Trade cost analysis is an essential tool for portfolio managers to evaluate the performance of brokers, algorithms, and execution strategies. By comparing execution prices to specified benchmarks, managers can assess the cost or benefit of their trades and optimise future trading decisions.
Key Concepts in Trade Cost Analysis
1. Trade Costs
Trade costs measure the difference between the execution price and a benchmark price, reflecting the effectiveness of the trade.
Formula for Absolute Trade Cost:
- Side: +1 for buy orders, -1 for sell orders.
Formula for Trade Cost in Basis Points (bps):
A positive cost indicates underperformance against the benchmark, while a negative cost signifies added value from the trade.
Examples of Trade Cost Calculations
Example 1: Basic Trade Cost
- Order: Buy
- Execution Price: $25.50
- Benchmark (Closing Price): $25.60
Step 1: Calculate Absolute Cost: ($25.50 – $25.60) = -$0.10
Step 2: Convert to Basis Points
Interpretation: A negative trade cost of 39.1 bps indicates added value, as the trader executed the buy order below the benchmark price.
2. Market-Adjusted Costs
To isolate the trader’s impact from general market movements, we calculate market-adjusted costs by accounting for the index’s performance over the trade horizon.
Market-Adjusted Cost Formula:
- Arrival Cost: Based on the arrival price benchmark.
- Index Cost: Reflects changes in the index’s value over the trade horizon.
- Beta (β): Sensitivity of the security to index movements.
Example 2: Market-Adjusted Cost
- Order: Buy
- Security Arrival Price: €10.00
- Index Arrival Price: €3,500
- Execution Price: €10.15
- Index VWAP: €3,507
- Beta (β): 1.5
Interpretation: The trader’s actions incurred a market-adjusted cost of 120 bps, which accounts for general market movements.
3. Added Value in Trading
Traders’ performance can also be evaluated by comparing actual costs to pretrade cost estimates.
Added Value Formula:Added Value (bps)=Arrival Cost (bps)−Estimated Pretrade Cost (bps)\text{Added Value (bps)} = \text{Arrival Cost (bps)} – \text{Estimated Pretrade Cost (bps)}Added Value (bps)=Arrival Cost (bps)−Estimated Pretrade Cost (bps)
Example: Calculating Added Value
- Arrival Cost: 150 bps
- Pretrade Cost Estimate: 160 bps
Interpretation: The negative added value means the trader outperformed the pretrade cost estimate, creating a benefit for the portfolio.
Trade Cost Components
Trade costs can be decomposed into:
- Execution Cost: Adverse price movements due to trade execution.
- Includes delay costs (pre-trade delays) and trading costs (market impact).
- Opportunity Cost: Costs due to unexecuted shares.
- Fixed Fees: Explicit costs like commissions.
Strategies to Reduce Costs
- Delay Costs:
- Minimize pre-trade delays through automation and efficient communication.
- Opportunity Costs:
- Invest unexecuted funds in alternative securities to avoid cash drag.
- Trading Costs:
- Use algorithms or high-touch approaches to minimize market impact.
- Pretrade Estimates:
- Incorporate cost modeling into trade planning for better execution strategies.
Key Takeaways
- Benchmark Selection: Choose benchmarks (e.g., arrival price, VWAP, or closing price) based on trade objectives.
- Market Adjustments: Incorporate beta and index performance to isolate trader performance.
- Decomposition: Break down costs into components for targeted improvements.
- Continuous Evaluation: Use trade cost analysis to refine execution strategies and achieve better outcomes.
By systematically analyzing and addressing trade costs, portfolio managers can enhance execution efficiency, reduce expenses, and maximize portfolio returns.
