Investment Phase
The investment cycle undergoes four different phases. At initiation, a portfolio manager (PM) with a long time horizon and high information content might want to invest some capital. The PM will call on his or her buy-side trader to implement the trade. Fundamentally, the buy-side trader cares most about keeping his job so the trader needs to balance considerations when selecting the best strategy to trade. The buy-side trader will then contact his counterpart on the sell-side trading desk to execute the trade. The sell-side trading desk requires constant development on many different tools for execution. At the top level, a sell-side trader needs a trade scheduler which will drive when to trade when breaking up a large order. Because liquidity is very seasonal and can vary throughout the day, the goal of a trade scheduler is to try to execute when there is most liquidity. In the United States, there are 13 major exchanges in addition to various dark pools. Hence, an effective smart order routing helps in executing efficiently. At last, the sell-side desk will execute in the market against high frequency market making firms who have very short trade horizon and almost no information content. While high frequency models are simpler with weaker alphas, strategies are implemented very efficiently. Usually there is a clear adverse selection component; high frequency players know least about the fundamentals of a stock and therefore, need to exit their positions as quickly as possible.
Factors to Consider on Buy-Side
A portfolio manager might be interested in many factors such as slippage, scalability, liquidity, and post trade analysis. Slippage refers to the cost to enter a position. Huge slippage eats away at the alpha of the trade. Scalability is important in that one always wants to be sure that an asset class can handle a large investment base. In a panic, a PM wants to know if his or her investment is still liquid; this refers to the liquidity of an investment. After the trade, many funds run a process known as post trade decomposition by analyzing the executing broker or buy side trader to see how effective they are.
Impact of Investment & Trading Time Horizons
Let's for the moment establish difference between a derivatives market maker who tends to hold on to positions longer versus a high frequency market maker with a shorter time horizon. A well-capitalized market maker in less liquid, but more structured markets such as options will care about the intelligence of their counterparties. For example, an options trader might welcome trading against large orders, if he or she could spread other trades against the large order, thereby replicating the position perfectly while capturing margin. Additionally, an options trader does not mind buying volatility at a fundamentally undervalued level for large size, because he or she can hold on to the position until maturity if needed to capture the difference between realized and implied volatility. What worries a derivatives trader is being on the other side of trades at fundamentally bad prices. So price matters more than size in certain structured markets. In comparison, a high frequency market maker cares more instead about avoiding trading against large orders which could move the market. A mutual fund might execute a large sell order at a fundamentally poor price, but a high frequency market maker will not trade against such an order, because it is not the job of a high frequency desk to hold onto inventory over long periods of time.
