Trading strategies are driven by specific motivations and influenced by various factors, such as market conditions, security characteristics, and portfolio requirements. Understanding these drivers and inputs is crucial for balancing trading costs, including market impact and execution risk. This guide covers the motivations behind trades, key factors influencing trading strategy selection, and the dynamics of trading costs.
Four Categories of Trade Motivation
1. Profit-Seeking Trades
- Objective: Generate alpha by exploiting perceived mispricings in securities.
- Key Concepts:
- Alpha Decay: The deterioration of alpha as market participants act on similar insights.
- Trade Urgency: Higher alpha decay (e.g., news-driven trades) necessitates rapid execution, whereas longer-term insights allow for slower execution.
- Execution Venues:
- Lit Venues: Transparent trading platforms (e.g., stock exchanges).
- Dark Pools: Alternative trading systems with low pre-trade transparency to prevent information leakage.
Challenges and Strategies:
- Minimize market impact costs by fragmenting orders across venues.
- Use dark pools to avoid signaling trade intentions but balance with lower execution certainty.
2. Risk Management and Hedging
- Objective: Adjust portfolio exposures to align with target risk levels or hedge specific risks.
- Examples:
- Portfolio Rebalancing: Adjusting duration in fixed-income portfolios.
- Hedging: Mitigating foreign exchange or interest rate risks using derivatives.
Key Considerations:
- Availability of liquid derivatives and fund mandates permitting their use.
- For portfolios without derivatives access, underlying securities are used for hedging.
- Leverage magnifies risks, requiring frequent risk monitoring.
3. Cash Flow Management
- Objective: Address investor subscriptions and redemptions.
Strategies to Address Cash Flow:
- Subscriptions:
- Use equitization strategies (e.g., ETFs, derivatives) to minimize cash drag while gradually investing in underlying securities.
- Redemptions:
- Sell securities with consideration for liquidity and tax implications.
- Align sales with net asset value (NAV) based on closing prices to mitigate tracking error.
4. Corporate Actions, Margin Calls, and Index Reconstitution
- Corporate Actions: Portfolio adjustments due to mergers, spinoffs, dividends, or coupons.
- Margin Calls: Urgent sales of portfolio holdings to meet leverage or derivatives-related losses.
- Index Reconstitution: For index-tracking funds, trading at closing prices minimizes tracking error when benchmark indices are updated.
Inputs to Trading Strategy Selection
1. Order Characteristics
- Side: Direction of the order (buy, sell, etc.).
- Absolute Size: Larger orders increase market impact costs.
- Relative Size: Orders constituting a higher percentage of average daily volume (ADV) lead to greater market impact costs.
2. Security Characteristics
- Security Type: Different instruments (e.g., equities, derivatives, FX contracts) have varying liquidity and trading costs.
- Short-Term Alpha: Higher alpha decay increases urgency, raising market impact costs.
- Price Volatility: High volatility raises execution risk (adverse price movement during trade).
- Liquidity: Greater liquidity (narrow bid-ask spreads, higher depth) lowers market impact and execution risk.
3. Market Conditions
- Volatility and Liquidity Dynamics:
- In crises, volatility increases, and liquidity declines, raising execution costs.
- Normal market conditions allow for better planning and execution efficiency.
4. Individual Risk Aversion
- High Risk Aversion: Prioritizes reducing execution risk by trading urgently, even at the expense of higher market impact.
- Low Risk Aversion: Accepts higher execution risk to reduce market impact costs through slower trades.
Trading Costs: Market Impact vs. Execution Risk
Market Impact Cost
- Definition: Adverse price movement caused by the order itself.
- Drivers:
- Large order sizes.
- Low liquidity.
- High urgency due to alpha decay.
Execution Risk
- Definition: Adverse price movement during the trading horizon.
- Drivers:
- High volatility.
- Longer trading horizons.
Trader’s Dilemma:
Balancing market impact and execution risk requires skillful judgment. Slower trades mitigate market impact but increase execution risk, and vice versa.
Example: Trading Costs and Strategy
Scenario: Portfolio Manager and Head Trader Discussion
- Factors Affecting Market Impact Costs:
- Order Size: Larger orders increase market impact.
- Liquidity: High liquidity reduces market impact.
- Alpha Decay: Faster decay increases urgency and market impact.
- Evaluating Statements:
- Statement 1 (True): Executing over a longer horizon reduces market impact by breaking the order into smaller parts.
- Statement 2 (False): Longer horizons increase execution risk, potentially leading to adverse price movements.
Conclusion
Effective trading strategies require balancing the dual objectives of minimizing trading costs and achieving timely execution. By considering trade motivations, security and market characteristics, and risk tolerance, traders and portfolio managers can optimize outcomes while navigating the complexities of market dynamics. 
