Costly Trading

Abstract

We revisit optimal execution of an active portfolio in the presence of slippage (aka linear, proportional, or absolute-value) costs. Market efficiency implies a close balance between active alphas and trading costs, so even small changes to trading optimization can make a big difference. It has been observed for some time that optimal trading involves a pattern of a no-trade zone with width increasing with slippage cost parameter c. In a setting of a reasonably stable (non-stochastic) forecast of future returns and a quadratic risk aversion, it is shown that c^1/2, which differs from the c^1/3 scaling reported for stochastic settings. Analysis of optimal trading employs maximization of a utility including projected alpha-based profits, slippage costs, and risk aversion and borrows from a physical analogy of forced motion in the presence of friction.

Tasks

Reproductions