Portfolio Trading Strategies Essay Example for Free

Portfolio Trading Strategies Essay Profits in equity are a function of timing and costs. Trading strategies are essentially focused on maximizing profits through cost maximization which in turn is linked with transaction costs. Thus cost of trading in also a consideration for determining trading strategy. Transaction costs are said to include commissions, execution and opportunity costs. (Collins. Fabozzi : 1991). Commissions are most easy to define as these are fixed and relate to the fees paid for trading. However there is a problem of measuring execution and opportunity costs as these are neither fixed nor can be easily measured. While a number of approaches have been developed for measuring opportunity and trading costs, a method to suit all circumstances has not been evolved thus far. The complexities involved and since minor differentials make major variation in profits an effective strategy to constantly provide yield is difficult. Investment strategies thus attempt to rationalize trading to provide benefits from execution as well as opportunity costs. Since there is no uniform strategy that can assure trading profits it is very difficult to balance the large number of factors which affect trades. Timing in fact is a constant which affects both opportunity and execution costs. Opportunity Costs and execution costs are both a variable component of transaction costs. Thus profits in transaction are determined by opportunity and execution costs and the balance that will be maintained between these. Opportunity costs are the performance shortfall that arises from a failure to execute the desired trade at the desired time. These indicate the difference between actual investment and the performance of a desired investment. This is adjusted for fixed and execution costs. Thus opportunity cost is incurred for not being able to implement the desired trade. Since opportunity costs are missed investment opportunities, these could in some respects be called hypothetical costs and thus are difficult to calculate. (Collins. Fabozzi : 1991) Execution costs arise out of the demand for immediate execution and are said to reflect the demand for liquidity and the trading activity at the time and date of conducting trade. (Collins. Fabozzi: 1991). These vary with the investment style and trading demands of the investor. Both information motivated traders and information less traders could use strategies to benefit from execution costs. The information motivated trader acts in the belief that he has superior information to that available to the average dealer. Thus he executes the trade using this information for making profits. This style of trading has a large price impact. On the other hand the information less trader allocates wealth based on a price which has been factored in the trade. These have a lesser impact than information motivated traders. The problem measuring execution costs occurs as the difference in the price of the costs in absence of a trade is not observable. (Collins. Fabozzi: 1991) Execution costs are determined by market impact and market timing costs. Market impact costs are the bid/ask spread and a price concession that compensates the buyer or seller for the risk that the investor’s transaction is information motivated.   The Market timing costs arise due to the fact that at the time of execution of the trade the asset’s price moves for reasons which are not related to the transaction.   Market impact measurement is dependent on the pre trade measures, the post trade measures and also average measures which can be undertaken throughout the day. These approaches aim to define the fair value of the trade at a particular time. It is this that determines execution costs. Market making strategy thus attempts to balance opportunity and execution costs. Patient trading strategies may result in high execution costs while aggressive trading strategies could impact the other way. (Collins. Fabozzi: 1991). On the other hand the cost management methodology is designed to capture maximum elements of the transaction process. (Collins. Fabozzi: 1991). Execution costs are also shown to be higher in an automated trading process in Paris relative to the New York Stock Exchange with floor based trading with human intervention. The lower execution in floor based system suggests that there is benefit in human intervention in the trading process. This is possible as the NYSE specialist is able to maintain narrow spreads, can anticipate future order imbalances and also helps reduce the volatility of transitory movements in share prices. Thus as specialist and floor traders use the human intellect to make time preferred trades, execution costs in manual trading are considerably lower than those in automated trading. This is also supported by the role played by market makers in forming prices and providing liquidity in the securities market as per example gleaned from the trading behavior of market makers on the New York Stock Exchange. (Madhavan. Smidt: 1993).       Reference Madhavan, Ananth. Smidt, Seymour. (1993). `An Analysis of Changes in Specialist Inventories and Quotations`, Journal of Finance, Vol 48, 1993 2. Venkataraman, Kumar. `Automated Versus Floor Trading: An Analysis of Execution Costs on the Paris and New York Exchanges, Journal of Finance, Vol 56, No. 4 3.  Ã‚  Ã‚  Ã‚  Ã‚  Ã‚  Ã‚  Ã‚  Ã‚  Ã‚  Ã‚   Collins, Bruce M. Fabozzi, Frank. (1991).   `A Methodology for Measuring Transaction Costs`, Financial Analysts Journal, March/April 1991. Preferred language style: English(U.K.)