Measuring Trade Difficulty

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Wayne H. Wagner, Partner Edward C. Story, Partner

SERVICES PROVIDED TO Institutional Investors

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LarryJ. Cuneo,Partner

Investment Managers

Mark Edwards, Associate

Institutional Traders

Michael Keady, Associate Rosemary Tribulato, Associate

Plan Sponsors

-MEASURING TRADE DIFFICULTY COMMENTARY #31

June 1991 One of the mileposts of an advancing technology is the creation of a set of terminology to describe actions and phenomena not heretofore requiring names. At worst, this becomes jargon. At best, it becomes a way of seeing things that were previously invisible.

-+lexusmopmental work on its @fIlreafP:IURE service-lrasrequired us to define new concepts of implementation cost analysis. In the next few commentaries,we will discuss four concepts in whichwe have advanced the state

of the art

difficulty, trade quality, opportunity/impacVtiming,

and

implementation shortfall.

We at Plexus are often asked "What is the optimal shares, size, timing, etc. given our management style?" We have found no easy

arising from independently derived prospects or indMdual liquidity requirements. The supply (or demand) is likely to be thin and sporadic.

answer. Trades are not alike. They differ in the ease or difficulty of execution.

Again according to Loeb, a $5 million trade in a $200 million company might cost 2.5 times as

Several factors combine to increase difficultv:

much as a $500,000trade.

L. The size of the company. As companies get smaller or more obscure. the

Anynews on the stockwill cause potentialbuyers and sellers to reassess the current positions. News or market price action -- a form of news in itself -- can wake up investors and increase the volume of potential trades.

Compahy SilC

number of

institutional shareholders also usually gets smaller. The smaller the number

The most surefire method of increasing supply is to attract sellers by raising the price in public markets. Some shareholders uninterested in selling at "a lower price:vill be drawa out by the higher price. David Whitcomb calls this gravitationalpull.

actMty.

Small stocks, however, may suffer from a lack of resiliency, the recovery to former levels once the

of

__

institutional holders, the more unlikely a comparable size order will appear on the other side. fte_qfrly-altCr'natiyss_arq to purchase f1s11 a broker at a significant premium or to assemble the position out of retail order flow. Assembling is usually a Iong and frequently self-defeating According to Tom Loeb a $5 million order in a $200 million company might cost will cost 2.5 times as much as the same trade in a $2 billion

supply imbalance recedes. Twisting Fischer Black's insight, the trade may not make enough noise to wake up potential sellers.

company.

2.

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The size of

the under-

order. To stand the effects of' size. think of flow rates into the market. With no special news

on a company, shares will come into the market randomly. Fischer Black calls this noise: orders

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Tom Loeb investigated the cost effects of the size of the company and the size of the order in his seminal work of 1988. However. these factors do not account for all differences in difficulty. We

have identified

two additional important

dimensions, market conditions and the desired speed of trading, which appear to lre of greater significance than company size and order size.

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The direction of stock price movement at the time of desired execution.

or participate orders imply medium urgency. Limit or crossing orders signal low urgency. A manager willing to chance that a limit order

Stockprices rise when

news item.

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the number of potential buyers

might not execute clearly isn't jumping on a hot

moving into a crowd of buyers will face adverse trading conditions: the order is on the same side

To summarize, we have defined four factors whose combined effect will determine trade difficulty and expected cost of transacting. The current weights in use by Plexus are:

complete the trade and take the prize is to outbid

Relative

exceeds the number of potential sellers.

A buyer

as the crowd. The only way he or she can

other potential buyers. fn contrast, a buyer moving into a crowd of sellers has the scarce goods. He or she can tantalize the most anxious seller to bid above rivals.

Plexus has measured the difference between trading in a market coming in and a market moving away to be 300 to 800 basis points. This factor dominates all other mst considerations, ittcluding size of comparry and size of ordcn It suggests that implementation costs can be lowered

liquidity Discretion (working, principal, Momentum (individual stock) Capitalization

25Vo

(shares desired/volume) 30Vo

etc.) 357o

l$Vo

(shares outstanding X price)

The relative weightings of these factors are updated on the basis of observation, and the database is still buildins.

by earlier manager decisions, before momentum has been established. The implementation cost savings may well exceed the effects of loss of claritv of decision.

-w.w.

4,

The urgency of the order. Orders that demand instant

NEWS OF PLEXUS Uigency

Our friends will be glad to know that we are now up to 16 clients and looking forward to a lot more!

liquidity call upon the market's facilities for

responding to

immediate demand. The chance of a random seller arrMng at the market at the same instant as a buyer is negligible. A market that is not naturally liquid must be made liquid by a market maker. He is willing to do so only at an expected profit. Urgency may arise from the type of decision information (news, first call) used by the manager. It also may stem from the personality of the manager, who may be impatient to complete his trade once he has finalized his decision. Traders get very good at reading the manager's signals and gauging the probable cost of implementing

More importantly, we are pleased

with the level of insight

and

information we have been able to deliver to our clients.

In

a$dition, David

Rismann,

formerly with Wilshire Associates, has joined Plexus Group and will be working with Larry Cuneo on client report production and technologl development.

the typical decision.

Urgency strongly interacts with the market direction. Marathon runners never make up on the downhills what they Iose on the uphills. Similarly, trading costs in adverse markets exceed the lowered costs of dealing in favorable trading

conditions. This is doubly important

(e)1991,PLEXUS GROUP A General Partnership

unde?

conditions of urgency.

You are welcome to reprint quotationsor extracts

Often, the best place to observe urgency is in the order instructions. A principal or market trade implies high urgency. Market-not-held,working

Group, 606 Wilshire Boulevard, Suite 310, Santa Monica CA 90401. Tel. (213) 45L-5A75.

from this material with credit given to Plexus