Chapter 9 - Minimizing Execution Costs

Abstract

This chapter focuses on various algorithmic trading strategies that are used for minimizing transaction execution costs. True transaction costs of securities are fundamentally immeasurable. The implementation shortfall method is widely accepted as a good surrogate measure for true transaction costs. The minimization of market impact, efficiently finding sources of liquidity anonymously, and the need to achieve best execution for low- or no-touch trading strategy can be addressed through the use of an algorithm. Algorithmic trading strategies that can improve trading costs for buy-side firms include enhanced direct market access (DMA) strategies such as iceberging, pegging, smart order routing, simple time slicing, and simple market on close (MOC). Iceberging involves a large order that can be partially hidden from other market participants by specifying a maximum number of shares to be shown. In smart order routing, liquidity from various sources are aggregated and orders are sent out to the destination offering the best price or liquidity. In simple time slicing, the order is split up and market orders are sent at regular time intervals, and in simple market on close (MOC), the order is sent into the closing auction. Other common algorithmic trading strategies for reducing the transaction costs include quantitative algorithms such Volume-Weighted Average Price (VWAP), Time-Weighted Average Price (TWAP), and implementation shortfall or arrival price.