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April 1, 2001

Evaluating the Process

By Marie S. Konstance

It is taken for granted that the quality of trading can influence investment returns. So where does the trader fit in and ensure he adds value? To answer this question, traders are using tools that can provide them timely feedback. These tools compare their trades to an accepted benchmark.

For example, decision price, the price that prevailed during the portfolio manager's stock selection, or when the order reached the trader's desk, is a good proxy for the price the portfolio manager is trying to achieve. It can be adjusted by an expectational cost, so the trader can compare trades with varying liquidity characteristics.

Another benchmark is the VWAP. This benchmark is suitable for trades that do not constitute a very large proportion of the average daily volume. Indeed, VWAP can be a good proxy for a passive trading strategy.

Many large firms review their trading performance on a monthly, weekly and even daily basis. Timeliness is critical. Regular review helps them to correct missteps and to maintain a productive dialogue with their portfolio managers.

At the tactical level, traders use a transaction cost measurement system for exceptions analysis (i.e. identifying which trades were the biggest winners and losers). This is useful in creating a feedback loop with portfolio managers and giving them color on the market conditions. It is also worthwhile to have a record of the time the order was received by the trader. This can help highlight the opportunity costs incurred between the time the portfolio manager made the investment decision and the time the trader implemented the trade.

The discretion the trader has over the order can provide critical information too. At Federated Investments, for example, the head trader Dave Briggs marks trades based on whether the trader had an opportunity to add value, or whether it was part of a list. He analyzes the orders in which the trader has discretion, and uses this analysis to enhance the skills of his trading desk.

Briggs uses both decision price and VWAP as a benchmark. On discretionary orders, traders must beat a multi-day order-based VWAP. Traders also attempt to beat VWAP on a list by optimizing the order relative to a benchmark such as the S&P futures contract.

At another large investment advisor, the manager's focus is on the unfilled shares. Is the position underwater? On the filled shares, how did the trader parcel out the order?

On the more strategic level, the trading desk manager can use transaction cost analysis to manage traders. In one large firm the manager focuses on the types of trades his traders are handling and the performance in different liquidity segments. Analysis has demonstrated, for example, that some of the most difficult trades were quite successful, while the small, throwaway' trades were quite costly. Those costs were significant because that segment accounted for 30 percent of trading flow.

Analyzing trading patterns has encouraged the firm to reallocate its priorities, and to focus on trouble spots. It also provided objective data for performance reviews. As all the traders had access to the same analysis, discussions of performance and objectives became much clearer.

Broker analysis is also useful. How much commission do you give various brokers versus their trading performance? Where do the brokers excel? Is their performance consistent? One trader was told that his broker was not scoring well compared with his benchmark. Only by examining the individual trades, therefore, was the trader able to determine that this under-performance was due to a couple of unusual trades, and was not a consistent pattern.

Many managers analyze the results of different types of trades. How costly are directed and soft dollar trades versus trades executed for research or quality? Are limit trades more costly than market trades? How is portfolio trading stacking up?

The types of analysis reflect the needs of the different institutions.

What is consistent, however, is the need of traders to evaluate where they've been and what that means for their strategy.

Marie S. Konstance is senior vice president, analytical products at ITG Inc. in New York.