trader who wishes to buy posts a bid, hoping others will sell to him or her, yielding negative implicit trading costs. If the bid-offer spread is sufficiently small, however, the trader might buy at the ask. This strategy typically involves using reserve or hidden orders and crossing (internally or externally) to provide additional sources of liquidity at low cost. Because trading is opportunistic, the liquidity strategy is NOT A TRUE participation strategy.

Example continued

As the order is received in the system at 10:03:18, a DEALER in the issue enters a quote of $19.96 bid (bid size: 100 shares) and $20.01 ask (ask size: 500 shares) to improve on ("step in front of") the prior best ask price of $20.03 and take the incoming market order.

Simple Logical Participation Strategies Volume-weighted average price (VWAP) strategy

Breaking up an order over time according to a pre-specified volume profile. The objective of this volume-weighted average price (VWAP) strategy is to match or improve upon the VWAP for the day. The trader attempts to match the expected volume pattern in the stock, typically over the whole day. Forecasts of the volume pattern are generally based on historical data (e.g., 21-day stock-specific or industry averages); increasingly, these forecasts are based on forward-looking volume predictors. Since the actual volume for the day is unknown before the end of the day, however, dynamic predictors are quite VOLATILE.

5.2.3. Need-Trustworthy-Agent Trading Focus

Buy-side traders often need to execute larger orders than the exchange can accommodate at any given moment, particularly when dealing with thinly traded issues. They recognize that their orders may create adverse impact if they are not handled carefully. Accordingly, these traders engage the services of a carefully selected floor broker to skillfully "work" such orders by placing a best efforts, market-not-held, or participate order. The advantage of these trades is that they match trading desires to interest in taking the other side of the trade as such interest is uncovered or arrives in the market. Orders are usually completed through a series of partial trades. Obviously, immediate execution is not of primary importance, so such orders are less useful for information-motivated traders. These orders are the epitome of the agency relationship. The trader passes control of the order to the broker, who then controls when and at what price the orders execute. The trader frequently does not know how much of an order was cleared until after the market closes. The agent, however, may serve multiple masters, including other clients and even the agent's own brokerage firm. The valuable information that a buyer or seller exists is revealed to the broker. It is difficult for the trader to know whether that information is used exclusively in the trader's best interests.

2.1. Order Types Limit Order Emphasis

By specifying the least favorable price at which an order can execute, A LIMIT ORDER emphasizes PRICE. However, limit orders can execute only when the market price reaches the limit price specified by the limit order. The timing of the execution, or even whether the execution happens at all, is determined by the ebb and flow of the market. Limit orders thus have EXECUTION UNCERTAINTY.

4.2. Traders' Selection of Order Types 4.2.1. Information-Motivated Traders

Information traders believe that they need to trade immediately and often trade large quantities in specific names. Demands for high liquidity on short notice may overwhelm the ready supply of stock in the market, triggering adverse price movements as the effect of these demands reverberates through the market. Information traders may use fast action principal trades. By transacting with a dealer, the buy-side trader quickly secures execution at a guaranteed price. The major cost of these trades arises because the dealer demands a price concession to cover the inventory risks undertaken. Furthermore, information-motivated traders fear that the price may move quickly to embed the information, devaluing their information edge. They are aware that their trading often moves the market, but they believe their information justifies the increased trading cost. Accordingly, information-motivated traders may wish to disguise their anxious trading need. Where possible, they use less obvious orders, such as market orders, to disguise their trading intentions. This behavior has led information traders to be called "wolves in sheep's clothing."

Example: Exhibit The BIDS and ASKS are ordered from BEST to WORST and time-stamped. These are actually LIMIT ORDERS because the prices at which the dealers are ready to trade are specified. Because Exhibit 1 lists limit orders, it is called a LIMIT ORDER BOOK.

Dealer A is quoting the INSIDE BID, or MARKET BID, which is the highest and best bid, at 98.85 Dealer C is quoting the INSIDE ASK, or MARKET ASK, which is the lowest ask, at 100.49. The inside quote, or market quote, is therefore 98.85 Bid, 100.49 Ask.

TYPES of order-driven markets are distinguished: 1. Electronic Crossing Networks 2. Auction Markets 3. Automated Auctions (Electronic Limit-Order Markets)

Electronic crossing networks are markets in which buy and sell orders are batched (accumulated) and CROSSED at a SPECIFIC POINT IN TIME, usually in an anonymous fashion. Crossing networks serve MAINLY INSTITUTIONAL INVESTORS. In using crossing networks, both buyer and seller: 1. AVOID THE COSTS OF DEALER SERVICES (the bid-ask spread), 2. AVOID the EFFECTS A LARGE ORDER can have on execution prices, and 3. AVOID INFORMATION LEAKAGE. COMMISSIONS are paid to the crossing network but are typically LOW. Participants CANNOT BE GUARANTEED THAT THEIR TRADES WILL FIND AN OPPOSING MATCH. *None of the participants observes the IDENTITIES or original submission SIZES of the others in the match pool. Crossing networks provide NO PRICE DISCOVERY.

2.1. Order Types Market Order Example

For example, an order to BUY 10,000 shares of BP p.l.c. directed to the London Stock Exchange (LSE) would execute at the best price available when the order reached that market. Suppose that when the order reaches the LSE, the lowest price at which a seller is ready to sell BP shares is 642p (pence) in quantity up to 8,000 shares (for a buyer, the lower the price, the better). The second-lowest price is 643p in quantity up to 6,000 shares. Thus, 8,000 shares of the market order would be filled (executed) at 642p and the balance of 10,000 - 8,000 = 2,000 shares would fill at 643p.

3.2. Pretrade Analysis: Econometric Models for Costs

Given post-trade shortfall estimates, we can build reliable pretrade estimates using econometric models. . trading costs are systematically related to certain factors, including the following: • stock liquidity characteristics (e.g., market capitalization, price level, trading frequency, volume, index Membership, bid-ask spread); • risk (e.g., the volatility of the stock's returns); • trade size relative to available liquidity (e.g., order size divided by average daily volume); • momentum (e.g., it is more costly to buy in an up market than in a down market); • trading style (e.g., more aggressive styles using market orders should be associated with higher costs than more passive styles using limit orders).

2.2.4. Hybrid Markets

Hybrid markets are combinations of the previously described market types. i.e New York Stock Exchange (NYSE), Offers elements of BATCH AUCTION MARKETS (e.g., the opening) and CONTINUOUS AUCTION MARKETS (intraday trading), as well as QUOTE-DRIVEN MARKETS (the important role of NYSE dealers, who are known as SPECIALISTS).

Implementation Shortfall Explicit Costs

Implementation shortfall can be analyzed into four components: 1. Explicit costs, including commissions, taxes, and fees.

4. Types of Traders and Their Preferred Order Types

Implementation strategy and cost are direct consequences of INVESTMENT MANAGEMENT STYLE. Some investment strategies are inherently inexpensive to implement—for example, CONTRARIAN, PASSIVE, and other "SLOW IDEA" strategies. Other strategies, particularly those based on stock price momentum or widely disseminated "NEWS," are inherently more expensive to implement. The keystone of the buy-side trader's choice of trading strategy is the urgency of the trade (the importance of certainty of execution).

2.3. The Roles of Brokers and Dealers Dealer

In contrast to the agency relationship of the broker with the trader, the relationship between the trader and a dealer is essentially adversarial. The dealer wants to sell merchandise at a higher price (the ask) than the purchase price (the bid). Adverse selection risk (the risk of trading with a more informed trader).

5.3. Automated Trading

Indeed, one of the more important implications of the growth of automated venues is the rapid expansion in algorithmic trading. Algorithmic trading refers to automated electronic trading subject to quantitative rules and user-specified benchmarks and constraints. Related, but distinct, trading strategies include using PORTFOLIOS TRADES, in which the trader simultaneously executes a set of trades in a basket of stocks, and SMART ROUTING, whereby algorithms are used to intelligently route an order to the most liquid venue. The term automated trading is the most generic, referring to any form of trading that is not manual, including trading based on algorithms.

Example:

Order to buy 1,000 shares of ECSI in a dealer market, and that 3 dealers (A, B, & C) make a market in those shares. Three DEALERS have put in the following quotes: A: bid: 98.85 for 600 shrs; ask: 100.51 for 1,000 shrs B: bid: 98.84 for 500 shrs; ask: 100.55 for 500 shrs C: bid: 98.82 for 700 shrs; ask: 100.49 for 800 shrs Thus, the bid-ask spreads of Dealers A, B, and C are, respectively, • 100.51 - 98.85 = 1.66 • 100.55 - 98.84 = 1.71 • 100.49 - 98.82 = 1.67

Specialized Strategies

Other strategies include: PASSIVE ORDER STRATEGIES: Do not necessarily guarantee execution; "HUNTER" strategies: opportunistically seek liquidity when it is offered; and more specialized strategies that target particular benchmarks. Market-on-close algorithms that target the closing price are an example of this last category. Smart routing, in which algorithms are used to intelligently route an order to the most liquid venue, can be viewed as a specialized form of algorithmic trading.

Other types of traders:

Other types of traders do not fit exactly into the above categories. Dealers, whose profits depend on earning bid-ask spreads, have short trading time horizons like information-motivated traders. Given that a transaction is profitable, however, they have no specific emphasis on time versus price. Arbitrageurs are sensitive to both price of execution and speed of execution as they attempt to exploit small price discrepancies between closely related assets trading in different markets. Day traders rapidly buy and sell stocks in the hope that the stocks will continue to rise or fall in value for the seconds or minutes they are ready to hold a position. Like dealers, they often seek to profitably accommodate the trading demands of others.

2.4. Evaluating Market Quality Markets are organized to provide: 1. Liquidity 2. Transparency (x) 3. Assurity of completion

TRANSPARENCY means that individuals interested in or transacting in the market can quickly, easily, and inexpensively obtain ACCURATE INFORMATION about quotes and trades (pretrade transparency), and that details on completed trades are quickly and accurately reported to the public (post-trade transparency).

2.2.3. Brokered Markets (2)

The TRADER might use the services of a broker to carefully try to uncover the other side of the trade in return for a COMMISSION; the broker might occasionally position a portion of the block. (To POSITION A TRADE is to take the other side of it, acting as a principal with CAPITAL AT RISK.) Brokers can also provide a reputational SCREEN to protect uninformed or liquidity-motivated traders. For example, the broker might "SHOP THE BLOCK" only to those potential counterparties that the broker believes are unlikely to front-run the trade

4.2. Traders' Selection of Order Types 4.2.3. Liquidity-Motivated Traders

The commitment or release of cash is the primary objective of liquidity-motivated traders. The types of orders used include market, market-not-held, best efforts, participate, principal trades, portfolio trades, and orders on ECNs and crossing networks. Low commissions and small impact are desirable, and liquidity traders can often tolerate somewhat more uncertainty about timely trade completion than can information-motivated traders. Many liquidity-motivated traders believe that displaying their true liquidity-seeking nature works in their favor. When trading with a liquidity-motivated trader, dealers and other market participants can relax some of the protective measures that they use to prevent losses to informed traders.

Effective Spread

The effective spread is two times the deviation of the actual execution price from the midpoint of the market quote at the time an order is entered. (If parts of the order execute at different prices, the WEIGHTED-AVERAGE execution price is used in computing the deviation from the midpoint.) The QUOTED spread is the simplest measure of round-trip transaction costs for an average-size order. The EFFECTIVE spread is a BETTER representation of the true cost of a round-trip transaction because it captures both PRICE IMPROVEMENT (i.e., execution within the quoted spread at a price such that the trader is benefited) and the tendency for larger orders to move prices (MARKET IMPACT).

Example: Continued Inside Bid-Ask= Market Bid-Ask= Inside Spread

The inside bid-ask spread, or market bid-ask spread (or inside spread or market spread for short), is 100.49 - 98.85 = 1.64, which in this case is lower than any individual dealer's spread. The trader also notes that the MID-QUOTE (halfway between the market bid and ask prices) is (100.49 + 98.85)/2 = 99.67. If the trader executes a market buy order for 1,000 shares, the trader would purchase 800 shares from Dealer C at 100.49 per share and 200 shares from Dealer A at 100.51 per share.

Introduction

The investment process has been described as a three-legged stool supported equally by securities research, portfolio management, and securities trading. Of the three, TRADING is often the least understood and least appreciated function. As we will show, a deeper appreciation for the trading function can be a powerful help in achieving investment success.

2. The Context of Trading: Market Microstructure

The portfolio manager needs to be familiar with MARKET MICROSTRUCTURE: • The market structures and processes that affect how the manager's interest in buying or selling an asset is translated into executed trades (represented by trade prices and volumes). Knowledge of market microstructure helps a portfolio manager understand how orders will be handled and executed

Bid Size & Ask Size

The quantity associated with the bid price is often referred to as the BID SIZE; The quantity associated with the ask price is known as the ASK SIZE. From the perspective of a trader executing an order to BUY a security from a dealer, a lower ask from the dealer is favorable to the trader. If the trader is executing an order to SELL a security to a dealer, a higher bid from the dealer is favorable to the trader

5.3.1. The Algorithmic Revolution

The rapid growth of algorithmic trading by institutional traders reflects complex regulatory and technological factors. In the US, decimalization (the use of a minimum price increment of 0.01, for US currency $0.01) has led to a dramatic REDUCTION OF STPREADS in US equities but has also REDUCED QUOTED DEPTHS. AVERAGE TRADE SIZE in many US markets, has fallen dramatically. For institutions with large orders, these changes greatly complicate the task of trading.

Implementation Shortfall (other) Implementation Shortfall for sell orders And how to adjust for market return

The shortfall computation is simply reversed for sells (for sells, the return on the paper portfolio is subtracted from the return on the actual portfolio). To illustrate the ADJUSTMENT FOR MARKET RETURN using the market model, suppose that the market had risen 1 percent over the period of trading and the beta of stock is 1.0. The market model is R = α +β x (RM) With a beta of 1.0, the predicted return on the shares would be 1.0 × 1% = 1% The MARKET-ADJUSTED IMPLEMENTATION SHORTFALL would be 0.87% - 1.0% = -0.13%.

2.1. Order Types Limit Order Example

The trader places an order to buy 10,000 shares of BP p.l.c. at 641p limit (which means at a price of 641p or lower), good for one day (the order expires at the end of trading that day). Suppose that this buy order's price is higher than that of any other limit buy order for BP shares at the time. If that is the case, then 641p becomes the best available bid, or MARKET BID, for BP shares. If a market sell order for 6,000 shares of BP arrives the instant after the trader's buy limit order for 10,000 shares, it will execute against that limit order. The trader will get a fill (execution) for 6,000 shares at 641p, leaving 4,000 shares of the order unfilled. At that point, favorable news on BP might reach the market. If so, the price of BP could move up sharply and not trade at or below 641p for the remainder of the day. If that is the case, at the end of the day, the trader will have 4,000 shares of his or her order unfilled and the order, which was good for one day, will expire.

Logic of Algorithmic Trading

The underlying logic behind algorithmic trading is to exploit market patterns of trading volume so as to execute orders with controlled risk and costs. This approach typically involves breaking large orders up into smaller orders that blend into the normal flow of trades in a sensible way to moderate price impact. For active equity trading desks, algorithmic or automated trading is the only recourse for efficiently handling increased volumes given increasingly smaller average trade size. Automated trading requires CONSTANT MONITORING to avoid taking unintentional risk.

4.2. Traders' Selection of Order Types 4.2.2. Value-Motivated Traders

The value-motivated trader develops an independent assessment of value and waits for market prices to move into the range of that assessment. Thus, the market comes with excess inventory to the trader and presents him with attractive opportunities. The typical value-motivated trader uses limit orders or their computerized institutional market equivalent. An attractive price is more important than timely activity. Thus, price is controlled but timing is not. Even though value-motivated traders may act quickly, they are still accommodative and pay none of the penalties of more anxious traders. As Treynor (1987) pointed out, value traders can sometimes operate as "the dealer's dealer," buying stock when dealers most want to sell stock.

TYPES of order-driven markets are distinguished: 1. Electronic Crossing Networks 2. Auction Markets 3. Automated Auctions (Electronic Limit-Order Markets)

These are COMPUTER-BASED AUCTIONS that operate continuously within the day using a specified set of rules to execute orders Electronic communications networks (ECNs), such as the NYSE Arca Exchange in the U.S. and the Paris Bourse , are examples of AUTOMATED AUCTIONS FOR EQUITIES. ECNs provide ANONYMITY and are COMPUTER-BASED. ECNS OPERATE CONTINUOUSLY and, as auction markets, provide PRICE DISCOVERY

• Undisclosed limit order, also known as a reserve, hidden, or iceberg order.

This is a limit order that includes an instruction not to show more than some maximum quantity of the unfilled order. For example, a trader might want to buy 200,000 shares of an issue traded on Euronext Amsterdam. The order size would represent a substantial fraction of average daily volume in the issue, and the trader is concerned that share price might move up if the full extent of his or her interest were known. The trader places an undisclosed limit order to buy the 200,000 shares, specifying that no more than 20,000 shares of the unfilled order be shown to the public at a time.

• Market on open order.

This is a market order to be executed at the opening of the market. Similarly, a market on close order is a market order to be executed at the market close. These are examples of orders with an instruction for execution at a specific time. The rationale for using these two types of orders is that the opening and close in many markets provide good liquidity.

• Participate (do not initiate) order.

This is a variant of the market-not-held order. The broker is to be deliberately low-key and wait for and respond to initiatives of more active traders. Buy-side traders who use this type of order hope to capture a better price in exchange for letting the other side determine the timing of the trade.

• Best efforts order.

This type of order gives the trader's agent even more discretion to work the order only when the agent judges market conditions to be favorable. Some degree of immediacy is implied, but not immediacy at any price.

4.1. The Types of Traders • Value-motivated traders

act on value judgments based on careful, sometimes painstaking research. They trade only when the price moves into their value range. As explained earlier, they trade infrequently and are motivated only by price and value. They tend to accumulate and distribute large positions quietly over lengthy trading horizons. Value-motivated traders are ready to be patient to secure a better price.

4.1. The Types of Traders • Liquidity-motivated traders

do not transact to reap profit from an information advantage of the securities involved. Rather, liquidity-motivated transactions are more a means than an end; such transactions may, for example, release cash proceeds to facilitate the purchase of another security, adjust market exposure, or fund cash needs. Lacking the information sensitivity of the information and value traders, liquidity-motivated traders tend to be natural trading counterparties to more knowledgeable traders. Thus, they need to be aware of the value their liquidity brings to knowledgeable traders.

5.2.6. Trading Technique Summary Need Trustworthy agent • Focus • Uses • Costs • Advantages • Weaknesses

• Focus • Uses • Costs • Advantages • Weaknesses

5.2.6. Trading Technique Summary Liquidity at any costs (I must trade) • Focus • Uses • Costs • Advantages • Weaknesses

• Focus: • Uses • Costs • Advantages • Weaknesses

Implementation Shortfall Advantages

• Links trading to portfolio manager activity, can relate costs to the value of investment ideas • Recognizes the trade off between immediacy and price • Allows attribution of costs • Can be built into portfolios optimizers to reduce turnover and increase realized performance • Cannot be gamed

Factors that contribute to market liquidity

• Many buyers & sellers: Increases the chance of quickly locating the opposite side of a trade at a competitive price. • Diversity of opinion, information, and investment needs among market participants: Increases the chance that a buyer , who might have a (+) opinion, can find a seller, who might have a (-) opinion about it or a need for cash. • Convenience: A readily accessible physical location or an easily mastered and well-thought-out electronic platform attracts investors • Market integrity: Investors who receive fair and honest treatment in the trading process will trade again

Implementation Shortfall Disadvantages

• Requires extensive data collection and interpretation • Imposes an unfamiliar evaluation framework on traders.

Considerations that come into play include the following: In summary, the key function of trade desk organization is to prioritize trading

• Small, liquidity-oriented trades can be packaged up and executed via direct market access and algorithmic trading. DIRECT MARKET ACCESS (DMA) refers to platforms sponsored by brokers that permit buy-side traders to directly access equities, fixed income, futures, and foreign exchange markets, clearing via the broker. • Large, information-laden trades demand immediate skilled attention. Senior traders are needed to manage the tradeoff between impact and delay costs by releasing the minimum amount of information into the market that is required to get the trade done. • In addition to best execution, the trader must be cognizant of client trading restrictions, cash balances, and brokerage allocations, if any.

Simple Logical Participation Strategies Percentage-of-volume strategy

• trading takes place in proportion to overall market volume (typically at a rate of 5-20 percent) until the order is completed.

5.2.6. Trading Technique Summary Advertise to draw liquidity • Focus • Uses • Costs • Advantages • Weaknesses

• Focus • Uses • Costs • Advantages • Weaknesses

5.2.6. Trading Technique Summary Costs are not important • Focus • Uses • Costs • Advantages • Weaknesses

• Focus • Uses • Costs • Advantages • Weaknesses

2.4. Evaluating Market Quality Markets are organized to provide: 1. Liquidity (x) 2. Transparency 3. Assurity of completion In detail, a LIQUID market is one that has the following characteristics:

1. **Low bid-ask spreads (TIGHT)** Quoted spreads & effective spreads are LOW. The costs of trading small amounts of an asset are themselves SMALL. Investors can trade positions without excessive loss of value. 2. **The market is deep** Depth = big trades tend not to cause large price movements. Costs of trading large amounts of an asset are relatively small. Deep markets have high quoted depth, which is the N. of shares available for buy or sell at the quoted bid & ask prices. 3. **The market is resilient**: A market is resilient if any discrepancies between market price & intrinsic value tend to be small and corrected quickly. The great advantage of mkt liq. is that traders & investors can trade QUICKLY w/out a MAJOR IMPACT on PRICE.

2.1. Order Types Market Order Definition

1. A market order is an instruction to EXECUTE AN ORDER PROMPTLY in the PUBLIC markets at the BEST PRICE available.

The Trade Management Guidelines are divided into three areas: processes, disclosures, and record keeping:

1. Processes. Firms should establish formal policies and procedures that have the ultimate goal of maximizing the asset value of client portfolios through best execution. A firm's policies and procedures should provide guidance to measure and manage effectively the quality of trade decisions. 2. Disclosures. Firms should disclose to clients and prospects 1) their general information regarding trading techniques, venues, and agents and 2) any actual or potential trading-related conflicts of interest. Such disclosure provides clients with the necessary information to help them assess a firm's ability to deliver best execution. 3. Record keeping. Firms should maintain proper documentation that supports 1) compliance with the firm's policies and procedures and 2) the disclosures provided to clients. In addition to aiding in the determination of best execution, the records may support a firm's broker selection practices when examined by applicable regulatory organizations.

2.1. Order Types Limit Order Definition

2. A LIMIT ORDER is an instruction to trade at the BEST PRICE available but only if the price is at least as good as the limit price specified in the order. For BUY orders, the trade price must NOT EXCEED THE LIMIT PRICE, while for SELL ORDERS, the trade price must be at least as high as the limit price. An instruction always accompanies a limit order specifying when it will EXPIRE.

Implementation Shortfall Realized Profit/loss

2. Realized profit/loss, reflecting the price movement from the decision price (usually taken to be the previous day's close)19 to the execution price for the part of the trade executed on the day it is placed.

Implementation Shortfall Delay Costs

3. Delay costs (slippage), reflecting the change in price (close-to-close price movement) over the day an order is placed when the order is not executed that day; the calculation is based on the amount of the order actually filled subsequently.

Implementation Shortfall Missed Trade opportunity cost

4. Missed trade opportunity cost (unrealized profit/loss), reflecting the price difference between the trade cancellation price and the original benchmark price based on the amount of the order that was not filled. Market movement is a component of the last three of these costs.

Summary of example

500 shares of the trader's market order execute at $20.01, which represents a price improvement of $0.02 relative to the market ask of $20.03 that the trader saw when the order was entered. (The lower purchase price represents a price improvement for the buyer.) From Exhibit 2 we see that: • The quoted bid-ask spread is $20.03 - $19.97 = $0.06. • The mid-quote is ($20.03 + $19.97)/2 = $20.00. • The effective spread is 2 × ($20.01 - $20.00) = 2 × $0.01 = $0.02, which is $0.06 - $0.02 = $0.04 less than the quoted spread. The price improvement has resulted in an EFFECTIVE SPREAD that is lower than the QUOTED SPREAD.

2.2.3. Brokered Markets

A broker is an AGENT of the BUY-SIDE TRADER who collects a commission for skillful representation of the trade. The BROKER may represent the trade to dealers in the security or to the market order flow. However, the term BROKERED MARKETS refers specifically to markets in which transactions are largely effected through a SEARCH-BROKERAGE MECHANISM away from public markets. Typically, these markets are important in countries where the underlying public markets are relatively SMALL or where it is DIFFICULT TO FIND LIQUIDITY in size. Consequently, brokered markets are mostly used for BLOCK TRANSACTIONS.

2.3. The Roles of Brokers and Dealers Broker

A broker is an AGENT of the investor; • Representing the order • Finding the opposite side of a trade ($$$) • Supplying market information • Providing discretion and secrecy • Providing other supporting investment service (providing the client with financing for the use of leverage, record keeping, cash management, and safekeeping of securities) • Supporting the market mechanism

Bid Price & Ask Price

A dealer's (or any trader's) bid price (or bid) is the price at which he will buy a specified quantity of a security. A dealer's (or any trader's) ask price (or ask, or offer price, or offer) is the price at which he or she will sell a specified quantity of a security. On the principle of buying low and selling high, a dealer's ask price is GREATER than his bid price.

5. Trade Execution Decisions and Tactics 5.1. Decisions Related to the Handling of a Trade Good trading lowers transaction costs and improves investment performance.

A head trader thinking about how to organize his or her team needs to develop a daily strategy which balances the trading needs of the portfolio manager(s) and the condition of the market.

2.1. Order Types Market Order Emphasis

A market order emphasizes IMMEDIACY of execution. However, a market order usually bears some degree of PRICE UNCERTAINTY (uncertainty about the price at which the order will execute). In today's markets, most market orders are effectively automated from the point of origin straight through to reporting and clearing.

• Portfolio trade (or program trade or basket trade).

A portfolio trade involves an order that requires the execution of purchases (or sales) in a specified basket (list) of securities at as close to the same time as possible. For example, an S&P 500 index fund manager with new cash to invest could execute a portfolio trade to buy the S&P 500 (the shares in the S&P 500 in their index weights). Portfolio trades are often relatively low cost because the diversification implied by multiple security issues reduces the risk to the other side of the trade.

5.2.6. Trading Technique Summary Liquidity at any costs (I must trade) • Focus • Uses • Costs • Advantages • Weaknesses

• Focus • Uses • Costs • Advantages • Weaknesses

Simple Logical Participation Strategies Time-weighted average price (TWAP) strategy

Assumes a flat volume profile and trades in proportion to time. Breaks up the order over the day in proportion to time, which is useful in thinly traded assets whose volume patterns might be erratic. The objective here is normally to match or beat a time-weighted or equal-weighted average price. The participation strategy trades at a constant fraction of volume (usually 5-20%), attempting to blend in with market volumes. This strategy can be reactive if based on past trades or proactive if based on a dynamic forecast of incoming volume

5.2.6. Trading Technique Summary Low cost whatever the liquidity • Focus • Uses • Costs • Advantages • Weaknesses

• Focus • Uses • Costs • Advantages • Weaknesses

6. Serving the Client's Interests Important issues related to protecting the client's interest. 6.1. CFA Institute Trade Management Guidelines

CFA Institute published the Trade Management Guidelines (2004): provide investment managers "a systematic, repeatable, and demonstrable approach to seeking best execution The concept of "Best Execution" is similar to that of "prudence" in intent and practice. Although prudence and Best Execution may be difficult to define or quantify, a general determination can be made as to whether they have been met. ... Prudence addresses the appropriateness of holding certain securities, while Best Execution addresses the appropriateness of the methods by which securities are acquired or disposed. Security selection seeks to add value to client portfolios by evaluating future prospects; Best Execution seeks to add value by reducing frictional trading costs. These two activities go hand in hand in achieving better investment performance and in meeting standards of prudent fiduciary behavior. The Guidelines define best execution as "the trading process Firms apply that seeks to maximize the value of a client's portfolio within the client's stated investment objectives and constraints." (Emphasis added; "Firms" refers to investment management firms.) The definition goes on to identify the four characteristics shown in the left-hand column of Exhibit 14. In the right-hand column, the authors amplify the thinking behind the guidelines.

Trading techniques 5.2.1. Liquidity-at-Any-Cost Trading Focus

Information traders who believe they need to trade in institutional block size with immediacy use these trading techniques. The problem, of course, is that everyone is wary of trading with an informed trader. On the other hand, dealers are mightily interested in finding out whether these anxious traders have any valuable information. Thus, these traders can usually attract brokers willing to represent their order, but often at a high commission rate or price concession. These trades demand high liquidity on short notice. They may overwhelm the available liquidity in the market and cause prices to move when their presence is detected. Traders who use these techniques usually recognize that these methods are expensive but pay the price in order to achieve timely execution. On occasion, urgency will place a normally nonaggressive trader into this category. A mutual fund with unusual end-of-day sales, for example, may need to liquidate security positions whatever the cost

5.2.5. Low-Cost-Whatever-the-Liquidity Trading Focus

Limit orders are the chief example of this type of order, particularly limit orders that specify prices that are "behind the market": either a limit buy order at a price below the best bid, or a limit sell order at a price above the best ask price. The objective is to improve on the market bid or the market ask, respectively. Minimizing trading costs is the primary interest of buy-side traders who use this type of order. There may not be a counterparty to the trader's order who is willing to trade on the terms suggested. This order type is best suited to passive and value-motivated trading situations. The advantages of such orders are low commissions, low impact, and possibly the elimination of the market maker spread. One major weakness, of course, is execution uncertainty (the uncertainty of whether any trades will be made at all). Traders could end up "chasing the market" if the market moves away from the limit price. Furthermore, if the limit price becomes "stale" because significant new information on the security reaches the public, the trader could find that a trade has been executed before he or she has been able to revise the limit price. For example, a limit buy order specifying a price that is well below the most recent transaction price runs the risk of being executed only if major negative news relating to the security reaches the public. If that happens, the security could trade down to even lower levels.

4.2. Traders' Selection of Order Types 4.2.4. Passive Traders

Low-cost trading is a strong motivation of passive traders, even though they are liquidity-motivated in their portfolio-rebalancing operations. As a result, these traders tend to favor limit orders, portfolio trades, and crossing networks. The advantages, in addition to certainty of price, are low commissions, low impact, and the possible reduction or elimination of bid-ask spread costs. The major weakness is the uncertainty of whether trades will be completed within a reasonable time frame. These orders and markets are best suited to trading that is neither large nor heavily concentrated.

AVERAGE EFFECTIVE SPREAD

MEAN EFFECTIVE SPREAD (sometimes dollar weighted) over all transactions in the stock in the period under study. The average effective spread attempts to MEASURE THE LIQUIDITY of a security's market

TYPES of order-driven markets are distinguished: 1. Electronic Crossing Networks 2. Auction Markets 3. Automated Auctions (Electronic Limit-Order Markets)

Many order-driven markets are AUCTION markets—that is, markets in which the orders of multiple buyers COMPETE for execution. Auction markets can be further categorized into: o Periodic auction markets or batch auction markets (where multilateral trading occurs at a single price at a prespecified point in time) o Continuous auction markets (where orders can be executed at any time during the trading day). Examples of batch auction markets are the OPEN and CLOSE of some stock exchanges; at these times, orders are Aggregated for execution at a SINGLE PRICE. In contrast to electronic crossing markets, auction markets provide PRICE DISCOVERY, lessening the problem of partial fills that we illustrated above for crossing networks.

5.2.2. Costs-Are-Not-Important Trading Focus

Market orders and the variations on this type (such as market on close) are examples of orders resulting from a costs-are-not-important focus. Some investors seldom consider using anything other than market orders when trading securities. Market orders work acceptably well for most mixes of investment strategies, in which it is difficult to assign pure information, value, or liquidity motivation. They also serve to mask trading intention, since all market orders look alike. Traders who use market orders trust the competitive market to generate a fair price. For many orders, fair market price is a reasonable assumption. Exchanges encourage market orders and set up elaborate procedures to assure that these orders receive fair "best execution" prices. Active control of the order is not required. Market orders work best for smaller trades and more liquid stocks. They are sometimes called "no-brainers" because they require little trading skill on the part of the buy-side trader or the broker. Because they require little effort or risk taking by market makers, they are inexpensive for a broker to execute and have been used to produce "soft dollar" commissions in exchange for broker-supplied services. Traders who use these orders pay ordinary spreads and commissions to have their orders executed rapidly. Trade costs are accepted without question; indeed, they are seldom even considered. The weakness of market orders is that all trader discretion is surrendered. The trader has no control over the trade, and the broker exercises only the most rudimentary cautions. The marketplace processes are viewed as sufficient to assure fair treatment. To retain discretion, such a trader may also consider using an aggressive limit order—for example, a limit buy order that improves on the best bid or a limit sell order that improves on the best ask price.

2.2. Types of Markets

Markets are organized to provide: • LIQUIDITY (the ability to trade without delay at relatively low cost and in relatively large quantities) • TRANSPARENCY (availability of timely and accurate market and trade information) • ASSURITY OF COMPLETION (trades settle without problems under all market conditions— • TRADE SETTLEMENT involves the buyer's payment for the asset purchased and the transfer of formal ownership of that asset).

Price Benchmarks: VWAP and Implementation Short Fall

Most traders measure implicit costs (i.e., costs excluding commissions) with reference to some price benchmark or reference point. We have already mentioned one price benchmark: the time-of-trade midquote (quotation midpoint), which is used to calculate the effective spread. When such precise information is lacking, the price benchmark is sometimes taken to be the volume-weighted average price (VWAP). The VWAP of a security is the average price at which the security traded during the day, where each trade price is weighted by the fraction of the day's volume associated with the trade. Alternative price benchmarks include the opening and closing prices for a security, which use less information about prices and are less satisfactory. Although VWAP involves a data-intensive calculation, a number of vendors supply it.

2.2.1. Quote-Driven (Dealer) Markets

Rely on dealers to establish firm prices at which securities can be bought and sold. A dealer (sometimes referred to as a market maker) is a business entity that is ready to buy an asset for inventory or sell an asset from inventory to provide the other side of an order to buy or sell the asset. In the traditional view, market makers or dealers passively provide immediacy or bridge liquidity, the price of which is the BID-ASK SPREAD (the ask price minus the bid price).

Implementation Shortfall Strategies

SEEK TO MINIMIZE IMPLEMENTATION SHORTFALL or OVERALL EXECUTION COSTS, usually represented by a weighted average of market impact and opportunity costs. are typically "FRONT-LOADED" in the sense of attempting to exploit market liquidity EARLY IN THE TRADING DAY. Implementation shortfall strategies are especially valuable for PORTFOLIO TRADES, in which controlling the risk of not executing the trade list is critical. They are also useful in TRANSITION MANAGEMENT (handing over a portfolio to a new portfolio manager), where multiperiod trading is common and there is a need for formal risk controls. CONSISTENT WITH THE MEAN-VARIANCE FRAMEWORK used by many quantitative managers

A few additional important ORDER TYPES are as follows: • Market-not-held order.

This type of order is relevant for trades placed on certain exchanges (regulated trading venues) where an order may be handled by an agent of the trader in executing trades (a broker). This variation of the market order is designed to give the agent greater discretion than a simple market order would allow. "Not held" means that the broker is not required to trade at any specific price or in any specific time interval, as would be required with a simple market order. Discretion is placed in the hands of a representative of the broker (such as a floor broker—an agent of the broker who, for certain exchanges, physically represents the trade on the exchange). The broker may choose not to participate in the flow of orders on the exchange if the broker believes he or she will be able to get a better price in subsequent trading.

5.3.3. The Reasoning behind Logical Participation Algorithmic Strategies

To take simple logical participation strategies first, underlying such strategies is the implicit assumption that participating in proportion to the actual trading volume can minimize trading costs. The logic for implementation shortfall strategies differs from that of the more traditional participation strategy. Completer here later....

4.1. The Types of Traders

Traders can be classified by their motivation to trade, as follows. • Information-motivated traders • Value-motivated traders • Liquidity-motivated traders • Passive traders

3. The Costs of Trading 3.1. Transaction Cost Components

Trading costs can be thought of as having two major components: • explicit costs • implicit costs EXPLICIT costs are the DIRECT costs of trading, such as broker commission costs, taxes, stamp duties, and fees paid to exchanges. They are costs for which a trader could be given a receipt. IMPLICIT costs, by contrast, represent indirect trading costs. No receipt could be given for implicit costs; they are real nonetheless. Implicit costs include the following: • The bid-ask spread. • Market impact • Missed trade opportunity costs (or unrealized profit/loss) • Delay costs (also called slippage)

2.2.2. Order-Driven Markets

Transaction prices are established by PUBLIC LIMIT ORDERS to BUY or SELL a security at specified prices. Such markets feature trades between public investors, usually WITHOUT intermediation by designated dealers (market makers). The limit order book would also be a possible but typically with PUBLIC TRADERS replacing DEALERS (dealers may trade in order-driven markets but do so alongside other traders). There might be MORE COMPETITION FOR ORDERS, because a trader does not have to transact with a dealer (as in a "pure" dealer market). But it is also possible that a trader might be DELAYED IN EXECUTING a trade or be unable to execute it because a dealer with an inventory of the security is not present. In order-driven markets, a TRADER CANNOT CHOOSE with whom to trade

Implementation Shortfall Strategies

Unlike simple logical participation strategies, implementation shortfall strategies solve for the optimal trading strategy that minimizes trading costs as measured by the implementation shortfall method.

Good example

What tactics are appropriate for each order? ABC is the largest in shares & value, but is the smallest as a % of average daily volume, and given the low spreads & low urgency level, it is ideally suited for algorithmic execution, probably with a VWAP algorithm using the entire day's liquidity. GHIJ is just 10% of average daily volume, but given the high urgency, an implementation shortfall algorithm might be preferred with a high urgency setting to aggressively execute the purchase. DEF is large relative to average daily volume and would likely be traded using a broker or crossing system to mitigate the large spreads.

VWAP Disadvantages

• Does not account for costs of trades delayed or canceled • Becomes misleading when trade is a substantial proportion of trading volume • Not sensitive to trade size or market conditions • Can be gamed by delaying trades

a.compare market orders with limit orders, including the price and execution uncertainty of each; b.calculate and interpret the effective spread of a market order and contrast it to the quoted bid-ask spread as a measure of trading cost; c.compare alternative market structures and their relative advantages; d.compare the roles of brokers and dealers; e.explain the criteria of market quality and evaluate the quality of a market when given a description of its characteristics; f.explain the components of execution costs, including explicit and implicit costs, and evaluate a trade in terms of these costs;

g.calculate and discuss implementation shortfall as a measure of transaction costs; h.contrast volume weighted average price (VWAP) and implementation shortfall as measures of transaction costs; i.explain the use of econometric methods in pretrade analysis to estimate implicit transaction costs; j.discuss the major types of traders, based on their motivation to trade, time versus price preferences, and preferred order types;

k.describe the suitable uses of major trading tactics, evaluate their relative costs, advantages, and weaknesses, and recommend a trading tactic when given a description of the investor's motivation to trade, the size of the trade, and key market characteristics; l.explain the motivation for algorithmic trading and discuss the basic classes of algorithmic trading strategies;

m.discuss the factors that typically determine the selection of a specific algorithmic trading strategy, including order size, average daily trading volume, bid-ask spread, and the urgency of the order; n.explain the meaning and criteria of best execution; o.evaluate a firm's investment and trading procedures, including processes, disclosures, and record keeping, with respect to best execution; p.discuss the role of ethics in trading.

4.1. The Types of Traders • Information-motivated traders

trade on information that has limited value if not quickly acted upon. Accordingly, they often stress liquidity and speed of execution over securing a better price. They are likely to use market orders and rely on market makers to accommodate their desire to trade quickly. They must execute their orders before the information on which they are buying or selling becomes valueless. Information traders often trade in large blocks. Their information frequently concerns the prospects of one stock, and they seek to maximize the value of the information. Successful information-motivated traders are wary of acquiring a public reputation for astute trading, because if they did, who would wish to trade against them? Accordingly, information traders often use deceptive actions to hide their intentions.

VWAP Advantages

• Easy to compute • Easy to understand • Can be computed quickly to assist traders during the execution • Works best for comparing smaller trades in non-trending markets