Reference Price Benchmarks for Trade Execution

Reference price benchmarks are critical tools for managing and evaluating trading performance. They are used to estimate expected trading costs, select optimal trading strategies, and assess post-trade execution. These benchmarks can be classified into pretrade, intraday, posttrade, and price target categories, each serving specific objectives depending on the trading strategy and market conditions.

Categories of Reference Price Benchmarks

1. Pretrade Benchmarks

Pretrade benchmarks are known before trading begins and are often used to evaluate the initial trading strategy.

• Decision Price:
  • The price of the security when the portfolio manager makes the investment decision.
  • Use Case: Common for active managers, this benchmark reflects the initial cost estimate of executing a trade.
• Previous Close:
  • The closing price from the previous trading day.
  • Use Case: Often used by quantitative managers applying systematic, rules-based strategies. It serves as a proxy for decision price in many cases.
• Opening Price:
  • The security’s price at the market’s opening on the trading day.
  • Use Case: Suitable for fundamental managers with long-term strategies, as it ignores overnight market-moving events. However, trades entered into opening auctions should avoid this benchmark due to potential distortions caused by their own orders.
• Arrival Price:
  • The price of the security when the trade order is submitted to the market.
  • Use Case: Frequently used by active managers aiming to generate alpha, this benchmark is ideal for assessing real-time execution against initial market conditions.

2. Intraday Benchmarks

Intraday benchmarks are calculated based on prices during the trading day and are suitable for passive or systematic trading strategies.

Advertisement

• Volume-Weighted Average Price (VWAP):
  • The average price of all trades executed during the trading period, weighted by trade volume.
  • Use Case: Best for managers seeking to align with the day’s trading volume patterns, such as during portfolio rebalancing. VWAP ensures sell orders provide cash to fund buy orders within the same day.
• Time-Weighted Average Price (TWAP):
  • The equal-weighted average price of all trades over the trading period, ignoring trade volume.
  • Use Case: Useful in markets with fluctuating volumes, TWAP mitigates the effect of outlier prices, such as trades at extreme highs or lows of the day.

3. Posttrade Benchmarks

Posttrade benchmarks are determined after trading has concluded and are commonly used for performance evaluation.

• Closing Price:
  • The final price of the security at the market close.
  • Use Case: Preferred by managers looking to minimize tracking error relative to benchmarks like an index, especially for index-tracking funds.
  • Drawback: Since the closing price is unknown during the trading horizon, it limits real-time performance assessment.

4. Price Target Benchmarks

Price target benchmarks are set based on a manager’s assessment of a security’s fair value.

• Definition:
  • The manager’s view of the fair value of a security. For example, if the current price is $10 but the manager values it at $10.50, the benchmark is $10.50.
• Use Case: Ideal for profit-seeking managers aiming for short-term alpha. This approach prioritizes buying below or selling above the target price.

Choosing the Right Benchmark

The choice of reference price benchmark depends on the trading strategy, manager’s objectives, and market conditions:

Conclusion

Reference price benchmarks are foundational for effective trade execution and performance evaluation. By selecting the appropriate benchmark, traders and portfolio managers can optimize execution strategies, balance trading costs, and achieve desired investment outcomes.