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September 22, 2005

Rethinking Pre-Trade: Brokers re-write the rules of pre-trade cost analysis

By Peter Chapman

First, these models assume that market impact is the same for both buys and sells. Piper believes the two types of trades impact the market differently. Second, the models distinguish between a so-called temporary market impact and a permanent market impact, arbitrarily assigning percentages to the two components. Piper discounts the notion of temporary impact.

Third, the models assume market impact is proportional to the size of the order. Piper maintains market impact does increase with the size of an order, but the relationship is not linear. At some point, market impact levels off.

Piper's rethinking of these assumptions makes its methodology significantly more accurate than the models of others, according to execs at the broker-dealer. Still, they concede the limitations of single-stock cost estimates. "A pre-trade estimate in a single name is a reference point," notes exec Dave Mortimer. "That's all the buyside uses it for."

Piper built its system in conjunction with QSG, a trading cost consultancy and software developer based in the suburbs of Chicago. QSG was founded by former Donaldson, Lufkin & Jenrette quants John Wightkin and Tim Sargent. Sargent also worked at Salomon Brothers where he developed the well-known StockFacts Pro package.

The methodology supporting QSG's post-trade cost measurement services is central to Piper's pre-trade offering, according to Piper. QSG analyzes its customers trades tick by tick in an effort to properly allocate market impact costs. It attempts to determine how much of the movement in a stock was caused by the trade in question and how much was done by someone else's trade.

"Tick distribution is key," notes Piper's Scott Wilson of his firm's pre-trade model. "We try to determine: What is the likelihood of each tick being higher or lower than the previous tick? All the other models are based on volatility. We use volatility, but it has a much lower weighting."

Mortimer adds: "We are trying to figure out some degree of direction. I wouldn't call it a momentum model. But we are trying to look at every single tick."

QSG's database is a key reason Piper chose to partner with the consultant. QSG obtains trade data from several money managers and plan sponsors. The existence of the database allows Piper to compare its estimates with the actual trades on a daily basis. "That grounds our pre-trade offering in empirical analysis," says Wilson. "It's not just based on theory and volatility."

Mortimer adds: "If we had that data ourselves, we probably would've done this on our own. That data is irreplaceable. Clients would not give us that data."

Lehman Brothers

Lehman, relatively speaking, is an old hand at pre-trade cost estimation. The bulge player built a cost forecasting system for basket trades two years ago. It moved into the single stock arena earlier this year.

Single stocks are a totally different ballgame, according to David Cushing, a Lehman managing director of equity analytics and algorithmic trading. The "variance," or amount a forecast can be off, rises dramatically with single stocks.