Calculating Scalabilty

rodneywkr · Nov 16, 2011

I know Bloomberg provides this option, not sure if anyone else. I have personally used the VWAP test with BB to backtest results of my system to see the "scalability".

If you don't have BB.... email a rep and request a 30day free trial

HFStartup · Nov 16, 2011

Quote from rodneywkr:

I know Bloomberg provides this option, not sure if anyone else. I have personally used the VWAP test with BB to backtest results of my system to see the "scalability".

If you don't have BB.... email a rep and request a 30day free trial
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Great suggestion! Thanks. Unfortunately, given the attributes of my trading methodology, there are reasons this solution may not work for me.

gmst · Nov 16, 2011

Quote from HFStartup:

GMST,

Sorry, totally missed the sarcasm. I know there are a lot of strong opinions about Jack on ET, but that is typically the case for most active posters.

It is funny that you mention developing a methodology and posting it because I did come up with one, although I didn't post it because I thought there must be some industry standard I am not aware of. I am probably missing some important details. I tend to be straight forward in how I do things, so this may be too simplistic...

Let's say I manage a portfolio that trades five equity indices and their corresponding derivatives. In this case I'll refer to them as indices A,B,C,D,& E. In reality, allocation to each of these indices is dynamically established by a proprietary trading model based on market activity rather than establishing targets at the beginning of the year or dividing the AUM by 5. But for this calculation, I made the assumption that capital would be allocated 20% to each index. (Assume all are highly liquid such as DIA, TLT, QQQ, etc.) Positions are taken that vary in length from 4 to over 270 days.

According to my trading methodology, I establish a position first with options by selling a put and setting aside the capital to buy the underlying if assigned. This means that I only acquire the underlying equities if assigned. Therefore, it seems to me that any limitations would be related to the option market's volume flow as opposed to the equity's. Further assume I can spread my orders over a range of strike prices and expiration months (let's just say 6 either way from the current ATM level.

My guess would be to take the average daily contract volumes of these options and multiply times a percentage that I feel would not impact the market. As a ballpark figure I would start with 3% as a estimate. Hypothetically speaking, if 100,000 contracts on average are traded per day on the options I would use to establish a position, then I would multiply by 3% to give me a total of a maximum of 3,000 contracts per day that could be traded without impacting the market. Since I always set aside the capital in the event of being assigned, I would then need to calculate this amount and add it to the amounts calcuated for the other 4 indices. If that total came up to $500,000,000 that is what I would presume is the level of scalability for my system givent current market volumes. I suppose I could even take this one step further by calulating the prior growth in volume of the option markets referred to above, and use that a my growth factor to determine how scalability will increase assuming constant future market volume growth at prior rates.

Obviously, the model above is based on a lot of assumptions and this is where my concern comes in. For example, is 3% as a level of market impact reasonable? Does this number vary considerably based on the financial instrument in question? How about the market in general?

I invite all to shoot holes in it or offer suggestions, because I have to come up with something and it has to be defensible.

Thanks.
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Your methodology and assumptions are fine. For a small fund like <100mm AUM, your methodology will work. But if you are working for a larger one like a billion or so, then funds in that catogory don't trade exchange traded options, rather go OTC and trade options with multiple banks. You can trade really really big size there. I think your wont' have any true limitation unless your fund is 10 billion in size or so. So i guess you don't need to worry really. Others may chime in.

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Calculating Scalabilty

rodneywkr

HFStartup

gmst