Is Volatility Your Nemesis or Best Friend? It Depends on Who You Ask

Abstract

This article summarizes results of an extensive empirical study motivated by the intuitively appealing statement that institutional clients’ average transaction costs are sensitive to market conditions. Using a comprehensive sample of client execution data covering two years of trading, we confirm that the average cost of institutional trades varies considerably and systematically with volatility, volume, and trade imbalance surprises. For the overwhelming majority of buy-side institutions, implementation shortfall is higher than normal when volatility and volume exceed their historical average values. However, the deviations of trading volume in excess of the values typically observed in high volatility conditions dampen the effect of a high volatility environment on the execution costs of institutional orders. We document a strong dependence of transaction costs on contemporaneous trade imbalances, which is amplified by higher than normal contemporaneous volatility. We observe that cost curves are more sensitive to order size in times of less favorable buy-sell trade imbalances, reflecting the role played by directional market pressure indicators. In summary, buy-side institutions should not neglect market conditions monitoring, as failure to adjust promptly to market conditions may result in deteriorated performance and missed cost savings opportunities.