Optimal Execution Horizon

Abstract

Execution traders know that market impact greatly depends on whether their orders lean with or against the market. We introduce the OEH model, which incorporates this fact when determining the optimal trading horizon for an order, an input required by many sophisticated execution strategies. From a theoretical perspective, OEH explains why market participants may rationally “dump” their orders in an increasingly illiquid market. OEH is shown to perform better than participation rate schemes and VWAP strategies. We argue that trade side and order imbalance are key variables needed for modeling market impact functions, and their dismissal may be the reason behind the apparent disagreement in the literature regarding the functional form of the market impact function. Our backtests suggest that OEH contributes substantial 'execution alpha' for a wide variety of futures contracts. An implementation of OEH is provided in Python language.

Keywords: liquidity, flow toxicity, broker, VWAP, market microstructure, adverse selection, probability of informed trading, VPIN, OEH

JEL Classification: C02, D52, D53, G14, G23