Market Drift Vs. Market Impact

One of the perennial problems with measuring execution slippage is how to break it into components and attribute between the market impact of the order itself and market drift. It’s very difficult to do – the two are deeply intertwined and not easily or reliably unraveled to give a clear answer. For any individual order, unless one has a very high participation rate, market drift is probably a lot more than you think, perhaps 80% of the slippage vs. 20% attributed to market impact.

However, in the absence of short-term alpha in your order flow, market drift would typically be neutral in the long run, over many orders market moves are sometimes favorable and sometimes adverse. You do have some control over market impact through the selection of your execution strategy and your urgency to complete. This is something QB has spent a lot of time on – balancing the tradeoff between price risk and liquidity premium. Working an order for longer reduces one’s cost of having to cross the spread (liquidity consuming) but introduces greater exposure to the market drift, which can be significant. QB’s algorithmic strategies are carefully engineered to minimize market impact as much as possible whilst respecting the ever-changing dynamics of the market.

There is a common misconception that market impact only arises from aggressive orders. This is not the case. One’s passive executions at seemingly favorable levels can hold the market at a level that is less favourable than would otherwise be achieved. This is commonly referred to as “adverse selection”; something we at QB are very conscious of when optimizing our order placement.

Measuring execution slippage consistently across one’s own order flow, and even breaking out by the underlying investment strategy, can better help identify its unique characteristics and the presence of short-term alpha. With strong short-term alpha, market drift would be an even greater component to slippage. If known this can prompt more urgent execution to reduce the exposure to the market drift, which is itself the alpha in this case.

In our co-founder’s seminal paper in 2000 (Almgren-Chriss: Optimal Execution of Portfolio Transactions), the concept of temporary market impact and permanent market impact were originally defined:

“The security’s price evolves according to two exogenous factors: volatility and drift, and one endogenous factor: market impact. Volatility and drift are assumed to be the result of market forces that occur randomly and independently of our trading.”

“As market participants begin to detect the volume we are selling (buying) they naturally adjust their bids (offers) downward (upward). We distinguish two kinds of market impact. Temporary impact refers to temporary imbalances in supply in demand caused by our trading leading to temporary price movements away from equilibrium. Permanent impact means changes in the “equilibrium” price due to our trading, which remain at least for the life of our liquidation.”

For the challenge in understanding temporary and permanent market impact, the best answer is to measure reversion: What happens to the market after the order is completed. This is somewhat of a proxy rather than a specific measure of market impact but it can provide a helpful perspective.

Today we announce the addition of multiple new reversion measures to our existing TCA benchmarks. These data points will help our clients gain further insights on their order flow. Contact us to find out more.

Quantitative Brokers
September 12, 2018
New York