Optimal Trading Strategy and Supply/Demand Dynamics

42 Pages Posted: 20 Mar 2005  

Anna A. Obizhaeva

New Economic School (NES)

Jiang Wang

Massachusetts Institute of Technology (MIT) - Sloan School of Management; China Academy of Financial Research (CAFR); National Bureau of Economic Research (NBER)

Multiple version iconThere are 3 versions of this paper

Date Written: February 2005

Abstract

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.

Keywords: price impact; limit order book; optimal execution

JEL Classification: G19, G20

Suggested Citation

Obizhaeva, Anna A. and Wang, Jiang, Optimal Trading Strategy and Supply/Demand Dynamics (February 2005). AFA 2006 Boston Meetings Paper. Available at SSRN: https://ssrn.com/abstract=686168 or http://dx.doi.org/10.2139/ssrn.686168

Anna A. Obizhaeva (Contact Author)

New Economic School (NES) ( email )

100A Novaya ul
Moscow, Skolkovo 143026
Russia

Jiang Wang

National Bureau of Economic Research (NBER)

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

Massachusetts Institute of Technology (MIT) - Sloan School of Management ( email )

E62-614
100 Main Street
Cambridge, MA 02142
United States
617-253-2632 (Phone)
617-258-6855 (Fax)

China Academy of Financial Research (CAFR)

1954 Huashan Road
Shanghai P.R.China, 200030
China

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