One of the most important decisions facing investment managers is how quickly they should implement their buy and sell decisions. Some prefer to bear the cost of instant liquidity; these investors see a need to act quickly on their opinions. Others argue that it pays to trade “patiently.” The goal of patient trading is to buy or sell at a desired price, rather than executing at a particular time. This may be achieved by a number of strategies, including the use of limit orders, or simply waiting for other buyers and sellers to appear before selecting which trades to execute.
Experience with an actual patient program trade used to buy a $40 million portfolio of small-cap stocks shows that patient trading can help to reduce transaction costs, but not by as much as some of its advocates have suggested. The patient program’s trading costs (before commissions) amounted to about 2.13 per cent. That is lower than the 2.5 to 3.5 per cent trading cost estimated for a traditional program trade, but not the negative cost (profit) some patient traders expect.
The experience also highlights the importance of measuring execution costs correctly. Traditional cost measures—such as the price paid compared with the volume-weighted average price of the stock on the trade date, or the execution price compared with some post-trade benchmark—mask very real market impact and adverse-selection costs. One measure that does incorporate both adverse selection and market impact, as well as bid-ask spread costs, is the implementation shortfall.
