Pairs Trading: Quantitative Methods and Analysis

CHAPTER 10

Trade Execution

INTRODUCTION

There is an oft-quoted maxim, “Concentrate on what you do best and delegate the rest.” Going with this idea, the general preference of the arbitrageur is to concentrate on deal analysis and delegate trade execution to a broker. The execution in this case is fairly involved, as the trades need to be done on a paired basis. Not only must the broker ensure that the positions in both the stocks satisfy the particular exchange ratio, but he or she also needs to ensure that the fill prices on the stocks capture the specified spread. Thus, at all times the broker needs to ensure that the ratio and spread constraints are satisfied. Given that the execution is fairly involved, there are only a select number of brokers who accept orders to be executed on a paired basis. In any case, there is now a need to specify the order unambiguously to a broker. We will discuss the unambiguous specification of a paired transaction in this chapter. There is also a need to verify that the order was executed to satisfaction. We will also discuss issues pertaining to execution quality and the criteria that could be used to measure it.

Next, we address trade executions in fixed value exchange transactions. Recall that in such transactions, the exchange ratio is gradually revealed as the pricing period unfolds, and the exact exchange ratio is known only at the end of the pricing period. This seems to carry with it the implication that the spread position can be put ...