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What are some good ways to estimate the capacity of a strategy from historical data (including full market depth)?

Obviously, a naive approach is that you want the strategy's returns to exceed its market impact. PBs mostly provide their institutional clients with software packages that estimate market impact for large orders. However, many strategies have unique and more intricate entries/exit than large-order-buy-and-hold. Moreover, there are strategies that are low-capacity and contingent on market depth events, both of which I'm guessing require very different underlying assumptions than the market impact models used for large orders.

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Hi kristine, I notice you have the same IP address as this user. Any relation? –  chrisaycock Jan 25 '13 at 19:57
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Yes, I wanted to use my own separate account from my boyfriend's stackoverflow account, in case I wanted access outside of home. Please let me know if it's in violation of any user policies. –  madilyn Jan 25 '13 at 20:32
    
No problem. The duplicate IP address came-up on my radar and I had to check it out. –  chrisaycock Jan 25 '13 at 21:09
    
Awesome, thank you! –  madilyn Jan 25 '13 at 21:31
    
+1, good question. Can you expand on why standard market impact modeling (such as that described here) is not adequate? It seems to me that the modeling tools would be the same, and what would change is instead the maximization problem implied by the strategy (in contrast with the simpler "execute a large block"). –  Ryogi Feb 2 '13 at 21:00
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1 Answer

I believe you approach this whole issue from the wrong end.

  • Market impact is a huge function of the size of your orders and therefore you cannot start to ask what strategies outperform certain market impact.

  • Instead you should start to think about required returns and associated risk tolerance. Also define prudent risk management rules. From that results an idea about the approximate trading size you are willing to put at risk.

  • After you clearly defined your risk/reward you will start looking which asset classes, market, holding periods, most likely satisfy your requirements.

  • After that you fine-tune your strategy approach and start thinking about particular strategies.

  • And when you have done all that you start thinking about market impact on your orders as a function of all the above plus your estimated position sizes.

Without any other information on your end I find it impossible to help you further. I am not asking for anything related to your strategy but its very hard to make an educated guess whether your particular strategy's expected gross return exceeds transaction related cost, including market impact. You rejected to volunteer any other information with a condescending attitude. Maybe others appreciate your particular approach to asking for help more than I do.

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I agree that knowing the other constraints imposed (e.g. risk capital, instrument class, holding period) are important. But these steps are relatively trivial. I've gone through the steps up until the last bullet point and have a strategy and an idea of the returns and risk measures to expect. Most people get up to this step and don't have to worry because there is plenty of capacity in the strategy. But especially if your SR is high, I've found that capacity tends to be low and estimating the capacity of the strategy from market impact and historical order flow is nontrivial. –  madilyn Jan 26 '13 at 15:44
    
could you please define "capacity"? I am not sure what you mean with that. Thanks –  Matt Wolf Jan 26 '13 at 15:48
    
If I understand you correctly then you want to assess what the expected cost of execution are for your particular strategy, the particular asset class and symbols you are targeting, for the particular capital you plan to employ. If that is correct then without further information on your part its impossible to tell you what such transaction related costs would be. –  Matt Wolf Jan 26 '13 at 15:50
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You came here to ask others for help, I never asked you to divulge strategy details to anyone. In my time here on this site you can see that I have not asked one single question, I devoted a small part of my free time to help others. But I do not appreciate to be accused of trying to harvest ideas by someone who joined 2 days ago and came here for help not the other way around. Its fine with me that you do not see value in my comments but stick to facts please. I doubt others will get you much further without you elaborating what you actually want. –  Matt Wolf Jan 26 '13 at 16:55
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By the way, I appreciate simplicity not academic "hot-shot" allures. You should consider yourself incredibly lucky you did not shower your attitude upon a trading floor, I can assure you that it would have become a day you would find hard to forget later. –  Matt Wolf Jan 26 '13 at 17:02
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