Reading 45: Execution of Portfolio Decisions Los l~Q1-9

impact, simple, discuss, classes, motivation

LOS l: Explain the motivation for algorithmic trading and discuss the basic classes of algorithmic trading strategies.

Q1. A simple logical participation strategy trades:

A) early in the day and attempts to minimize market impact.

B) with market flow and attempts to minimize opportunity costs.

C) with market flow and attempts to minimize market impact.

Q2. George White, CFA, and Elizabeth Plain, CFA, manage an account for Briggs and Meyers Securities. In managing the account, White and Plain use a variety of strategies, and they trade in different markets. They use econometric analysis to estimate costs, for example, and algorithmic methods to execute the strategies. White and Plain also use both market orders and limit orders. Their supervisor has asked them to compose a summary of their trading records to see how the various strategies have worked.

The supervisor asks about how to assess the costs and risks of the various types of trades. The supervisor specifically asks White and Plain to explain the difference in the risks associated with market and limit orders. After White and Plain explain how limit orders can give a better price, the supervisor asks why they wouldn’t always use limit orders. White explains the details of execution uncertainty and price uncertainty and how they relate to market and limit orders. As part of the discussion, Plain explains the principle of the effective spread that is associated with market orders. She uses a recent example where the quoted bid and ask price of GHT stock was $25.40 and $25.44 respectively. When White and Plain put in a buy order for 300 shares of GHT stock, at that quoted spread, the order was immediately executed at $25.45. She then calculates the effective spread.

In summarizing transactions costs, White explains how transactions costs include both implicit and explicit costs. He describes a recent situation where he and Plain placed a large buy order for CRD stock. Only half of the trade was executed on the day the order was made, and the second half of the buy order for CRD was executed on the following day. This occurred because the order was for a large number of shares and CRD stock traded in a relatively illiquid market.

The supervisor asks if there are methods for analyzing and predicting costs associated with the size of the order and the liquidity of the market. White and Plain use an econometric model as part of their pre-trade analysis to estimate implicit transactions costs. Their econometric models use the following inputs: market capitalization, volume, and measures of momentum. White says that linear econometric models have proven the most effective because the inputs are fairly normally distributed. Plain says that in addition to simply estimating the costs of a proposed trade, the model can also indicate the optimal size of the trade.

White and Plain also explain their algorithmic methods of trading. They engage in passive trading combined with pegging and discretion strategies that are designed to seize liquidity. They recently decided to trade GHT stock using algorithmic methods. White said that GHT was a good stock to trade this way because their trades of the stock are very small in relation to the volume of the stock in the whole market. Plain adds by saying that GHT has a large spread, and this also makes algorithmic trading ideal for this stock.

Which of the following statements regarding market orders is most accurate? Market orders:

A) have price uncertainty, and limit orders have execution uncertainty.

B) have execution uncertainty, and limit orders have price uncertainty.

C) and limit orders both have execution uncertainty and no price uncertainty.

Q3. In the example given by Plain, what was the effective spread for the order of 300 shares of GHT stock?

A) $0.06

B) $0.02

C) $0.04

Q4. In the example given by White, the term that describes the costs associated with the purchase of CRD stock is:

A) delay costs.

B) missed trade opportunity.

C) volume-weighted costs.

Q5. In the discussion concerning the use of econometric methods in estimating trading costs, White commented on the use of linear methods, and Plain commented on using the models to estimate the optimal trade size. With respect to these statements:

A) White was incorrect and Plain was correct.

B) White was correct and Plain was incorrect.

C) both White and Plain were correct.

Q6. With respect to the reasons given for using algorithmic methods for trading GHT stock:

A) White was correct and Plain was incorrect.

B) White and Plain were both correct.

C) Plain was correct and White was incorrect.

Q7. The best classification of the algorithmic method used by White and Plain is:

A) implementation shortfall strategy.

B) simple logical participation strategy.

C) opportunistic participation strategies.

Q8. A trader must trade an entire portfolio of stocks. Which of the following would be the best strategy to pursue?