Implementation Shortfall: Difference between revisions
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'''Implementation Shortfall''' is defined as the difference between the [[money]] return on a notional or paper portfolio in which positions are established at the prevailing [[price]] when the decision to trade is made (known as the decision price, the arrival price, or the strike price) and the actual portfolio's return. The implementation shortfall [[method]] correctly captures all elements of transaction costs. The method takes into account not only explicit trading costs, but also the implicit costs, which are often significant for large orders<ref>CFA Program Curriculum 2018, p.251-251</ref>. | '''Implementation Shortfall''' is defined as the difference between the [[money]] return on a notional or paper portfolio in which positions are established at the prevailing [[price]] when the decision to trade is made (known as the decision price, the arrival price, or the strike price) and the actual portfolio's return. The implementation shortfall [[method]] correctly captures all elements of transaction costs. The method takes into account not only explicit trading costs, but also the implicit costs, which are often significant for large orders<ref>CFA Program Curriculum 2018, p.251-251</ref>. | ||
Implementation shortfall is the execution price minus the decision price, divided by the decision price. Thus, with slippage (i.e., positive transaction costs), implementation shortfall is negative for both buys and sells. For example, if the decision price is $10 and purchase is executed at $10.15, then the implementation shortfall is -0.015, for [[cost]] of 1.5 percent<ref>B. Litterman 2004, p.425</ref> | Implementation shortfall is the execution price minus the decision price, divided by the decision price. Thus, with slippage (i.e., positive transaction costs), implementation shortfall is negative for both buys and sells. For example, if the decision price is $10 and purchase is executed at $10.15, then the implementation shortfall is - 0.015, for [[cost]] of 1.5 percent<ref>B. Litterman 2004, p.425</ref> | ||
==Four components of implementation shortfall== | ==Four components of implementation shortfall== | ||
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* '''explicit costs''', including commissions, taxes, and fees | * '''explicit costs''', including commissions, taxes, and fees | ||
* '''realized [[profit]]/loss''', reflecting the price movement from the decision price to the execution price for the part of the trade executed on the day it is placed | * '''realized [[profit]]/loss''', reflecting the price movement from the decision price to the execution price for the part of the trade executed on the day it is placed | ||
* '''delay costs''', reflecting the change in price over the day an order is placed when the order is not executed that day; the calculation is based on the amount of the order actually filled subsequently | * '''[[delay costs]]''', reflecting the change in price over the day an order is placed when the order is not executed that day; the calculation is based on the amount of the order actually filled subsequently | ||
* '''missed trade opportunity cost''', reflecting the price difference between the trade cancellation price and the original benchmark price based on the amount of the order that was no filled | * '''missed trade opportunity cost''', reflecting the price difference between the trade cancellation price and the original [[benchmark]] price based on the amount of the order that was no filled | ||
==Implementation shortfall measurement== | ==Implementation shortfall measurement== | ||
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==Examples of Implementation Shortfall== | ==Examples of Implementation Shortfall== | ||
* An example of implementation shortfall is when a trader purchases a stock at $50 per share, but when the order is executed, the price is $51. In this case, the trader has experienced an implementation shortfall of $1 per share. | * An example of implementation shortfall is when a trader purchases a stock at $50 per share, but when the order is executed, the price is $51. In this case, the trader has experienced an implementation shortfall of $1 per share. | ||
* Another example of implementation shortfall can occur when a trader places a market order for a large quantity of a security. In this case, the trader is likely to experience a gap in the price between the order and the execution, resulting in an implementation shortfall. | * Another example of implementation shortfall can occur when a trader places a [[market order]] for a large quantity of a security. In this case, the trader is likely to experience a gap in the price between the order and the execution, resulting in an implementation shortfall. | ||
* A third example of implementation shortfall can occur when a trader attempts to exit a position in a security. If the trader places a limit order, the price of the security may move away from the limit order before it can be executed, resulting in an implementation shortfall. | * A third example of implementation shortfall can occur when a trader attempts to exit a position in a security. If the trader places a limit order, the price of the security may move away from the limit order before it can be executed, resulting in an implementation shortfall. | ||
==Advantages of Implementation Shortfall== | ==Advantages of Implementation Shortfall== | ||
The implementation shortfall method has several advantages. It accurately captures all elements of transaction costs, including explicit and implicit costs. It also provides an easy way to compare the performance of different portfolios, as it allows for the analysis of both paper and actual returns. Additionally, it can be used to evaluate the effects of different trading strategies, and it can be adjusted to take into account different market conditions. Finally, it is a relatively simple method to implement, making it ideal for investors who do not have the resources to use more sophisticated techniques. | The implementation shortfall method has several advantages. It accurately captures all elements of transaction costs, including explicit and implicit costs. It also provides an easy way to compare the performance of different portfolios, as it allows for the analysis of both paper and actual returns. Additionally, it can be used to evaluate the effects of different [[trading strategies]], and it can be adjusted to take into account different [[market conditions]]. Finally, it is a relatively simple method to implement, making it ideal for investors who do not have the resources to use more sophisticated techniques. | ||
==Limitations of Implementation Shortfall== | ==Limitations of Implementation Shortfall== | ||
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In summary, there are several approaches to minimizing implementation shortfall, including optimal execution, impact cost minimization, volume weighted average price (VWAP) and tactical asset allocation. These approaches seek to reduce the cost of trading by taking into account both explicit and implicit costs, such as market impact, when making trading decisions. | In summary, there are several approaches to minimizing implementation shortfall, including optimal execution, impact cost minimization, volume weighted average price (VWAP) and tactical asset allocation. These approaches seek to reduce the cost of trading by taking into account both explicit and implicit costs, such as market impact, when making trading decisions. | ||
==Footnotes== | ==Footnotes== | ||
<references /> | <references /> | ||
{{infobox5|list1={{i5link|a=[[Look-Ahead Bias]]}} — {{i5link|a=[[Gamma hedging]]}} — {{i5link|a=[[Vomma]]}} — {{i5link|a=[[Capped Index]]}} — {{i5link|a=[[Margin level]]}} — {{i5link|a=[[Downside deviation]]}} — {{i5link|a=[[Short call option]]}} — {{i5link|a=[[Selling Into Strength]]}} — {{i5link|a=[[Zomma]]}} }} | |||
==References== | ==References== | ||
Latest revision as of 22:33, 17 November 2023
Implementation Shortfall is defined as the difference between the money return on a notional or paper portfolio in which positions are established at the prevailing price when the decision to trade is made (known as the decision price, the arrival price, or the strike price) and the actual portfolio's return. The implementation shortfall method correctly captures all elements of transaction costs. The method takes into account not only explicit trading costs, but also the implicit costs, which are often significant for large orders[1].
Implementation shortfall is the execution price minus the decision price, divided by the decision price. Thus, with slippage (i.e., positive transaction costs), implementation shortfall is negative for both buys and sells. For example, if the decision price is $10 and purchase is executed at $10.15, then the implementation shortfall is - 0.015, for cost of 1.5 percent[2]
Four components of implementation shortfall
Implementation shortfall can be analysed info four components[3]
- explicit costs, including commissions, taxes, and fees
- realized profit/loss, reflecting the price movement from the decision price to the execution price for the part of the trade executed on the day it is placed
- delay costs, reflecting the change in price over the day an order is placed when the order is not executed that day; the calculation is based on the amount of the order actually filled subsequently
- missed trade opportunity cost, reflecting the price difference between the trade cancellation price and the original benchmark price based on the amount of the order that was no filled
Implementation shortfall measurement
Implementation shortfall measures the price distance between the final, realized trade price, and pre-trade decision price. Implementation shortfall can be distinguished by three categories[4]:
- paper portfolio represents the ideal situation. All securities are transacted at benchmark prices. Transaction costs, commissions, bid-ask spread, liquidity impact, opportunity costs, market trends, and slippage do not happen
- actual portfolio reflects reality; all securities are transacted in real markets. Market impact, commissions, bid-ask spread, liquidity, opportunity costs, and slippage are factored in
- rabbit portfolio represents expected trading costs; all securities are transacted in expected markets. The paper portfolio has no trading costs. The actual portfolio has high trading costs. The rabbit portfolio falls somewhere between the two. The rabbit portfolio is the benchmark by which traders measure performance
Improving the implementation shortfall
The implementation shortfall is a useful concept for several reasons. It is important to track whether your trading ideas are being successfully implemented in practice. A hedge fund is not interested in making money in principle but in practice, and a large shortfall drives a wedge between the two. Studying your performance and implementation shortfall can help you decide whether to focus your efforts on improving your trading implementation or the strategy's alpha signals. If your shortfall is low, you should focus on improving your strategy and developing new trading ideas. In contrast, if your paper portfolio is doing well but your actual portfolio is suffering from a large shortfall, then you should focus on implementation[5].
Examples of Implementation Shortfall
- An example of implementation shortfall is when a trader purchases a stock at $50 per share, but when the order is executed, the price is $51. In this case, the trader has experienced an implementation shortfall of $1 per share.
- Another example of implementation shortfall can occur when a trader places a market order for a large quantity of a security. In this case, the trader is likely to experience a gap in the price between the order and the execution, resulting in an implementation shortfall.
- A third example of implementation shortfall can occur when a trader attempts to exit a position in a security. If the trader places a limit order, the price of the security may move away from the limit order before it can be executed, resulting in an implementation shortfall.
Advantages of Implementation Shortfall
The implementation shortfall method has several advantages. It accurately captures all elements of transaction costs, including explicit and implicit costs. It also provides an easy way to compare the performance of different portfolios, as it allows for the analysis of both paper and actual returns. Additionally, it can be used to evaluate the effects of different trading strategies, and it can be adjusted to take into account different market conditions. Finally, it is a relatively simple method to implement, making it ideal for investors who do not have the resources to use more sophisticated techniques.
Limitations of Implementation Shortfall
The implementation shortfall method, while useful, does have certain limitations. These include:
- It does not account for the impact of adverse selection, where an investor may receive a worse price than expected due to informed traders exploiting the order size.
- It does not account for the cost of market impact, which is the cost of moving prices in the market due to the large order.
- It does not account for price slippage, which is the difference between the expected price a trader will receive and the actual price they receive.
- It does not account for the cost of liquidity, which is the cost of trading in thin markets.
- It does not account for the costs associated with order splitting and timing, which is the cost associated with splitting large orders into smaller ones or timing them at certain points in the day.
- It does not account for the cost of taxes, which can be significant for some investors.
- Optimal Execution: This approach attempts to minimize the total cost of trading by using algorithms to adjust the trading strategy based on market conditions. It can help reduce implementation shortfall by seeking out the most cost-effective execution options.
- Impact Cost Minimization: This approach seeks to minimize the impact of trading on the market price. It is based on the premise that large orders can have a negative impact on the market price and thus increase the cost of execution.
- Volume Weighted Average Price (VWAP): This approach seeks to limit the impact of trading on the market price by dividing a large order into smaller chunks and executing them at different prices throughout the day.
- Tactical Asset Allocation: This approach seeks to maximize returns by taking into account the market conditions when deciding which asset classes to invest in. It takes into account the cost of trading when selecting the asset classes.
In summary, there are several approaches to minimizing implementation shortfall, including optimal execution, impact cost minimization, volume weighted average price (VWAP) and tactical asset allocation. These approaches seek to reduce the cost of trading by taking into account both explicit and implicit costs, such as market impact, when making trading decisions.
Footnotes
| Implementation Shortfall — recommended articles |
| Look-Ahead Bias — Gamma hedging — Vomma — Capped Index — Margin level — Downside deviation — Short call option — Selling Into Strength — Zomma |
References
- CFA Program Curriculum, (2018), John Wiley & Sons, New York.
- Kim K., (2010), Electronic and Algorithmic Trading Technology, Academic Press, Amsterdam.
- Litterman B., (2004), Modern Investment Management, John Wiley & Sons, Canada.
- Pedersen L.H., (2015), Efficiently Inefficient, Princeton University Press, New Jersey.
Author: Małgorzata Oleksińska
