Implementation shortfall and VWAP

CFA Level III
#1

Are these the main two approaches to tracking trading costs ? Where does effective spread fit in ?

#2

Effective Spread: 2 x difference in midpoint of bid ask spread and the actual trade execution price. To answer your above question, yes the act as a measurement benchmark when comparing transaction costs.

#3

Thanks I know the formula too. Just wondering when to use ?

#4

Effective spread is a tool uses to determine if you’re “providing liquidity” or “requiring liquidity”. General rule of thumb is if you’re Effective Spread < Quote Spread, there’s good depth and liquidity in the market and you’re providing liquidity. If the Eff. Spread > Quote spread, the market is not as liquid and you’re paying extra via the bid/ask spread. The two approaches you mentioned above are for managers to try and assess their trading strategies. Problem with VWAP is that it can be gamed and shouldn’t be used in trending markets or when a large trade would have a significant market impact because the VWAP will be near the trade price. That said, if there’s no urgency to a trade and it’s a small trade, VWAP is effective. Implementation Shortfall is better suited for when you want to trade an entire portfolio and/or urgency exists for the trade to be completed, perhaps because of opportunity costs. It ensures that the trades will get placed early in the day compared to the VWAP where the trade is broken up throughout the trading day. In addition, I/S cannot be gamed so it’s less likely to be manipulated. There are a few other strategies that fall in the algorithmic logical participation strategies such as % of trading volume where a % of the trade is broken up. PJStyles

#5

Thanks PJ

#6

For buy orders, effective Spread = 2 x (the actual trade execution price - midpoint of bid ask spread when order is entered); for sell orders, it is the opposite.

#7

Also, the ONLY time the Effective Spread will equal the Quoted Spread is when a purchase is made at the Ask price and a Sale is made at the Bid price It was a question that has stuck in my head for some reason.

#8

bigwilly Wrote: ------------------------------------------------------- > Also, the ONLY time the Effective Spread will > equal the Quoted Spread is when a purchase is made > at the Ask price and a Sale is made at the Bid > price > > It was a question that has stuck in my head for > some reason. I know, because it’s the 3rd time you post that fact.

#9

And you might thank me if it shows up on the test :slight_smile: