Below, you’ll find my personal CFA level 3 trading and rebalancing notes…
You can find a list of the other categories here: CFA Level 3 Notes, Formulas, and Weights.
Types of Markets
- Quote-Driven (dealers)
- Order-Driven (no dealers)
- Brokered Markets
Effective Spread is two times the difference between the actual price and the midpoint when the order is entered… used to show price improvement.
Electronic Crossing Networks batch buy and sell orders and cross them at set times (usually anonymous).
NYSE is a hybrid market that offers both batch auction markets (market opening) and quote-driven markets.
Adverse Selection Risk occurs when trading with a more informed trader.
- Low Bid-Ask Spreads
- Market Depth… number of shares available at bid and ask (how much do large trades move prices)
- Resilient Markets quickly correct mispricing between market price and intrinsic value
- Many Buyers and Sellers
- Information and Many Opinions
- Integrity (assurity of contract)
Implicit Trading Costs
- Bid-Ask Spread
- Market Impact costs occur happens when trades are split up
- Missed Trade Opportunity costs occur when a limit order isn’t executed
- Delay Costs (Slippage Costs) occur when large trades don’t completely fill due to size and liquidity. Information is leaking to the market and impacting price movements.
Volume-Weighted Average Price (VWAP) is often compared to the trade execution price to determine implicit cost. VWAP is less informative for trades that make up more of the total trading volume. Dealers can also take advantage of VWAP by delaying some trades to next day.
Implementation Shortfall is the difference between the decision price and the actual portfolio’s return.
Four Implementation Shortfall Components
- Explicit Costs (commissions, fees, and taxes)
- Realized Profit/Loss is the price at decision (usually previous day’s close price) vs the execution price on the day it’s placed.
- Delay Costs (Slippage) is the close-to-close price difference when a trade isn’t filled.
- Missed Trade Opportunity is the difference between the decision price and the trade cancellation price.
Soft Dollar Commissions are less exact and CFA Institute members need to set policies to seek best execution for clients.
Types of Traders
- Information-Motivated Traders stress liquidity and execution speed.
- Value-Motivated Traders only trade when prices move into a value range.
- Liquidity-Motivated Traders need to exit positions to free up cash for other opportunities.
- Passive Traders seek liquidity and try to lower trading costs.
Sunshine Trades, IPOs, and secondary offers often publicly display trade desire to draw trading interest before the actual order. This can lower market impact on prices.
Algorithmic Trading is rules-based and doesn’t require manual work once set up. Smart Routing is used to automatically trade on the most liquid exchange.
Algorithmic VWAP used when the order is a low percentage of average daily trading volume.
Meat-Grinder Effect takes big trades and breaks them down into smaller trades.
Logical Participation Strategies break up orders overtime and the Implementation Shortfall Strategy frontloads most the trades in a day. The goal is to lower implicit costs.
In 1979 the US Federal Reserve Bank (Paul Volcker) switched focus from controlling interest rates to controlling monetary growth. “Don’t fight the Fed” – Martin Zweig
Heisenberg Principle: Trade execution process masks what would exist without the trade taking place.
Percentage-of-Portfolio Rebalancing uses trigger points and corridors to determine rebalancing. To improve precision, monitoring should happen daily.
Perold-Shape Rebalancing Strategies Analysis
Buy-and-Hold is a do-nothing strategy that uses risk-free portion as a floor. The “cushion” is the difference between the portfolio value and the floor value. This strategy has unlimited upside and is a linear function.
Constant-Mix uses a constant weight for assets in a portfolio. It’s a contrarian strategy that provides liquidity. If markets are flat but oscillating, constant-mix outperforms. This strategy has a concave payoff (selling insurance).
Constant-Proportion Strategy (CPPI) is similar to constant-mix but subtracts the floor. This strategy outperforms in markets that trend up or down… but in a flat bit oscillating market, it underperforms. This strategy has a convex payoff (buying insurance).
In strong bull markets, CPPI tends to outperform Buy-and-Hold, which outperforms constant-mix.
Please comment below if you have any suggestions or questions. Also, the next category in my CFA level 3 study list is Performance Evaluation.