Modeling Trading Liquidity and Slippage in Daily Stock Simulations

Summary

The document considers how to set a plausible maximum daily transaction size in a simulation of US stocks that assumes execution at the closing price. The response offers practical liquidity assumptions based on average daily volume and notes that a strategy’s market impact cannot be represented by turnover alone if the simulated fill uses a different price benchmark.

It cites a rule of thumb that trades below a stated share of average daily volume may be modeled with VWAP or implementation-shortfall execution, and suggests adding a fraction of the bid–ask spread as slippage. For a simulation that specifically assumes closing-price execution, it recommends using daily VWAP as a proxy or estimating the variability between closing prices and VWAP, then accounting for that in a liquidity premium. These are broad practices rather than a calibrated model: the response does not establish that a fixed participation threshold works for every stock, market condition, or order type.

Key ideas

• Transaction size should be assessed relative to average daily volume when modeling liquidity.
• VWAP or implementation-shortfall execution is suggested for trades below a cited volume participation threshold.
• A fraction of the bid–ask spread can serve as a basic slippage allowance.
• Closing prices may differ from VWAP, so the difference should be measured or VWAP used as a proxy.
• The suggested assumptions are rules of thumb and require calibration to the stock and execution context.

Tags

# transaction size and liquidity in simulation of US stocks


# transaction size and liquidity in simulation of US stocks












i am developing a simulation trading in US stocks. i have 1 transaction a day per stock, assumed for simplicity to be executed at the daily closing price. in order to determine a reasonable maximal size for the transaction, i need some assumption concerning the liquidity of the stock. if the stock's daily turnover is X USD, i would like to know what would be a reasonable assumption for the transaction size relative to X, so that the transaction is considered small enough to be executed at the historical daily price. e.g. is 0.1X good enough?

## Answer by lehalle (score 4)

https://quant.stackexchange.com/a/3952

The common practices are:

- if you trade less than 8% of the Average Daily Volume, you can use a VWAP or Implementation Shortfall algo.

- you need to "add" a slippage of 1/3 of the bid ask spread of the stock.

Your only issue is that you want to use the close price instead of the VWAP one. Best option is to use the daily VWAP as a proxy. Otherwise measure the std between the close and the VWAP and add a multiple of it to your "liquidity premium".

You can find more details in "Navigating Liquidity 6: A global menu for optimal trading" pages 42 and more.

Shown in full with attribution under the source's licence. Licence: CC BY-SA 4.0 (Stack Exchange)

This summary was written by Stratmill's research agent from the original; it is not a copy of the source.