Benchmarks for Trade Execution

Reference prices, also called price benchmarks, are specified prices, price-based calculations, or price targets used to select and execute a trade strategy. Traders use reference prices to determine the effectiveness of their trades, both past and proposed. According to the timing of the trade and the analysis, reference prices are categorized as follows:

• Pre-trade benchmarks are known before trading begins.
• Intraday benchmarks are computed on the basis of market prices that occur during the trading period.
• Post-trade benchmarks are established after trading is completed.
• Price target benchmarks are specified as a price to meet or beat (transact more favorably).

Pre-trade Benchmarks

Pre-trade benchmarks are established when we know the benchmark's reference price before we start trading. Portfolio managers who make trading decisions using quantitative models or portfolio optimizers that rely on past trading prices (like the previous day's closing price) might also indicate a pre-trade benchmark. When studying for exams, it's crucial to understand the vocabulary related to these benchmarks, as many quantitative techniques in this section, such as implementation shortfall, rely on them.

Decision price: This represents the price of the security at the moment the manager decides to buy or sell it. This can be easily confused with the current market price, but often, managers will make a buy or sell decision, and much time can pass before the actual closing of the trade. Remember, the current market price is dynamic and will change from moment to moment during trading hours, but the decision price is fixed once a choice to trade has been solidified.

Previous close: This represents the final price of the security on the last trading day. This measure is often useful for quantitatively focused managers who use quant trading models.

Opening price: References the security's beginning price for the trading day in question (often the current day). Using an opening price for a current trading day benchmark eliminates overnight risk, which is the chance that prices swing between trading sessions due to new information becoming available. In this situation, the market is said to “gap” up or gap down.

Arrival price: This is the price of the security at the time the order is entered into the market for execution. Managers can often use arrival prices to help measure total trading costs. The closer the execution price is to the arrival price, the lower the associated costs (or potentially even negative in terms of costs).

Intra-day Benchmarks

An intraday price benchmark is based on a price that occurs during the trading period. The most common intraday benchmarks used in trading are volume-weighted average price (VWAP) and time-weighted average price (TWAP).

Volume Weighted Average Price (“VWAP”)

VWAP is popular among portfolio managers who need to rebalance during the day, often having many buy and sell orders at once, and who wish to participate with the trade volume. Since VWAP is the average daily execution price, scaled by volume, higher VWAP for sale orders means higher sales prices (or during times of rising volume), and lower VWAP for buy orders means lower prices paid (or during times of decreasing volume).

Time-weighted Average Price (“TWAP”).

The TWAP benchmark price is defined as an equal-weighted average price of all trades executed over the day or trading horizon. The TWAP benchmark is used by investors to evaluate fair and reasonable trading prices in market environments with high volume uncertainty and for securities that are subject to spikes in trading volume throughout the day.

Post-trade Benchmarks

Closing prices are often used by passive managers who need to know index values and individual securities values at the end of a trading session. The closing price is the value of a security at its last transaction during a trading session. This is often important for mutual fund managers who manage funds that only calculate NAV once daily at closing.

Price Target Benchmarks

Price target benchmarks are a set reference point used by portfolio managers to help gauge the viability of their trading system. The use of limit orders fits in neatly with price target benchmarks. For example, a trader who wishes to purchase a stock for $20.00, despite that it is trading slightly higher (say $20.30), can set a limit-buy order at $20.00. This means the trader can wait for the market to turn. Once the stock reaches $20.00, the order will be filled at the limit price or less. A limit-sell order is the opposite. A limit order will be filled at the specified limit price or higher once it is reached.

Question

“The price of the security at the moment the manager decided to buy or sell it”is best represented by which of the following:

1. Arrival price.
2. Decision price.
3. Target benchmark price.

Solution

The correct answer is A.

The arrival price represents the actual price of the security at the time when the manager decides to buy or sell it. It takes into account the price at the moment of execution.

B is incorrect. “Decision price” is not a commonly used term in finance or trading. The price at the moment of the manager's decision is typically referred to as the “arrival price.”

C is incorrect. “Target benchmark price” is not the appropriate term for the price at the moment the manager decides to execute a trade. A benchmark price is often used as a reference point for performance evaluation but is not the same as the price at the time of the decision.

Portfolio Management Pathway Volume 2: Learning Module 8: Trade Strategy and Execution; Los 8(c) Compare benchmarks for trade execution