question on execution of portfolio decision, thanks

CFA Level III
#1

hi guys,

on execution of portfolio decisions,

schweser notes say:

“in a low cost whatever the liquidity trading focus, the trader places a limit order outside the current bid-ask quotes in order to minimize trading costs. for example, a trader may place a limit buy order at a price below the current market bid. The strength of this strategy is that commissions, spreads and market impact costs tend to be low.”

i am not sure how

a) commissions

b) spreads

c) market impact costs

would tend to be lower in this strategy?

please help explain, thanks!

#2

that’s one way.

you’d make trade decisions to minimize commission/spread/mkt impact cost.

you’re not trading in a specific way and magically commission/spread/mkt impact are reduced.

rather, you’re trading such that commission/spread/mkt impact are minimized.

do you follow me? it’s the objective, not the side-effect (per se).

#3

yes i got it. but how does that ONE strategy lower such costs?

#4

If you place a limit, rather than buying without:

  • you avoid the bid-ask spread because you buy at the bid
  • you don´t have a high market impact as you don´t push the ask side with the orders

Additionally, commissions may be calculated on the actual amount and might be lower if you have a lower execution price.

This would be my explanation…

#5

can you elaborate on the spread part?

thanks!

#6

Placing a limit order makes you buy at the bid price (the highest price that a buyer is willing to pay). If you don´t use a limit, you´d buy at the ask (the lowest price that a seller wants to get), which is (depending on the securities characteristics) higher than the bid, naturally.

This spread is important in more illiquid securities (for a bond, e.g., the spread might constitute a significant yield difference).

#7

i think i am confused.

what is the MARKET BID?

#8

Market bid refers to the left side of an exchange quote, e.g. 90,12 / 91,63 (where 90,12 is the highest price a buyer is willing to pay). In a low-cost-whatever-the-liquidity, you might place a limit buy order at 90,05…

#9

can you explain again the low market impact?

#10

Buying without limit means taking the pieces from the ask side (what is offered by the sellers). Depending on the size you have to buy and the sizes offered, you have the risk to “drive up” the prices on the ask side.

#11

so we have the BID- ASK thing.

buying at the limit doesnt necessarily mean the BID price in the pair.

#12

Correct, you might place the limit outside the spread!

#13

the dealer’s bid is what he’d pay and the dealer’s ask is what he wants. this is the quoted market bid-ask.

the trader’s bid is what he’d pay and his ask is what he wants.

so you’re comparing (dealer bid vs trader ask) and (dealer ask vs trader bid)

the trader would intentionally bid a lower price than the dealer’s ask. this would drive the spread down.