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Optimal Trading Strategy and Supply/Demand Dynamics

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  • Anna Obizhaeva
  • Jiang Wang
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    Abstract

    The supply/demand of a security in the market is an intertemporal, not a static, object and its dynamics is crucial in determining market participants' trading behavior. Previous studies on the optimal trading strategy to execute a given order focuses mostly on the static properties of the supply/demand. In this paper, we show that the dynamics of the supply/demand is of critical importance to the optimal execution strategy, especially when trading times are endogenously chosen. Using a limit-order-book market, we develop a simple framework to model the dynamics of supply/demand and its impact on execution cost. We show that the optimal execution strategy involves both discrete and continuous trades, not only continuous trades as previous work suggested. The cost savings from the optimal strategy over the simple continuous strategy can be substantial. We also show that the predictions about the optimal trading behavior can have interesting implications on the observed behavior of intraday volume, volatility and prices.

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    Bibliographic Info

    Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 11444.

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    Date of creation: Jun 2005
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    Handle: RePEc:nbr:nberwo:11444

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    Citations

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    Cited by:
    1. Kovaleva, P. & Iori, G., 2012. "Optimal Trading Strategies in a Limit Order Market with Imperfect Liquidity," Working Papers 12/05, Department of Economics, City University London.
    2. Rene Carmona & Kevin Webster, 2013. "The Self-Financing Equation in High Frequency Markets," Papers 1312.2302, arXiv.org.
    3. Rama Cont & Arseniy Kukanov, 2012. "Optimal order placement in limit order markets," Papers 1210.1625, arXiv.org, revised Jul 2013.
    4. Rama Cont & Arseniy Kukanov, 2012. "Optimal order placement in limit order markets," Working Papers hal-00737491, HAL.
    5. Gerardo Hernandez-del-Valle & Carlos Pacheco-Gonzalez, 2009. "Optimal execution of Portfolio transactions with geometric price process," Papers 0908.1211, arXiv.org, revised Nov 2009.
    6. Rossella Agliardi & Ramazan Gençay, 2012. "Hedging through a Limit Order Book with Varying Liquidity," Working Paper Series 12_12, The Rimini Centre for Economic Analysis.
    7. Wei Cui & Anthony Brabazon & Michael O'Neill, 2011. "Dynamic trade execution: a grammatical evolution approach," International Journal of Financial Markets and Derivatives, Inderscience Enterprises Ltd, vol. 2(1/2), pages 4-31.
    8. Large, Jeremy, 2007. "Measuring the resiliency of an electronic limit order book," Journal of Financial Markets, Elsevier, vol. 10(1), pages 1-25, February.
    9. Ryosuke Ishii, 2009. "Optimal Execution in an Evolutionary Setting," KIER Working Papers 670, Kyoto University, Institute of Economic Research.
    10. Rene Carmona & Kevin Webster, 2012. "High Frequency Market Making," Papers 1210.5781, arXiv.org.
    11. Terrence Hendershott & Charles M. Jones & Albert J. Menkveld, 2011. "Does Algorithmic Trading Improve Liquidity?," Journal of Finance, American Finance Association, vol. 66(1), pages 1-33, 02.
    12. Kervel, V.L. van, 2013. "Competition between stock exchanges and optimal trading," Open Access publications from Tilburg University urn:nbn:nl:ui:12-5663709, Tilburg University.
    13. Olivier Gu\'eant, 2013. "Permanent market impact can be nonlinear," Papers 1305.0413, arXiv.org, revised Mar 2014.
    14. Peter Bank & Antje Fruth, 2013. "Optimal Order Scheduling for Deterministic Liquidity Patterns," Papers 1310.3077, arXiv.org.
    15. Adrian Buss & Bernard Dumas, 2013. "Financial-market Equilibrium with Friction," NBER Working Papers 19155, National Bureau of Economic Research, Inc.
    16. Olivier Gu\'eant, 2012. "Optimal execution and block trade pricing: a general framework," Papers 1210.6372, arXiv.org, revised Jul 2014.
    17. Olivier Gu\'eant, 2012. "Execution and block trade pricing with optimal constant rate of participation," Papers 1210.7608, arXiv.org, revised Dec 2013.
    18. Aurélien Alfonsi & Alexander Schied, 2010. "Optimal trade execution and absence of price manipulations in limit order book models," Post-Print hal-00397652, HAL.
    19. Olivier Gu\'eant & Charles-Albert Lehalle, 2012. "General Intensity Shapes in Optimal Liquidation," Papers 1204.0148, arXiv.org, revised Jun 2013.
    20. Aurélien Alfonsi & Alexander Schied, 2013. "Capacitary measures for completely monotone kernels via singular control," Post-Print hal-00659421, HAL.

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