August 12, 2020

Participation Rates and Trading Costs

The ultimate objective of Best Execution is reducing trading costs. By keeping trading costs as low as possible the trader increases the net alpha of the order adding incremental value to the overall portfolio. Everything else under the topic of Best Execution can be understood as a means towards this end.

This week’s highlights:

  • Getting the right participation rate is the key to minimizing trading costs. It involves matching the speed of trading a stock to the speed at which its price moves.
  • To determine the participation rate that is appropriate for the speed of trading requires a tool set of metrics that measure the behavioral characteristics of the market (Volatility, Momentum), the order (%ADV, Spread) and the different tools that participate in the market to implement the order (brokers and strategies).

One of the keys to minimizing trade costs is by achieving (or at least getting close) to the optimal participation rate. The participation rate is a measure of the speed of trading relative to the available liquidity in the marketplace. Identifying the correct participation rate is the key to solving the trading puzzle known as the “Traders Dilemma”. The Trader’s dilemma is all about the velocity of trading. If I trade too fast, I will incur price impact. I will be responsible for increasing the price that I must pay for the stock and so increase my trading costs. On the other hand, if I trade too slowly, I risk the opportunity cost of missing better priced liquidity. I wind up having to pay higher prices if the market moves away from me and also incur higher trading costs.

Click here to read more.

By Henry Yegerman, ISS LiquidMetrix

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