Before going live with a trading strategy, it's crucial to assess its market capacity (how much capital it can handle without compromising returns) and its potential impact on traded asset prices. This assessment is fundamental to avoiding problems such as the degradation of returns due to excessive capacity or a negative influence on market prices. Here's how to do it.
Trading simulation (backtesting)
Start by simulating your strategy on historical data to understand how it would have performed under various market conditions. During this simulation, pay attention to your strategy's trading volumes in relation to total market volumes.
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Estimate order book depth (if applicable)
Analyze the depth of the order book for the assets your strategy plans to trade. A shallow order book may mean that your strategy could have a significant impact on prices if it trades large volumes.
Use market impact models
Models such as Kyle's model or the permanent volume model can help estimate the potential impact of your orders on market prices. These models take into account variables such as order volume and market volatility to predict the impact on prices.
Examine how much the price of an asset could slip if your strategy placed a large order. Slippage is the difference between the expected price of an order and the price at which the order is actually executed.
Analysis of liquidity trends
Study the liquidity trends of the assets you plan to trade. If an asset has historically exhibited low levels of liquidity at certain periods, your strategy may have more impact on the market during those periods.
Consider hiring specialized consultants or partnering with entities that have expertise in market impact assessment. Their experience can provide valuable insights.
Limiting order size
A prudent approach is to limit the size of your orders when you start trading live. This allows you to assess the real impact of your strategy on the market before potentially increasing order size.
Assessing market capacity and the potential impact of a trading strategy before it goes live is essential to ensure the strategy's sustainability and effectiveness. By combining rigorous quantitative analysis with operational prudence, you can better prepare your strategy to navigate the markets in real-time.
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