IDEAS home Printed from https://ideas.repec.org/p/arx/papers/2110.15239.html
   My bibliography  Save this paper

Costly Trading

Author

Listed:
  • Michael Isichenko

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 $\Delta$ 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 $\Delta\sim c^{1/2}$, which differs from the $\Delta\sim c^{1/3}$ 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.

Suggested Citation

  • Michael Isichenko, 2021. "Costly Trading," Papers 2110.15239, arXiv.org.
    • Handle: RePEc:arx:papers:2110.15239
    as

    Download full text from publisher

    File URL: http://arxiv.org/pdf/2110.15239
    File Function: Latest version
    Download Restriction: no
    ---><---

    References listed on IDEAS

    as
    1. Miguel, Víctor de & Nogales, Francisco J., 2013. "Multiperiod portfolio selection with transaction and market-impact costs," DES - Working Papers. Statistics and Econometrics. WS ws131615, Universidad Carlos III de Madrid. Departamento de Estadística.
    2. Richard Martin & Torsten Schoneborn, 2011. "Mean Reversion Pays, but Costs," Papers 1103.4934, arXiv.org.
    3. Thomas Philippon, 2015. "Has the US Finance Industry Become Less Efficient? On the Theory and Measurement of Financial Intermediation," American Economic Review, American Economic Association, vol. 105(4), pages 1408-1438, April.
    4. Jean-Philippe Bouchaud, 2021. "The Inelastic Market Hypothesis: A Microstructural Interpretation," Papers 2108.00242, arXiv.org, revised Jan 2022.
    5. Nicolae Gârleanu & Lasse Heje Pedersen, 2013. "Dynamic Trading with Predictable Returns and Transaction Costs," Journal of Finance, American Finance Association, vol. 68(6), pages 2309-2340, December.
    6. George M. Constantinides, 2005. "Capital Market Equilibrium with Transaction Costs," World Scientific Book Chapters, in: Sudipto Bhattacharya & George M Constantinides (ed.), Theory Of Valuation, chapter 7, pages 207-227, World Scientific Publishing Co. Pte. Ltd..
    7. Joachim de Lataillade & Cyril Deremble & Marc Potters & Jean-Philippe Bouchaud, 2012. "Optimal Trading with Linear Costs," Papers 1203.5957, arXiv.org.
    Full references (including those not matched with items on IDEAS)

    Most related items

    These are the items that most often cite the same works as this one and are cited by the same works as this one.
    1. Johannes Muhle-Karbe & Xiaofei Shi & Chen Yang, 2020. "An Equilibrium Model for the Cross-Section of Liquidity Premia," Papers 2011.13625, arXiv.org.
    2. Johannes Muhle-Karbe & Max Reppen & H. Mete Soner, 2016. "A Primer on Portfolio Choice with Small Transaction Costs," Papers 1612.01302, arXiv.org, revised May 2017.
    3. Martin Herdegen & Johannes Muhle-Karbe & Dylan Possamaï, 2021. "Equilibrium asset pricing with transaction costs," Finance and Stochastics, Springer, vol. 25(2), pages 231-275, April.
    4. Florent Gallien & Serge Kassibrakis & Semyon Malamud, 2018. "Hedge or Rebalance: Optimal Risk Management with Transaction Costs," Risks, MDPI, vol. 6(4), pages 1-14, October.
    5. Joachim de Lataillade & Ayman Chaouki, 2020. "Equations and Shape of the Optimal Band Strategy," Papers 2003.04646, arXiv.org, revised Mar 2020.
    6. Jan Kallsen & Johannes Muhle-Karbe, 2013. "The General Structure of Optimal Investment and Consumption with Small Transaction Costs," Papers 1303.3148, arXiv.org, revised May 2015.
    7. Filippo Passerini & Samuel E. Vazquez, 2015. "Optimal Trading with Alpha Predictors," Papers 1501.03756, arXiv.org, revised Jan 2015.
    8. Ibrahim Ekren & Johannes Muhle-Karbe, 2017. "Portfolio Choice with Small Temporary and Transient Price Impact," Papers 1705.00672, arXiv.org, revised Apr 2020.
    9. Bruno Bouchard & Masaaki Fukasawa & Martin Herdegen & Johannes Muhle-Karbe, 2018. "Equilibrium Returns with Transaction Costs," Post-Print hal-01569408, HAL.
    10. Lukas Gonon & Johannes Muhle-Karbe & Xiaofei Shi, 2019. "Asset Pricing with General Transaction Costs: Theory and Numerics," Papers 1905.05027, arXiv.org, revised Apr 2020.
    11. Martin Herdegen & Johannes Muhle-Karbe & Dylan Possamai, 2019. "Equilibrium Asset Pricing with Transaction Costs," Papers 1901.10989, arXiv.org, revised Sep 2020.
    12. Matt Emschwiller & Benjamin Petit & Jean-Philippe Bouchaud, 2019. "Optimal multi-asset trading with linear costs: a mean-field approach," Papers 1905.04821, arXiv.org, revised Apr 2020.
    13. Ayman Chaouki & Stephen Hardiman & Christian Schmidt & Emmanuel S'eri'e & Joachim de Lataillade, 2020. "Deep Deterministic Portfolio Optimization," Papers 2003.06497, arXiv.org, revised Apr 2020.
    14. Eduardo Dávila & Cecilia Parlatore, 2021. "Trading Costs and Informational Efficiency," Journal of Finance, American Finance Association, vol. 76(3), pages 1471-1539, June.
    15. Bruno Bouchard & Masaaki Fukasawa & Martin Herdegen & Johannes Muhle-Karbe, 2017. "Equilibrium Returns with Transaction Costs," Papers 1707.08464, arXiv.org, revised Apr 2018.
    16. Richard J. Martin, 2012. "Optimal multifactor trading under proportional transaction costs," Papers 1204.6488, arXiv.org.
    17. Ibrahim Ekren & Ren Liu & Johannes Muhle-Karbe, 2015. "Optimal Rebalancing Frequencies for Multidimensional Portfolios," Papers 1510.05097, arXiv.org, revised Sep 2017.
    18. Rim Bernoussi & Michael Rockinger, 2023. "Rebalancing with transaction costs: theory, simulations, and actual data," Financial Markets and Portfolio Management, Springer;Swiss Society for Financial Market Research, vol. 37(2), pages 121-160, June.
    19. A. Rej & R. Benichou & J. de Lataillade & G. Z'erah & J. -Ph. Bouchaud, 2015. "Optimal Trading with Linear and (small) Non-Linear Costs," Papers 1511.07359, arXiv.org, revised Nov 2016.
    20. Alain Bensoussan & Guiyuan Ma & Chi Chung Siu & Sheung Chi Phillip Yam, 2022. "Dynamic mean–variance problem with frictions," Finance and Stochastics, Springer, vol. 26(2), pages 267-300, April.

    More about this item

    NEP fields

    This paper has been announced in the following NEP Reports:

    Statistics

    Access and download statistics

    Corrections

    All material on this site has been provided by the respective publishers and authors. You can help correct errors and omissions. When requesting a correction, please mention this item's handle: RePEc:arx:papers:2110.15239. See general information about how to correct material in RePEc.

    If you have authored this item and are not yet registered with RePEc, we encourage you to do it here. This allows to link your profile to this item. It also allows you to accept potential citations to this item that we are uncertain about.

    If CitEc recognized a bibliographic reference but did not link an item in RePEc to it, you can help with this form .

    If you know of missing items citing this one, you can help us creating those links by adding the relevant references in the same way as above, for each refering item. If you are a registered author of this item, you may also want to check the "citations" tab in your RePEc Author Service profile, as there may be some citations waiting for confirmation.

    For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: arXiv administrators (email available below). General contact details of provider: http://arxiv.org/ .

    Please note that corrections may take a couple of weeks to filter through the various RePEc services.

    IDEAS is a RePEc service. RePEc uses bibliographic data supplied by the respective publishers.