In our last post, we talked about the challenges of selecting an optimal trading benchmark. If you didn’t read it, no worries. The 10-second recap is Arrival is usually (but not always) the optimal benchmark for transition management (or TM) events. It is both unbiased and more reflective of the TM execution performance.

The next logic question is when do you start? Sorry, but there is no hard and fast answer to the question of when to start a TM or portfolio trade. Every event is different – this is where portfolio analysis, market expertise, and back-tested models come into play. We must understand the assets we are trading and how their volume and volatility change daily. As in part 1 of this series, we used the S&P 500 as a proxy. In this example, we look at the underlying securities for the 12 months ending April 2022.

We don’t believe starting at the market open is optimal in many situations. Instead, the CAPIS transition management team analyzes market data to estimate a better starting point. While there is no firm answer, generally we start 5-10 minutes after market opening. By doing this, we allow the markets to settle, see improved volumes, and for spread to tighten. This approach can vary widely based on the trade positions’ market cap and relative spreads.

For example, we may start risk-neutral trading (buys and sells) more quickly for large cap names (even 2-3 minutes after the open). These positions are often less volatile and we see spread costs normalize more quickly than smaller cap stocks.

We cannot only look at volume when determining a start time because there is a point of diminishing return starting to trade later in the day. Starting too late in the day forces you to become a more significant percentage of the residual day’s volume, leading to increased trade costs and a heightened opportunity cost risk (e.g., not being in your model portfolio as soon as possible).

Looking at the same data as the chart above, but comparing volatility relative to volume, we see the volatility outpaces volume 2-3x in the first 30 minutes of the day, which is greater than any other period during the trading day.

So, it’s not surprising to see an inverse relationship between low trade volumes and higher spread costs during the first 10-20 minutes of the US trading day. It can be so extreme that waiting even a few minutes can result in spreads compressing by a very large margin. In trades we’ve managed, we’ve seen spreads reduce by 50-120 bps in the first 15 minutes.

Earlier I said volume isn’t everything, and the chart above proves this. The volume in the 1st ½ hour is similar to the volume in the last ½ hour. However, the volatility is nearly twice as high when comparing the morning to the afternoon.

Looking at the chart below (BofA Securities, 2022), we can better visualize the spreads throughout the trading day. I think this is one of the best examples of why we often avoid the first 10-15 minutes of the US trading day. Immediately after the market open, S&P 500 spreads averaged approximately 24 bps. By 9:40 am, spreads have fallen to about 13 bps –a 45% decrease in just 10 minutes.

Let’s wrap this up.

There is no perfect time to start a transition trade. However, this is where the art and science of TM come into play. A provider can (and should!) look at near-term historical data (usually 20 days) to better understand the portfolio’s volumes, spreads, and volatility. The data helps in the creation of an event’s overall trade strategy.

At CAPIS, we provide such analysis and often find a clear inflection point where volumes are more optimal, and spreads are lower. We often analyze intraday (usually for the last few days) spread and volume for equities to identify the outliers. These positions shouldn’t impact overall trade execution or strategy, but we can often build risk-neutralizing baskets of these outliers to reduce opportunity risk and manage trade costs.

If I had to summarize these articles into a few bullet points, here they are:

• Benchmarks should help you understand trading effectiveness. Pick one that best does that for your specific situation. We like Arrival.
• The first 5-10 minutes of the US trading day is defined by lower volume but much higher spreads and volatility.
• Generally, excess spreads reduce after the first 15-30 minutes to a more average daily level. This is often a good point to mark your benchmark (Arrival, right?) and start trading.
• When in doubt, trust but verify your provider. Ask questions. Understand why they are recommending the strategy. And ask for a detailed post-trade analysis. These are your assets, after all.

If you have thoughts, questions, or want to say hi, reach out on LinkedIn or email me at [email protected].

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