Balancing Execution Risk and Trading Cost in Portfolio Trading Algorithms

Abstract

In this article, we discuss the balance between risk and cost in the context of portfolio trading algorithms. We provide examples of how trading a basket in a coordinated manner can lead to more efficient execution than trading each stock independently. Specifically, by trading buy and sell orders in a synchronized way, advanced algorithms can execute more passively, reducing cost without increasing risk. We discuss how this cost–risk trade-off can be achieved via an optimization approach, even when additional constraints such as cash- or beta-neutrality are applied. Finally, we address the importance of incorporating intraday variation in cost and risk when formulating an optimal algorithmic trading strategy.