Trading Strategy Selection
Trading strategy selection refers to choosing the most appropriate approach to execute a trade in a way that is consistent with the manager’s objectives. The appropriate trade strategy is typically determined in collaborating with a buy-side trader.
On this page, we discuss examples of some common trade types and their most appropriate trading strategy. In particular, we discuss the appropriate trade strategy for the following set of trades:
- short-term alpha
- long-term alpha
- risk rebalancing
- cash flow driven trades:
- client redemption
- new trade mandate
Short-term alpha trades try to trade short-term mispricings in a liquid equity market (e.g., overreaction to news flows). In his case, the urgency is high and the typical reference price will be the price target benchmark of the manager. An arrival price benchmark may also be used to evaluate the quality of the execution.
These kinds of trades will typically be executed using an algorithm.
Long-term alpha trades tend to have low urgency and can be traded over a longer period. Typically, alpha is based on changes in fundamental conditions. The execution method in the case of long-term alpha trades will typically buy or sell securities gradually to avoid information leakage and pressure on the dealer’s prices.
In a risk rebalance, the manager wishes to rebalance the fund or hedge certain risk exposures. The urgency is typically fairly low since the rebalance consists of both buys and sells. This lower execution risk because there is less directional exposure. The reference price is typically the time-weighted average price (TWAP).
An algorithm that targets the TWAP over the trading day (or multiple days) is most appropriate.
Cash flow driven
We consider two kinds of cash flow driven trades:
- In the case of a client redemption, the manager will liquidate holdings to meet client redemptions. The fund bears the risk that liquidations are not made at the closing prices used to calculate the redemption. As a consequence, the trade needs to be completed by the end of the trading day and the reference price is the closing price. The optimal execution approach is to execute a reasonable amount of liquidity in the closing auction; execute the remainder before the close of trading (e.g. at VWAP).
- A second kind of cash flow driven trades is cash inflows that need to be invested. In this case, performance measurement will begin at the current day’s closing price when the funds are received and the account comes into existence. In some cases, liquidity may be too low to execute all the trades at once. In that case, futures can be used to create market exposure. The underlying stock positions are then gradually bought and the futures positions unwound.
We discussed several trading cases that managers may encounter. Each of these kinds of trades requires a different trading strategy to execute them properly.