Trading Strategies and Strategy Selection

Trade strategy inputs refer to the characteristics that inform the particular trade strategy chosen. The goal is to maximize the benefit of the trade, taking into consideration costs and risks. The following are the main inputs used in trade strategy selection:

• Order characteristics.
• Security characteristics.
• Market conditions.
• Individual risk aversion.

Order characteristics

• Side: For example, buy, sell, cover, or short. The trade side has implications in a moving market. A sell order may take longer to execute in a market that is trending down, for example.
• Size: Describes the principal amount of funds being used to buy and sell; this affects market impact. Larger order sizes have a greater market impact and will typically be spread out over longer periods. Having higher trade urgency with a larger order size will increase market impact.
• Relative size (% of ADV): Calculates the particular order size as a percentage of the security's average daily volume (ADV). ADV standardizes the order size for comparison against other orders. ADV is calculated using (order size/average daily volume). Therefore, if a stock has an average daily volume of $10,000, and a sell order is placed for $200, this means the relative size of the trade is 2.00%.

  Relative size as an input function the same as size; that is, larger relative size trades carry larger market impact potential.

Security characteristics

Security-related considerations include the following:

• Security type: Answers the question of what type of security is being traded. Trading a particular security often comes with different exchange options. For example, would it be best to trade an emerging market common share on the firm’s local exchange or as an American Depository Receipt (“ADR”) or even as a derivative?
• Short-term alpha: The expected price movement in the security over the trading horizon, apart from market impact costs. Securities trending in an adverse direction can benefit from quicker transactions to avoid alpha decay. If the security price is expected to trend in the right direction, a slower transaction can mean higher profits.
• Price volatility: The annualized price volatility of the security. As volatility increases, it becomes more difficult to predict near-term prices and transaction rates. More volatility is, therefore, associated with execution risk.
• Security liquidity: The liquidity profile of the security (e.g., ADV, bid–ask spread, average trade size). A stock with better liquidity will have a smaller bid-ask spread and/or lower transaction costs. Illiquid securities will come with a higher cost to trade and thus less profit.

Market Conditions

Market conditions affect the liquidity of all securities. During a market crisis, liquidity can disappear, making it an inopportune time, to say the least, to sell a security. Market holidays and year-end or quarter-end dates can also affect liquidity in a more predictable way. Occasionally, new levels of trading volume will cause firms' equity shares to be listed on a larger, more liquid exchange or de-listed from a well-known exchange, making the same shares more or less liquid.

Individual risk aversion

Specific levels of comfortability with risk also inform the trading process. All else equal:

$$ \begin{array}{c|c|c}
\textbf{Trader Type} & \textbf{Market Risk Concern} & \textbf{Trade Urgency} \\ \hline
\textbf{More risk-averse} & \text{Higher} & \text{Higher} \\ \hline
\textbf{Less risk-averse} & \text{Lower} & \text{Lower}
\end{array} $$

Market risk refers to the chance that the price of the security will move in an adverse manner. This is not the same as market impact or volatility. Traders who are risk averse will tend to trade with higher urgency to avoid the possible losses from a market price that goes the wrong direction before a trade. The faster a trade is executed, the lower the market risk will be since there is less time for the fundamental value of the security to move. This, however, comes at the price of increased market impact risk.

Many individual traders will be worried about information leakage and may want to trade on exchanges that have less transparency in order to safeguard their informational privacy. Information leakage can result in losses due to market impact. Another technique is to slice up large trades into various blocks and execute them over time as conditions present themselves favorably. Often, algorithms are designed to do this at a lower Volume Weighted Average Price (“VWAP”), which is a measurement tracking the overall price at which a security was traded at when broken out into several trades.

Question

A more risk-averse trader, all else equal, would most likely be associated with:

1. Lower trade urgency.
2. Higher trade urgency.
3. Lower market risk concern.

Solution

The correct answer is A.

A risk-averse trader is more cautious and tends to avoid taking unnecessary risks. As a result, they would likely have lower trade urgency, meaning they would be less inclined to make quick, impulsive trades. They are more likely to take their time and carefully consider their trading decisions.

B is incorrect. A risk-averse trader would generally have lower trade urgency, not higher. They are less likely to engage in hurried or impulsive trading.

C is incorrect. A risk-averse trader typically has a higher concern for market risk. They are more cautious and concerned about potential losses, so they would tend to be more risk-averse in their trading strategies.

Portfolio Management Pathway Volume 2: Learning Module 8: Trade Strategy and Execution; Los 8(b) Discuss inputs to the selection of a trading strategy