In the UPX Fund, an investment in the new technology sector has performed well and is expected to continue to do so. However, the proportion of the fund invested in the new technology sector is now larger than what is permitted in the fund prospectus. Holt intends to reduce the holdings in the sector to comply with the prospectus over the next two months before the quarter ends. The volume of shares that need to be sold is approximately 20% of the daily volume in their respective individual markets.
To execute the trades in the new technology sector, Holt asks his team to consider three possible options:
| Option 1 | Have a broker act as a principal for the entire amount that needs to be sold. |
| Option 2 | Use a scheduled algorithm to execute the trade based on available daily liquidity over eight weeks. |
| Option 3 | Trade in a “dark pool” so as not to reveal any information about the amount to be traded. |
Which trading option is most appropriate for selling securities from the new technology sector of the UPX Fund?
- Option 1
- Option 2
- Option 3
Solution
B is correct. A scheduled algorithm over the eight-week period is the best option for selling the securities. There is sufficient liquidity in the market, because on any given day, the amount sold will be approximately 0.5% of the daily volume: 20% daily volume ÷ (5 days × 8 weeks) = 0.5%. The price impact of trading will be minimal, and there is no trade urgency given the time horizon for liquidating the shares.
A is incorrect. Given that the trade can be executed over a two-month period, there is no reason to incur the expense of having a broker act as a principal trader for all the shares. If there were a need to trade the shares quickly, this kind of strategy could be warranted.
Why A is incorrect? Its a large order 20% holding so for a large order we will use broker? How to undetsand whether this ordrr is large or not. I thought it is 20% of Daily Vol so I thought it is large. For large order we use High Touch Approaches only
The reason option A is considered incorrect in this context is because, despite the fact that the order represents 20% of the daily volume, the overall size of the order is not considered large enough to necessitate the use of a broker acting as a principal for the entire amount.
In institutional trading, the decision to use a broker as a principal is often influenced by the size and urgency of the order. In this case, since the order can be executed over a two-month period, there is no immediate need for urgency. Additionally, the size of the order, when spread out over the eight weeks, results in a daily volume impact of approximately 0.5%, which is considered manageable and not large enough to warrant the higher costs associated with having a broker act as a principal.
High touch approaches, which involve more direct interaction with a broker, are typically employed for larger orders where minimizing market impact is crucial. In this scenario, using a scheduled algorithm over the two-month period is deemed more appropriate due to its cost-effectiveness, minimal market impact, and alignment with the time horizon for liquidating the shares.