Trade execution evaluation measures and compares how well different execution algorithms work. So traders can choose the best ones to achieve their trading goals and reduce transaction costs.
Execution efficiency is measured by comparing the average order execution price with a reference price. It’s to see if the order was executed too high or too low. Two common reference prices are: volume-weighted average price (VWAP) and time-weighted average price (TWAP).
Volume-weighted average price
VWAP is the average price of all trades executed during the calculation period, weighted by their volume. It’s calculated using the following formula:
Where
– Pi is the trade execution price for trade i;
– Qi is the execution volume of trade i.
VWAP reflects all market activity, supply and demand for all market participants, so it provides a reasonable standard for evaluating trade execution.
Here’s the formula to evaluate trade performance:
Where
– P is the average order execution price;
– S is the direction of the opened position (S = 1: long position, S = -1: short position)
For example, an investor executes a buy order with an average order execution price of 20,500 VNĐ. VWAP during the trading day is 20.000 VNĐ.
This means that investors bought on average 2.5% higher than other buyers during the day.
Time-Weighted Average Price
TWAP is the simple average price of all trades executed during the calculation period:
Where:
– Pi is the execution price for trade i;
– N is the number of execution price.
TWAP does not consider trading volume. So investors use TWAP when they want to ignore outlier trades. Outlier trades can be caused by large orders at low or high prices during the calculation period.
Công thức đánh giá hiệu suất thực thi giao dịch:
Where:
– P is the average order execution price
– S is the direction of the opened position (S = 1: long position, S = -1: short position)
Trading Application
For index investing strategies, especially for mutual funds, the annual returns are usually similar to the benchmark index. In this case, transaction execution may be the most important factor in the end result besides administrative costs, fees, and taxes.
The following is an example of how execution costs affect two index funds.
As shown above, investment fund B performs 2% better than investment fund A. In this example, the only difference in performance is the main reason for the success or failure of the fund manager.
Execution costs also matter for individual investors in Vietnam. Frequent trading and the high volatility of each stock can make individual investors overlook the impact of execution costs. However, with an account turnover rate of 2 times per month, i.e. 24 times per year, an average execution cost of 0.5% is equivalent to 12% annually. In a normal market, it would not be surprising if 95% of individual investors lose money with this execution cost.