_d-

reffiffiffi #ffi
tu#ffiffiq.Wffi
#rffie-*$s
PARTNERS: SERVICES PROVIDED TO
Wayne H. Wagner Institutional Investors
Edward C. Story Investment Managers
Larry J. Cuneo -- Institutional Traders
Plan Sponsors

IMMEDIACY COST AND OPPORTUNIW COST

COMMENTARY #22

May 1989

The basic decision faced by a buy-side trader is between taking an immediate

execution or waiting for a later execution, perhaps under more favorable terms.
By moving quickly, he expects to incur an Immediacy Cost, while he exposes
himself to a potential Opportunity Cost if he waits. How that tradeoff of
expectations is made is the heart and the art of trading.

Trading requires a delicate balancing between two sons for wanting to trade immediately: they know
expectationalcosts that are faced in every trading something that will soon make prices move.
decision: These information motivated traders hope to pass
off improperly valued stock on the uninformed.
n An Immediacy Cost that is high for traders The dealer, of course, stands in the first row, and
who demand immediate execution. and is while his information sources are usually very
expectationally lower for less urgent traders good, he can seldom expect to be the first to
who can wait for a counterpartythat, hopeful- know anything.
ly, will trade at a more favorable price.
What the dealer must do, then, is to protect him-
* An Oooortunitv Cost that increases as ex- self by [1] refining his information sources, espe-
pected time to completion increases" Oppor- cially by learning about his clients and their access
tunity cost is incurred when the information to information, [2] turninghis inventoryas quickly
motivatingthe trade impacts prices before the as possible, and, most importantly, [3] operating
trade can be completed. with a large enough spread between buy price and
sell price to cover both operating costs and losses
Market liquidity is not a to investors who possess superior information.
free good in most markets.
Immediac]f
{.ost',, ,.,',.!,:':'
Some markets, e.g. Trea- Thus investors
sury Bills, have high natural who demand im-
liquidity as outside moti- mediacy usually
vated buyers and sellers must transactwith
interact with each other. a market function-
ory, and can
Markets that are not naturally liquid can be expect to pay the
made liquid artificially. Specialists, dealers, and costs of having
other market functionaries earn a living by provid- that service provi-
ing market liquidity to otherwise illiquid markets. ded to them. A
By buying and selling from their own inventory, trader who can
they provide immediate liquidity for investors for wait, in contrast, Figure L

whom it would be an inconvenience (at minimum) displays by his very

Immediacy Cost
to wait for a natural counterparty. nonchalance that
he is not motivated by information. Also, a
Of course the dealer is not a patsy in this activity; trader who can wait greatly enhances the proba-
he knows that hidden among the convenience bility that another natural investor will appear to
motivated traders are traders with tansible rea- claim the other side of his trade without invokins

:l:il* i,tuiIlirrlr **iil*i*rrJ. $r:il*: i.** i:,rr:t* i-4*.*:r-*. {l*iifc}rl:i"r t*d*: f- i}-13 j4*1-:r#ii
the services of a dealer. pected trading cost is much wider and further to
the right. Not only should the index fund be
Thus the expected cost of immediacy slopes unwilling to incur Immediacy Costs, index fund
downward with time, as shown in Figure 1. Note managers have a great deal more flexibility to
that these arc expectational costs; sometimes an apply to their trading. They can apply trading
expensive.trade can be done quickly; at other techniques which may take a relatively long time
times delay will not serve to reduce the cost of a to find the counterparty and complete the trade.
particular trade. As the trader approaches the
market, however, he faces an Immediacy Cost that The total expected
slopes downwardwith expected time to execution. trade cost for the
slow-information
Now consider an investor manager lies be-
who possesses a bit of tween the two ex-
Opportuhity knowledge which is not tremes.
COSt] ::i::::::i]:]ii:i:i::]].]:1
yet fully appreciated by
the rest of the market. The appropriate
His expected cost, the trading techniques
cost of not transacting differ for each of
soon enough, is steeply upward sloping, as shown these styles of
by the uppermost cun'e -- labeled I as in informa- investment man- Figure 3
tion -- in Figure 2. We call this curve Oppor- agement. Infor- Total Trade Costs
tunity Cost. Note that the curve rises more mation traders
steeply than the Immediacy Cost curve falls in need to apply trading techniques which provide
Figure 1. Compared to the expected Opportuni- very rapid execution, such as market orders for
E Cost, the Immediacy Cost pales to insignifi- smaller trades and principal trades for large
cance for the information motivated investor. orders. These techniqueswill probably cost more
in Immediacy Costs, but they will avoid a po-
Investors who are tentially larger opportunity cost.
motivated by less
time-sensitive in- Slower-information traders have more time and
formation, (e.g. more flexibility. They can afford to wait for
contrarian manag- better trading situations. They can, for example,
ers or undiscovered advertise their interest in hopes of drawing out
value seekers) the natural other side. They can also afford to
would have a less wait for lower cost trading alternatives like Cross-
steeply sloping Op- ing Networks.
portunityCost. The
value they seek is The greatest trading advantage, however goes to
Figure 2 the index fund, who can afford to wait until the
not likely to be dis-
covered in a very Opportunity Cost market comes to him on suitable terms. Thinking
short period of of it differently, he lets the other side determine
time. We have labeled them S for slower. The the timing of the trade. This is valuable to the
lowest curve, labeled P for passive, represents the counterparty, comparable to the accommodating
indexfund,which never trades on information and disposition of the dealer. The danger, of course,
faces a minimal OpportunityCost due only to the is that the index fund does not possess the infor-
desire to remain fully invested. mation and quick turnaround advantages of the
dealer. While he should be able to reduce his
ffi Total expectational trade cost is trading cost significantly, it would seem to require
the sum of the Immediacy Cost substantial additional trading skills and presence
-.:-,
j9:1'- and the Opportunity Cosl. As for the index fund to match the dealer's ability to
LfT"
uos[' shown in Figure 3, these lotal make money in the trading process.
expected trade costs curves have
a "belly" which rePresents an So far, we have shown that trading involves bal-
area of minimum cost. For in- ancing the declining Immediacy Cost against the
formation motivated traders, tlibt rising Opportunity Cost. This is not an easy task.
area of cost is found close to zero time-to-com- We have already pointed out how these costs are
pletion and is short in duration. expectational in nature, and therefore difficult to
assess. Also, we have shown that they differ for
In contrast, the index fund's area of lowest ex- different management strategies. In addition,

2
the tradeoffvaries for different securities, or for
the same security under different market condi-
tions. It is a well tuned skill, usually accumulated
over years of experience, that correctly balances
these opposing influences and minimizes trade
costs.
Even though measure-
ment of these expected
Implications
costs is difficult to the
point of impossible, we
can draw some interest-
ing insights from thinking
of trading cost as a tradeoff between immediacy
and opportunity.
Most traders prefer to deal with the known devil
of Immediacy Cost rather than struggle with the
unknown devil of Opportunity Cost. For the
trader to be effective in driving down true transac-
tion costs, he needs an appreciation for decision
process that led to the trades. If the trades are
not based on immediate information, the trader
can use the flexibility to attempt to reduce trans-
action costs.
The word attempt in the previous sentence is key.
Waiting for better terms to trade on will not
always work out. The trader who exercises this
discretion will be at risk. A chastised trader can
always avoid this risk by executing all trades
immediately, i.e. before the Immediacy Cost curve
flattens out. The implication is that lowering
transaction cost depends on both the trader and
the portfolio manager and the quality of their
interaction.
Another important point is that most execution
evaluation services fail to measure opportunity
cost. (If your database consists of trades, how do
you measure a trade that wasn't there?) Unless
the leakage in the decision implementation is
accounted for, the measurement system is easily
gamed. An evaluation which shows well while
performance is poor clearly fails its main objec-
tive.
Pressure to reduce
trading costs will not
Conclnsion
succeed unless it is
done with an under-
standing of the trad-
ing process. Portfolio
managers who think of trading as something
separate and apart will fail to achieve excellent
implementation of their ideas. Sponsorswho wish
to fulfill their fiduciary duties with respect to
transaction costs need to learn a lot more about
securities markets and how the trading process
works.
Plexus Group is extremely pleased that
Jack Morton has joined us to work with
our clients in the Trade Advisory Service.
For many years, Jack was the head trader
at Dewey Square Investors, the money
management arm of The Bank of Boston.
We value Jack not only for his depth oi
experience of in-the-trenches trading, but
also for his insightful views on market pro-
CESSCS.
Jack wrote an article entitled Ethical
Issues in Trading for the CFA Trading
Strategies and Execution Costs Seminar
Proceedings. We thought so highly of his
thoughtsthat it was reprinted in The Com-
plete Guide to Securities Transactions.
(Which is now available in bookstores!!).
Our plan is to have Jack write the next
Commentary, which will give our readers
a chance to ponder his interesting insights.
Welcome, Jack. We look forward to work-
ing with the ideas and experience that you
bring to Plexus.