Immediacy Cost-Opportunity Cost

8/14/2019 Immediacy Cost-Opportunity Cost

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IMMEDIACY COST AND OPPORTUNIW COSTCOMMENTARY #22

May 1989The basic decision faced by a buy-side trader is between taking an immediateexecution or waiting for a later execution, perhaps under more favorable terms.By moving quickly, he expects to incur an Immediacy Cost, while he exposeshimself to a potential Opportunity Cost if he waits. How that tradeoff ofexpectations is made is the heart and the art of trading.

Trading requires a delicate balancing between twoexpectationalcosts that are faced in every tradingdecision:n An Immediacy Cost that is high for traderswho demand immediate execution. and isexpectationally lower for less urgent traderswho can wait for a counterpartythat, hopeful-ly, will trade at a more favorable price.* An Oooortunitv Cost that increases as ex-pected time to completion increases" Oppor-tunity cost is incurred when the informationmotivatingthe trade impacts prices before thetrade can be completed.

sons for wanting to trade immediately: they knowsomething that will soon make prices move.These information motivated traders hope to passoff improperly valued stock on the uninformed.The dealer, of course, stands in the first row, andwhile his information sources are usually verygood, he can seldom expect to be the first toknow anything.What the dealer must do, then, is to protect him-self by [1] refining his information sources, espe-cially by learning about his clients and their accessto information, [2] turninghis inventoryas quicklyas possible, and, most importantly, [3] operatingwith a large enough spread between buy price andsell price to cover both operating costs and lossesto investors who possess superior information.

Immediac]f{.ost',, ,.,,.!,::Market liquidity is not afree good in most markets.Some markets, e.g. Trea-sury Bills, have high naturalliquidity as outside moti-vated buyers and sellersinteract with each other.

Thus investorswho demand im-mediacy usuallymust transactwitha market function-ory, and canexpect to pay thecosts of havingthat service provi-ded to them. Atrader who canwait, in contrast,displays by his verynonchalance thathe is not motivated by information. Also, atrader who can wait greatly enhances the proba-bility that another natural investor will appear toclaim the other side of his trade without invokins

Markets that are not naturally liquid can bemade liquid artificially. Specialists, dealers, andother market functionaries earn a living by provid-ing market liquidity to otherwise illiquid markets.By buying and selling from their own inventory,they provide immediate liquidity for investors forwhom it would be an inconvenience (at minimum)to wait for a natural counterparty.Of course the dealer is not a patsy in this activity;he knows that hidden among the conveniencemotivated traders are traders with tansible rea-

Figure LImmediacy Cost

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Now consider an investorwho possesses a bit ofknowledge which is notyet fully appreciated bythe rest of the market.His expected cost, thecost of not transactingsoon enough, is steeply upward sloping, as shownby the uppermost cun'e -- labeled I as in informa-tion -- in Figure 2. We call this curve Oppor-tunity Cost. Note that the curve rises moresteeply than the Immediacy Cost curve falls inFigure 1. Compared to the expected Opportuni-E Cost, the Immediacy Cost pales to insignifi-cance for the information motivated investor.

OpportuhityCOSt] ::i::::::i]:]ii:i:i::]].]:1

Investors who aremotivated by lesstime-sensitive in-formation, (e.g.contrarian manag-ers or undiscoveredvalue seekers)would have a lesssteeply sloping Op-portunityCost. Thevalue they seek isnot likely to be dis-covered in a veryshort period of

the services of a dealer.Thus the expected cost of immediacy slopesdownward with time, as shown in Figure 1. Notethat these arc expectational costs; sometimes anexpensive.trade can be done quickly; at othertimes delay will not serve to reduce the cost of aparticular trade. As the trader approaches themarket, however, he faces an Immediacy Cost thatslopes downwardwith expected time to execution.

pected trading cost is much wider and further tothe right. Not only should the index fund beunwilling to incur Immediacy Costs, index fundmanagers have a great deal more flexibility toapply to their trading. They can apply tradingtechniques which may take a relatively long timeto find the counterparty and complete the trade.The total expectedtrade cost for theslow-informationmanager lies be-tween the two ex-tremes.The appropriatetrading techniquesdiffer for each ofthese styles ofinvestment man-agement. Infor-mation traders

Figure 3Total Trade Costsneed to apply trading techniques which providevery rapid execution, such as market orders forsmaller trades and principal trades for largeorders. These techniqueswill probably cost morein Immediacy Costs, but they will avoid a po-tentially larger opportunity cost.Slower-information traders have more time andmore flexibility. They can afford to wait forbetter trading situations. They can, for example,advertise their interest in hopes of drawing outthe natural other side. They can also afford towait for lower cost trading alternatives like Cross-ing Networks.The greatest trading advantage, however goes tothe index fund, who can afford to wait until themarket comes to him on suitable terms. Thinkingof it differently, he lets the other side determinethe timing of the trade. This is valuable to thecounterparty, comparable to the accommodatingdisposition of the dealer. The danger, of course,is that the index fund does not possess the infor-mation and quick turnaround advantages of thedealer. While he should be able to reduce histrading cost significantly, it would seem to requiresubstantial additional trading skills and presencefor the index fund to match the dealer's ability tomake money in the trading process.So far, we have shown that trading involves bal-ancing the declining Immediacy Cost against therising Opportunity Cost. This is not an easy task.We have already pointed out how these costs areexpectational in nature, and therefore difficult toassess. Also, we have shown that they differ fordifferent management strategies. In addition,

Figure 2Opportunity Costtime. We have labeled them S for slower. Thelowest curve, labeled P for passive, represents theindexfund,which never trades on information andfaces a minimal OpportunityCost due only to thedesire to remain fully invested.ffi Total expectational trade cost is

-.:-, the sum of the Immediacy Costj9:1'- and the Opportunity Cosl. AsLfT" shown in Figure 3, these lotaluos[' expected trade costs curves havea "belly" which rePresents anarea of minimum cost. For in-formation motivated traders, tlibtarea of cost is found close to zero time-to-com-pletion and is short in duration.In contrast, the index fund's area of lowest ex-2


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the tradeoffvaries for different securities, or forthe same security under different market condi-tions. It is a well tuned skill, usually accumulatedover years of experience, that correctly balancesthese opposing influences and minimizes tradecosts.

Implications Even though measure-ment of these expectedcosts is difficult to thepoint of impossible, wecan draw some interest-ing insights from thinkingof trading cost as a tradeoff between immediacyand opportunity.Most traders prefer to deal with the known devilof Immediacy Cost rather than struggle with theunknown devil of Opportunity Cost. For thetrader to be effective in driving down true transac-tion costs, he needs an appreciation for decisionprocess that led to the trades. If the trades arenot based on immediate information, the tradercan 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 notalways work out. The trader who exercises thisdiscretion will be at risk. A chastised trader canalways avoid this risk by executing all tradesimmediately, i.e. before the Immediacy Cost curveflattens out. The implication is that loweringtransaction cost depends on both the trader andthe portfolio manager and the quality of theirinteraction.Another important point is that most executionevaluation services fail to measure opportunitycost. (If your database consists of trades, how doyou measure a trade that wasn't there?) Unlessthe leakage in the decision implementation isaccounted for, the measurement system is easilygamed. An evaluation which shows well whileperformance is poor clearly fails its main objec-tive.

ConclnsionPressure to reducetrading costs will notsucceed unless it isdone with an under-standing of the trad-ing process. Portfoliomanagers who think of trading as something

separate and apart will fail to achieve excellentimplementation of their ideas. Sponsorswho wishto fulfill their fiduciary duties with respect totransaction costs need to learn a lot more aboutsecurities markets and how the trading processworks.Plexus Group is extremely pleased thatJack Morton has joined us to work withour clients in the Trade Advisory Service.For many years, Jack was the head traderat Dewey Square Investors, the moneymanagement arm of The Bank of Boston.We value Jack not only for his depth oiexperience of in-the-trenches trading, butalso for his insightful views on market pro-CESSCS.

Jack wrote an article entitled EthicalIssues in Trading for the CFA TradingStrategies and Execution Costs SeminarProceedings. We thought so highly of histhoughtsthat 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 nextCommentary, which will give our readersa chance to ponder his interesting insights.Welcome, Jack. We look forward to work-ing with the ideas and experience that youbring to Plexus.

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Immediacy Cost-Opportunity Cost