Optimal Participation and Short-Term Alpha

Abstract

One of the most important decisions a trader has to make is how aggressively to execute. The right execution aggressiveness depends critically on short-term alpha. This article uses the Goldman Sachs trading cost model to derive the trader's optimal execution aggressiveness for different short-term alpha estimates. In this analysis, the trader optimizes execution aggressiveness by choosing the participation rate that minimizes execution shortfall. Shortfall has two components: liquidity impact and alpha loss. Increasing the participation rate speeds up executions and reduces alpha loss but increases impact. The optimal participation rate balances the reduced alpha loss of faster executions against the higher impact. For large-cap stocks and orders (2% of a day's volume, for example), when the expected alpha-to-close is 20 bps, the optimal participation is 7%.