42 Pages Posted: 20 Mar 2005
Date Written: February 2005
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: 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
By Jim Gatheral