Immediacy Cost-opportunity Cost

_d-

reffiffiffi

#ffi

tu#ffiffiq.Wffi #rffie-*$s

PARTNERS: Wayne H. Wagner Edward C. Story Larry J. Cuneo

SERVICES PROVIDED TO Institutional Investors Investment Managers

--

Institutional Traders Plan Sponsors

IMMEDIACY COST AND OPPORTUNIW COST COMMENTARY #22

May 1989 The basic decision faced by a buy-side trader is between taking an immediate execution or waiting for a later execution, perhaps under more favorable terms. By moving quickly, he expects to incur an Immediacy Cost, while he exposes

himself to a potential Opportunity Cost if he waits. How that tradeoff of expectations is made is the heart and the art of trading. Trading requires a delicate balancing between two expectationalcosts that are faced in every trading

sons for wanting to trade immediately: they know

decision:

These information motivated traders hope to pass

n

off improperly valued stock on the uninformed.

*

something that

will soon make prices

move.

An Immediacy Cost that is high for traders who demand immediate execution. and is expectationally lower for less urgent traders

The dealer, of course, stands in the first row, and while his information sources are usually very good, he can seldom expect to be the first to

who can wait for a counterpartythat, hopefully, will trade at a more favorable price.

know anything.

An

Oooortunitv Cost that increases as expected time to completion increases" Opportunity cost is incurred when the information motivatingthe trade impacts prices before the trade can be completed.

Market liquidity is not Immediac]f

{.ost',,

,.,',.!,:':'

a

free good in most markets. Some markets, e.g. Treasury Bills, have high natural

liquidity as outside motivated buyers and sellers interact with each other. Markets that are not naturally liquid can be made liquid artificially. Specialists, dealers, and other market functionaries earn a living by providing market liquidity to otherwise illiquid markets. By buying and selling from their own inventory, they provide immediate liquidity for investors for whom it would be an inconvenience (at minimum) to wait for a natural counterparty.

Of course the dealer is not

a patsy

in this activity;

he knows that hidden among the convenience motivated traders are traders with tansible rea-

:l:il* i,tuiIlirrlr **iil*i*rrJ. $r:il*: i.**

What the dealer must do, then, is to protect himself by [1] refining his information sources, especially by learning about his clients and their access to information, [2] turninghis inventoryas quickly as possible, and, most importantly, [3] operating with a large enough spread between buy price and sell price to cover both operating costs and losses to investors who possess superior information.

Thus

investors

who demand immediacy usually must transactwith a market function-

ory, and can expect to pay the costs of having that service provided to them. A

trader who can wait, in contrast, displays by his very

Figure

L

Immediacy Cost

nonchalance that he is not motivated by information. Also, a trader who can wait greatly enhances the probability that another natural investor will appear to claim the other side of his trade without invokins

i:,rr:t* i-4*.*:r-*. {l*iifc}rl:i"r

t*d*: f-

i}-13

j4*1-:r#ii

the services of a dealer.

Thus the expected cost of immediacy slopes downward with time, as shown in Figure 1. Note that these arc expectational costs; sometimes an expensive.trade can be done quickly; at other times delay will not serve to reduce the cost of a particular trade. As the trader approaches the market, however, he faces an Immediacy Cost that slopes downwardwith expected time to execution.

Now consider an investor

who possesses a bit of knowledge which is not yet fully appreciated by the rest of the market. His expected cost, the cost of not transacting

Opportuhity COSt]

::i::::::i]:]ii:i:i::]].]:1

soon enough, is steeply upward sloping, as shown by the uppermost cun'e -- labeled I as in informa-

tion -- in Figure 2. We call this curve Opportunity Cost. Note that the curve rises more steeply than the Immediacy Cost curve falls in Figure 1. Compared to the expected OpportuniE Cost, the Immediacy Cost pales to insignificance for the information motivated investor. motivated by less time-sensitive in(e.g. contrarian manag-

ers or undiscovered

value

seekers) would have a less

The total expected trade cost for the

slow-information manager lies between the two extremes.

The

appropriate

trading techniques differ for each of

these styles of

investment man- Figure 3 agement. Infor- Total Trade Costs mation traders need to apply trading techniques which provide very rapid execution, such as market orders for smaller trades and principal trades for large orders. These techniqueswill probably cost more

in Immediacy Costs, but they will avoid a po-

ing Networks. Figure 2

Opportunity Cost

short period of

time. We have labeled them S for slower. The lowest curve, labeled P for passive, represents the indexfund,which never trades on information and faces a minimal OpportunityCost due only to the desire to remain fully invested.

-.:-, j9:1'LfT" uos['

techniques which may take a relatively long time to find the counterparty and complete the trade.

Slower-information traders have more time and more flexibility. They can afford to wait for better trading situations. They can, for example, advertise their interest in hopes of drawing out the natural other side. They can also afford to wait for lower cost trading alternatives like Cross-

formation,

ffi

unwilling to incur Immediacy Costs, index fund managers have a great deal more flexibility to apply to their trading. They can apply trading

tentially larger opportunity cost.

Investors who are

steeply sloping OpportunityCost. The value they seek is not likely to be discovered in a very

pected trading cost is much wider and further to the right. Not only should the index fund be

Total expectational trade cost is the sum of the Immediacy Cost and the Opportunity Cosl. As shown in Figure 3, these lotal expected trade costs curves have a "belly" which rePresents an

The greatest trading advantage, however goes to the index fund, who can afford to wait until the market comes to him on suitable terms. Thinking of it differently, he lets the other side determine the timing of the trade. This is valuable to the counterparty, comparable to the accommodating disposition of the dealer. The danger, of course, is that the index fund does not possess the information and quick turnaround advantages of the dealer. While he should be able to reduce his trading cost significantly, it would seem to require substantial additional trading skills and presence for the index fund to match the dealer's ability to make money in the trading process.

area of minimum cost. For information motivated traders, tlibt area of cost is found close to zero time-to-completion and is short in duration.

So far, we have shown that trading involves balancing the declining Immediacy Cost against the rising Opportunity Cost. This is not an easy task. We have already pointed out how these costs are expectational in nature, and therefore difficult to assess. Also, we have shown that they differ for

In contrast, the index fund's area of lowest

different management strategies.

2

ex-

In

addition,

the tradeoffvaries for different securities, or for the same security under different market conditions. It is a well tuned skill, usually accumulated over years of experience, that correctly balances these opposing influences and minimizes trade costs.

Implications

Even though measurement of these expected costs is difficult to the point of impossible, we can draw some interesting insights from thinking

Pressure to reduce trading costs will not Conclnsion succeed unless it is done with an understanding of the trading process. Portfolio managers who think of trading as something separate and apart will fail to achieve excellent implementation of their ideas. Sponsorswho wish to fulfill their fiduciary duties with respect to transaction costs need to learn a lot more about securities markets and how the trading process works.

of trading cost as a tradeoff between immediacy and opportunity.

Most traders prefer to deal with the known devil of Immediacy Cost rather than struggle with the unknown devil of Opportunity Cost. For the trader to be effective in driving down true transaction costs, he needs an appreciation for decision process that led to the trades. If the trades are not based on immediate information, the trader can use the flexibility to attempt to reduce transaction costs. The word attempt in the previous sentence is key.

Waiting for better terms to trade on will not always work out. The trader who exercises this discretion will be at risk. A chastised trader can always avoid this risk by executing all trades immediately, i.e. before the Immediacy Cost curve flattens out. The implication is that lowering transaction cost depends on both the trader and the portfolio manager and the quality of their

interaction. Another important point is that most execution evaluation services fail to measure opportunity cost. (If your database consists of trades, how do you measure a trade that wasn't there?) Unless the leakage in the decision implementation is accounted for, the measurement system is easily gamed. An evaluation which shows well while performance is poor clearly fails its main objective.

Plexus Group is extremely pleased that Jack Morton has joined us to work with our clients in the Trade Advisory Service. For many years, Jack was the head trader at Dewey Square Investors, the money management arm of The Bank of Boston. We value Jack not only for his depth oi experience of in-the-trenches trading, but also for his insightful views on market proCESSCS.

Jack wrote an article entitled Ethical Issues in Trading for the CFA Trading Strategies and Execution Costs Seminar Proceedings. We thought so highly of his thoughtsthat it was reprinted in The Complete Guide to Securities Transactions. (Which is now available in bookstores!!). Our plan is to have Jack write the next Commentary, which will give our readers a chance to ponder his interesting insights.

Welcome, Jack. We look forward to working with the ideas and experience that you

bring to Plexus.