Quantitative Trading by Chan Ernie

Author:Chan, Ernie
Language: eng
Format: epub
Publisher: Wiley
Published: 2010-05-10T16:00:00+00:00

MINIMIZING TRANSACTION COSTS

We saw in Chapter 3 how transaction costs can impact a strategy’s actual return. Besides changing your brokerage or proprietary trading firm to one that charges a lower commission, there are a few things you can do in your execution method to minimize the transaction costs.

To cut down on commissions, you can refrain from trading low-price stocks. Typically, institutional traders do not trade any stocks with prices lower than $5. Not only do low-price stocks increase your total commissions costs (since you need to buy or sell more shares for a fixed amount of capital), percentage-wise they also have a wider bid-ask spread and therefore increase your total liquidity costs.

In order to minimize market impact cost, you should limit the size (number of shares) of your orders based on the liquidity of the stock. One common measure of liquidity is the average daily volume (it is your choice what lookback period you want to average over). As a rule of thumb, each order should not exceed 1 percent of the average daily volume. As an independent trader, you may think that it is not easy to reach this 1 percent threshold, and you would be right when the stock in question is a large-cap stock belonging to the S&P 500. However, you may be surprised by the low liquidity of some small-cap stocks out there.

For example, at the time of this writing, IRN is a stock in the S&P 600 SmallCap Index. It has a three-month average volume of about 51,000, and it closed today at $4.45. So 1 percent of this average volume is just 510 shares, which are worth only $2,269!

Another way to reduce market impact is to scale the size of your orders based on the market capitalization of a stock. The way to scale the size is not an exact science, but most practitioners would not recommend a linear scale because the market capitalization of companies varies over several orders of magnitude, from tens of millions to hundreds of billions. A linear scale (i.e., scaling the capital of a stock to be linearly proportional to its market capitalization) would result in practically zero weights for most small- and microcap stocks in your portfolio, and this will take away any benefits of diversification. If we were to use linear scale, the capital weight of the largest large-cap stock will be about 10,000 of the smallest small-cap stock. To reap the benefits of diversification, we should not allow that ratio to be more than 10 or so, provided that the liquidity (volume) constraint described above is also satisfied. If the capital weight of a stock is proportional to the fourth root of its market cap, it would do the trick.

There is one other way to reduce market impact. Many institutional traders who desire to execute a large order will break it down into many smaller orders and execute them over time. This method of trading will certainly reduce market impact; however, it engenders another kind of transactions costs, namely, slippage.

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