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MEASURING TRADE DIFFICULTYCOMMENTARY #31June 1991One of the mileposts of an advancing technology is the creation of a set ofterminology to describe actions and phenomena not heretofore requiring names.At worst, this becomes jargon. At best, it becomes a way of seeing things thatwere previously invisible.

-+lexusmopmental work on its @fIlreafP:IURE service-lrasrequired usto define new concepts of implementation cost analysis. In the next fewcommentaries,we will discuss four concepts in whichwe have advanced the stateof the art difficulty, trade quality, opportunity/impacVtiming, andimplementation shortfall.

Wayne H. Wagner, PartnerEdward C. Story, PartnerLarryJ. Cuneo,PartnerMark Edwards, AssociateMichael Keady, AssociateRosemary Tribulato, Associate

We at Plexus are often asked "What is theoptimal shares, size, timing, etc. given ourmanagement style?" We have found no easyanswer. Trades are not alike. They differ in theease or difficulty of execution.Several factors combine to increase difficultv:L. The size of thecompany. As com-panies get smaller ormore obscure. thenumber of insti-tutional shareholders

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also usually gets smaller. The smaller the numberof institutional holders, the more unlikely acomparable size order will appear on the other_ _ side. fte_qfrly-altCr'natiyss_arq to purchase f1s11a broker at a significant premium or to assemblethe position out of retail order flow. Assemblingis usually a Iong and frequently self-defeatingactMty.According to Tom Loeb a $5 million order in a$200 million company might cost will cost 2.5times as much as the same trade in a $2 billioncompany.

arising from independently derived prospects orindMdual liquidity requirements. The supply (ordemand) is likely to be thin and sporadic.Again according to Loeb, a $5 million trade in a$200 million company might cost 2.5 times asmuch as a $500,000trade.Anynews on the stockwill cause potentialbuyersand sellers to reassess the current positions.News or market price action -- a form of news initself -- can wake up investors and increase thevolume of potential trades.The most surefire method of increasing supply isto attract sellers by raising the price in publicmarkets. Some shareholders uninterested inselling at "a lower price:vill be drawa out by thehigher price. David Whitcomb calls thisgravitationalpull.Small stocks, however, may suffer from a lack ofresiliency, the recovery to former levels once thesupply imbalance recedes. Twisting FischerBlack's insight, the trade may not make enoughnoise to wake up potential sellers.Tom Loeb investigated the cost effects of the sizeof the company and the size of the order in hisseminal work of 1988. However. these factors donot account for all differences in difficulty. Wehave identified two additional importantdimensions, market conditions and the desiredspeed of trading, which appear to lre of greatersignificance than company size and order size.

SERVICES PROVIDED TOInstitutional InvestorsInvestment ManagersInstitutional TradersPlan Sponsors

.....l,,,,0idef .Si2C2. The size of theorder. To under-stand the effects of'size. think of flowrates into the market.With no special newson a company, shares will come into the marketrandomly. Fischer Black calls this noise: orders

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3. The direction ofstock price move-ment at the time ofdesired execution.Stockprices rise whenthe number ofpotential buyersexceeds the number of potential sellers. A buyermoving into a crowd of buyers will face adversetrading conditions: the order is on the same sideas the crowd. The only way he or she cancomplete the trade and take the prize is to outbidother potential buyers. fn contrast, a buyermoving into a crowd of sellers has the scarcegoods. He or she can tantalize the most anxiousseller to bid above rivals.Plexus has measured the difference betweentrading in a market coming in and a marketmoving away to be 300 to 800 basis points. Thisfactor dominates all other mst considerations,ittcluding size of comparry and size of ordcn Itsuggests that implementation costs can be loweredby earlier manager decisions, before momentumhas been established. The implementation costsavings may well exceed the effects of loss ofclaritv of decision.4, The urgency ofthe order. Ordersthat demand instantliquidity call upon the Uigencymarket's facilities forresponding toimmediate demand. The chance of a randomseller arrMng at the market at the same instantas a buyer is negligible. A market that is notnaturally liquid must be made liquid by a marketmaker. He is willing to do so only at an expectedprofit.Urgency may arise from the type of decisioninformation (news, first call) used by the manager.It also may stem from the personality of themanager, who may be impatient to complete histrade once he has finalized his decision. Tradersget very good at reading the manager's signalsand gauging the probable cost of implementingthe typical decision.Urgency strongly interacts with the marketdirection. Marathon runners never make up onthe downhills what they Iose on the uphills.Similarly, trading costs in adverse markets exceedthe lowered costs of dealing in favorable tradingconditions. This is doubly important unde?conditions of urgency.Often, the best place to observe urgency is in theorder instructions. A principal or market tradeimplies high urgency. Market-not-held,working

or participate orders imply medium urgency.Limit or crossing orders signal low urgency. Amanager willing to chance that a limit ordermight not execute clearly isn't jumping on a hotnews item.To summarize, we have defined four factorswhose combined effect will determine tradedifficulty and expected cost of transacting. Thecurrent weights in use by Plexus are:Relative liquidity 25Vo(shares desired/volume)Discretion 30Vo(working, principal, etc.)Momentum 357o(individual stock)Capitalization l$Vo(shares outstanding X price)The relative weightings of these factors areupdated on the basis of observation, and thedatabase is still buildins. -w.w.

NEWS OF PLEXUSOur friends will be glad to knowthat we are now up to 16 clients andlooking forward to a lot more!More importantly, we are pleasedwith the level of insight andinformation we have been able todeliver to our clients.In a$dition, David Rismann,formerly with Wilshire Associates,has joined Plexus Group and will beworking with Larry Cuneo on clientreport production and technologldevelopment.

(e)1991,PLEXUS GROUPA General PartnershipYou are welcome to reprint quotationsor extractsfrom this material with credit given to PlexusGroup, 606 Wilshire Boulevard, Suite 310, SantaMonica CA 90401. Tel. (213) 45L-5A75.