Trading Strategies

Trading Strategies

The goal of any trade is to find a balance between the cost of execution and other risks with the benefits expected from executing the trade. Various trades have differing desired outcomes (i.e., making a quick profit vs. rebalancing a fund to match an index). This means not all trades are well compared. The following are examples of common trade strategies that will be discussed in this reading.

  • Short-term alpha: equity trade (high trade urgency).
  • Long-term alpha: fixed-income trade (low trade urgency).
  • Risk rebalances: buy/sell basket trade to rebalance a fund’s risk exposure.
  • Cash flow-driven: client redemption trade to raise proceeds.
  • Cash flow-driven: cash equitization (derivatives) trade to invest a new client mandate.

Short-term Alpha

These orders are designed for short-term gains, aiming to outperform the market. They're urgent because market opportunities can vanish quickly, so traders must be cautious to avoid causing excessive market impact.

Although trading at market open is an option, US opening auctions typically involve only 1-4% of the daily volume. If the order is a significant portion of the daily volume, using a pricing algorithm to spread out the trade during the day may be necessary.
Using a dark pool or private exchange might not be ideal here because there’s a higher risk of not getting the desired executions if offsetting orders don’t come through.

Long-term Alpha

These trades resemble short-term alpha trades but differ in urgency. Given a longer timeframe, the manager can be patient, spreading out the process over days or weeks. A hasty trade in an illiquid asset can leak information, signaling significant portfolio changes and causing unnecessary market impact.

Risk Rebalance

These trades involve adjusting a fund’s risk exposure by buying or selling a group of securities. For instance, a manager holding emerging market securities might do this when concerned about new trade tariffs affecting the portfolio’s risk limits. The trade’s scale is usually not substantial due to the large forex trading volume, reducing the risk of information leaks. Urgency depends on specific trade circumstances and acceptable risk levels in the portfolio’s securities.

Client Redemption (Cash Flow Driven)

When clients want to redeem shares, managers often have to sell to generate the required cash. If the order could impact the market, the manager must be cautious in managing this risk. Using a closing price as a reference is suitable for this trade. Since these stocks might trade on multiple exchanges, sending the order to the closing auction on these exchanges can ensure an auction-guaranteed closing price for all submitted orders. This strategy removes potential disparities between order execution and the earlier requested closing reference price.

New Mandate (Cash Flow Driven)

In this case, a client may hire a portfolio manager to track a broad market index, such as the S&P 500. If the new mandate is that the performance will be tracked relative to the new benchmark at the close of trading the next day, the manager will have little time to begin building the appropriate basket of stock investments that would replicate the index performance.

In this case, purchasing the proper amount of equity futures would allow the manager to gain full exposure as of an immediate point in time and could begin making the requisite purchases of the underlying index after that. As new shares are purchased, the futures would have to be trimmed back each time so as not to double-expose the portfolio to any positions.

Question

Which of the following trade types is least likely to have high urgency?

  1. New mandate.
  2. Long-term alpha.
  3. Short-term alpha.

Solution

The correct answer is B.

Long-term alpha trading typically involves investment strategies with extended time horizons, where traders aim to generate positive returns over a more extended period. This type of trading is often less urgent and typically involves more thorough research and analysis, making it less likely to have high urgency compared to shorter-term strategies.

A is incorrect. A “new mandate” trade may be associated with high urgency, especially if it involves quickly deploying capital or making significant portfolio adjustments to meet new investment objectives.

C is incorrect. Short-term alpha trading is generally associated with higher urgency. Traders in this category seek to capitalize on short-lived market opportunities or price discrepancies, and therefore, they often need to act quickly, making it more likely to have high urgency.

Reading 11: Trade Strategy and Execution

Los 11 (d) Recommend and justify a trading strategy (given relevant facts)

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