Optimal Trading Strategy and Supply/Demand Dynamics
Anna A. Obizhaeva
New Economic School (NES)
Massachusetts Institute of Technology (MIT) - Sloan School of Management; China Academy of Financial Research (CAFR); National Bureau of Economic Research (NBER)
AFA 2006 Boston Meetings Paper
The supply/demand of a security in the market is an intertemporal, not a static, object and its dynamics are 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 are of critical importance to the optimal execution strategy, especially when trading times are endogenously chosen. Using the limit-order-book market, we develop a simple framework to model the dynamics of supply/demand and their 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.
Number of Pages in PDF File: 42
Keywords: price impact; limit order book; optimal execution
JEL Classification: G19, G20
Date posted: March 20, 2005
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