Are You Better Off Trading Blocks in Volatile Markets? Yes

Abstract

The volatility that gripped the market during the latter half of 2008 led many traders to change their trading behavior. The relative volume of block trades that were executed in the market decreased during this period. Many traders moved away from trading large blocks, to trading strategies that enabled them to spread their orders throughout the trading day, closer to a VWAP style, in order to reduce their risk. From an implementation shortfall perspective, however, the risk of spreading the order throughout the day is higher than executing the order quickly, as in the case of executing a large block.

The author suggests that the fundamental reason for the difference in risk perspectives among traders, and the theoretical risk based on implementation shortfall measures, is the way traders are measured and compensated. Traders measured versus a VWAP benchmark see a greater variance in their performance in more volatile markets. In order to manage their career risk, they seek to match their trading behavior with their performance benchmark. The increased volatility in the market exacerbated the problem.

The article compares the incurred risk of several strategies to demonstrate that less-aggressive strategies, such as VWAP, incur more risk than aggressive strategies that trade blocks opportunistically as they become available. The author suggests that the best way to address the misalignment between the investment objectives of the firm and the trading objectives of the desk is to measure traders’ performance using an implementation shortfall benchmark rather than a VWAP benchmark. He also suggests that incorporating risk into the post-trade measurement process leads to a harmonization of the objectives of traders and portfolio managers.