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 behaviour. 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. We suggest that the fundamental reason for the difference in risk perspectives among traders, and the theoretical risk based on Implementation Shortfall measures, is due to the way that traders are measured and compensated. Traders who are measured versus a VWAP benchmark would see a greater variance in their performance in more volatile markets. In order to manage their career risk, they would seek to match their trading behaviour with their performance benchmark. The increased volatility in the market exacerbated the problem. We compare the incurred risk of several strategies to demonstrate that less aggressive strategies, such as VWAP, incur more risk than aggressive strategies which trade blocks opportunistically as they become available. We suggest 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. We also suggest that incorporating risk into the post-trade measurement process would lead to a harmonization of the objectives of traders and portfolio managers.