A buy-side handbook

Algorithmic trading

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©The Trade Ltd. London 2005. Although The Trade has made every effort to ensure the accuracy of this publication, neither it nor any contributor can accept any legal responsibility whatsoever for consequences that may arise from errors or omissions or any opinions or advice given. This publication is not a substitute for professional advice on a specific transaction. No reproduction allowed without prior permission.

■ A buy-side handbook Algorithmic trading

ifferentiating between the algorithmic trading offerings of brokers D remains a problem for the buy-side. At the same time, brokers are searching for ways to achieve competitive edge and raise the profile of their algorithmic trading capabilities. These issues have to be overcome to realise the exponential growth that is forecast for algorithmic trading. The TRADE in association with leading industry participants drawn from the brokerage and vendor communities has set out to bring clarity and thought-leadership to the issues that are driving developments in the algorithmic space by publishing ‘A buy-side handbook on algorithmic trading’. Part 1, ‘Market and mechanics’, examines what is driving the growth of algorithmic trading, focusing on the rapidly evolving shape of the market. Insights are offered into how algorithms work and the relative merits of broker-driven versus broker-neutral algorithms are quantified. Part 2, ‘Honing an algorithmic trading strategy’, highlights the issues that buy-side traders must address once the decision has been taken to adopt an algorithmic strategy. Selecting an appropriate trading benchmark, the importance of anonymity to stem information leakage, applying stealth through sophisticated gaming theory, and customisation of broker algorithms are all addressed here. Part 3, ‘Quantifying and enhancing value’, focuses on measuring and interpreting the performance of disparate broker algorithms, the value added through independent third-party transaction cost analysis and the role of technology in enhancing market access. Part 4, ‘Emerging trends and future direction’, covers ‘next generation’ algorithms, focusing on implementation strategies for basket trading and the shape of the market going forward, when competition and increased buy-side demand will call for a higher order of intelligence in engineering algorithms. The handbook is completed with a guide to broker algorithms, containing details of individual broker offerings and including information on the range of benchmarks available, levels of customisation, performance measurement and connectivity options. ■ John Lee Editor & Publisher The TRADE


■ A buy-side handbook – Algorithmic trading Contents Part 1: Market and mechanics page 9 Chapter 1: Algorithmic trading – Upping the ante in a more competitive marketplace Part 2: Honing an algorithmic trading strategy page 41 Chapter 4: Choosing the right algorithm for your trading strategy Wendy Garcia. European Sales Trading. CSFB page 29 Chapter 3: Build or buy? Allen Zaydlin. analyst. UBS Investment Bank page 51 Chapter 5: Anonymity and stealth Richard Balarkas. head of European Algorithmic Trading. global head of AES™ Sales. executive director – Equities. InfoReach page 59 Chapter 6: Customising the broker’s algorithms Richard Balarkas. Citigroup Owain Self. TABB Group Tracy Black. CSFB ■ ALGORITHMIC TRADING ■ A BUY-SIDE HANDBOOK ■ THE TRADE 2005 . global head of AES™ Sales. CEO. UBS Investment Bank 4 page 21 Chapter 2: Understanding how algorithms work Dr Tom Middleton. executive director.

managing director. managing director. PhD. Global Execution Services. EMEA . Miletus Trading page 79 Chapter 8: Making the most of third-party transaction analysis: the why. Anna Bystrik. Automated Trading Systems. Nexa Technologies Mark Ponthier. head of Algorithmic Trading. vice president. JP Morgan page 89 Chapter 9: Enhancing market access Robert L Kissell. JP Morgan Appendix page 115 The TRADE guide to broker algorithms page 130 Contact information ■ A BUY-SIDE HANDBOOK ■ THE TRADE 2005 Mark Muñoz. when. ITG Inc.■ A buy-side handbook – Algorithmic trading Contents Part 3: Quantifying and enhancing value page 67 Chapter 7: Measuring and interpreting the performance of broker algorithms Part 4: Emerging trends and future direction page 97 Chapter 10: Basket algorithms – The next generation Ian Domowitz. research analyst. Nexa Technologies ■ ALGORITHMIC TRADING . Corporate Development. ITG Inc. senior vice president. senior vice president in charge of Product Sales. what and how? Robert Kay. director – Engineering. Miletus Trading Richard Johnson. director. Henry Yegerman. head of Algorithmic Trading. USA. JP Morgan Andrew Freyre-Sanders. GSCS Information Services page 107 Chapter 11: The future of algorithmic trading 5 Carl Carrie.

part 1: Market and mechanics 9 21 29 Chapter 1 Algorithmic trading – Upping the ante in a more competitive marketplace Chapter 2 Understanding how algorithms work Chapter 3 Build or buy? .

Brokers and technology providers are offering better and more integrated technologies to both access and utilise low. and what impact will the widespread adoption of algorithms have on the direction of order flow? Wendy Garcia* t is undeniable that the popularI ity of algorithmic trading continues to grow. This year. TABB Group has seen tremendous swings in the way buy-side traders route their order flow. adoption of algorithms has grown faster than any other trading tool. have willingly folded algorithmic trading models into their everyday methodologies in efforts to effectively and anonymously find sources of liquidity for their large orders. ■ A BUY-SIDE HANDBOOK ■ THE TRADE 2005 9 * Wendy Garcia. one of which is the increasingly difficult struggle to provide access to liquidity centres. The questions begin to develop when examining the market conditions that are expected to support the further growth of this particular ■ ALGORITHMIC TRADING electronic trading mechanism. efficiency. Market participants. analyst. while simultaneously minimising market impact.and no-touch trading technologies. This rapid acceptance is attributable primarily to changes in market structure. TABB Group . making trading easier and more efficient. For example. Firms are significantly reallocating the way they route their orders to the market in response to a number of interdependent and unique forces. and the need to achieve best execution.■ Chapter 1 Market and mechanics Algorithmic trading – Upping the ante in a more competitive marketplace What will fuel the growth in algorithmic trading. Over the past year. cost. and how its evolution and even deeper acceptance within the marketplace will impact the direction of order flow in the future. especially those on the buyside.

While in 2004 there were a mere ■ THE TRADE 2005 . On a relative basis. At the same time. Currently. we have seen a sizable increase in FIX-based order flow from 2004 to 2005. remaining steady through 2007. as well as redefined the basis on which partnerships are developed and maintained. This reality has significantly strengthened the competition among brokers. with a coterie of firms vying for valuable scraps. namely a long-standing trusted client/broker relationship. As algorithms have become more widely accepted and usage has increased. Drivers of algorithmic use There are a number of drivers behind the increased use of algorithms. is no longer considered a primary foothold against the competition.■ Chapter 1 Market and mechanics ■ “The compound annual growth rate for algorithm use from 2004 through 2007 is projected at 34%. in part to help reduce costs as they look to brokers for execution-only services. buy-side firms routed 17% less order flow over the phone than they did only one year ago. ■ ALGORITHMIC TRADING ■ A BUY-SIDE HANDBOOK 10 The buy-side/sell-side relationship: One key factor that has and will continue to play a significant role in the way in which algorithms are developed is the changing relationship the buy-side has with its brokers. as the compound annual growth rate for algorithm use from 2004 through 2007 is projected at 34%. and if this trend were to be projected out to 2007. the buyside is anxious to trim the number of broker relationships it maintains. the more sophisticated needs of the buy-side trader. It is typical in today’s markets that. including the changing dynamics of the relationship between the buy-side and sell-side. we still see algorithms making the greatest advances over that same time period. buy-side traders are not interested in developing new relationships or even furthering existing relationships. However. and the increasing presence of order management system (OMS) vendors. buy-side traders will only route 20% of their flow by phone. FIX traffic will level out. a small number of ‘bulge-bracket’ brokers lead the way in algorithmic trade model development. from 7% to 38% of flow. unless a broker has an improved algorithmic trading model to offer for order execution. What used to be seen as key in holding on to clients.” overall.

Trading models also enable traders to better align their execution strategies against their goals. then any sign that traders can ‘reverse-engineer’ these algorithms would endanger the entire field. brokers and order management system vendors. strategy security is a concern. focusing on either large or small firms. In addition. the format and direction of order flows will continue to shift in accordance to the speed and fluidity with which the ■ ALGORITHMIC TRADING buy-side makes its needs known and seeks to address them. The increasing presence of the OMS: Also changing and impacting the trading environment and order flow is the relationship between clients. In order to compete more effectively. buy-side traders have an even more compelling reason for leveraging automated trading strategies. The needs of the sophisticated buy-side trader: As the buy-side continues to take a more directive approach to order flow. others more recently have focused on model customisation as a way to gain buy-side favour in an increasingly competitive environment. and design their strategies according to the particular needs of their targeted firm size. As algorithms become more sophisticated and more widely adopted. brokers need to look at the desires clients have for increased customisation. many sell-side firms have developed targeted marketing strategies that align their models with specific customer segments. Still other firms have targeted size. One obstacle to the increased use of ■ A BUY-SIDE HANDBOOK ■ THE TRADE 2005 11 . While those brokers who were first off the line with algorithmic trade models have succeeded at landing more clients. If the perceived value of algorithms is derived from anonymity. including the ability of algorithmic trade orders to react – appropriately – to changes in market conditions and updates. A lesser concern is the potential of a firm’s proprietary desk to illegitimately access the electronic flow. additional strategies are created. In satisfying perceived and actual buy-side needs for further algorithmic trade development. Competition in this market will only become fiercer as more firms enter the market. today there is a much wider selection of broker-based algorithms on firms’ desks.■ Chapter 1 Market and mechanics handful of brokers providing algorithms. buy-side adoption grows and high commission business becomes more challenging.

However. Buy-side and sell-side traders are in favour of standardising systems for consistency in parameters such as aggressiveness and time constraints. including linking them to their transaction cost analysis tools and their order management systems. a VWAP or Market-On-Close algorithmic trade strategy may be similar across brokers. there also is a danger in overloading the existing technology to the point where its proper functionality is hindered. creating inefficiencies that could lead to a loss of the ease of implementation and integration that initially drew a buy-side trading desk to use a particular OMS to begin with. including linking them to their transaction cost analysis tools and their order management systems. it is not yet possible to standardise the systems with the availability of algorithmic customisation. which are how different algorithms are electronically marked as they are sent through the electronic trade process. say. buy-side firms are aiming to integrate algorithms more tightly into the trading process by linking their OMS directly to the algorithmic server. fills must be either manually ■ THE TRADE 2005 . TABB Group sees this integration becoming a more important driver of algorithms’ growth. If traders enter orders through a separate webservice or desktop application. although the generic tag for. However. As usage increases. The advantages of tight integration are twofold. The buy-side continues to look for additional ways to more efficiently integrate algorithms into their processes. give brokers the ability to offer customisable algorithmic trades to clients. and brokers are looking to the OMS providers to ■ ALGORITHMIC TRADING ■ A BUY-SIDE HANDBOOK 12 normalise the data or provide an internal matching system in order to make the trade process more efficient. In these instances the tags differ from trade to trade across brokers. Tags.” algorithmic trade models is brokers’ use of tags as they continually search for a competitive edge. As traders seek a more holistic trade management system.■ Chapter 1 Market and mechanics ■ “The buy-side continues to look for additional ways to more efficiently integrate algorithms into their processes. The recent acquisition of Macgregor by ITG illustrates the value of a more seamless integration of OMS and advanced trading tools.

As more options are made available. thereby increasing their usage comfort level significantly.■ Chapter 1 Market and mechanics entered into the OMS. The buy-side now is questioning with more frequency where and how algorithms can add value to the trade process. the percentage of brokers connected to the investment manager’s order management system is rising. TABB Group has found that quantitative firms are deeply engaged in optimising the trading process. or those with fewer than $10 billion in assets under management. Tighter integration between the buy-side and sell-side trading platforms continues at breakneck speed. not surprising considering they traditionally have a broader knowledge base about how the algorithmic trade systems function. thirdparty applications may not offer all the variables of a direct connection. Large firms. connecting to the OMS is a requirement for doing business. TABB Group can cite several reasons for this progression. Buy-side quant firms on average have five OMS algo■ ALGORITHMIC TRADING rithm links. defined as those with over $50 billion in assets under management. With some measurable time under their belts in using algorithms. the downside for brokers is that the OMS/FIX infrastructure is the stepping-stone to alternative execution vendors and has been an integral cause of the liquidity shift. Algorithmic trade strategies In a short time period. the buyside has graduated from basic users of algorithms to fickle clients. Indeed. It follows logically ■ A BUY-SIDE HANDBOOK ■ THE TRADE 2005 13 . In addition. traders are now better equipped to use historical information from preand post-trade analysis with enough confidence to develop trade methodologies based on past performance. such as increases in algorithmic trade options and crossing networks. The automation of almost every process is a key component to the quantitative business model. growing more selective of the algorithms they deploy and even building strategies around them. double the number of fundamental and mixed firms. or imported into Excel and then uploaded to the OMS. it is noteworthy that the buy-side is actually using a method to choose which algorithmic model to use for particular trades at this point. As the number of relationships decreases. Indeed. the buy-side trader is maintaining growth in control over its order flow. are twice as likely to have OMS algorithm links as smaller firms. given the use of trial and error a year ago (see Exhibit 1 overleaf). For all the benefits of electronic trading.

as algorithm use grows more pervasive throughout the industry. Quantitative shops and some large firms are increasingly building in-house technologies in an attempt to develop customised proprietary algorithms that are better suited to their direct needs. their demands for more flexible. the race to the top will be based on differentiation and ability to disguise intent to prevent gaming. Each strategy has its own pros and cons.■ Chapter 1 Market and mechanics Exhibit 1: How algorithms are selected – two-year comparison Trader’s PM discretion TCA Order objectives Stock characteristics Market conditions Liquidity As any destination Flexibililty 7% 2005 Response: 65% 9% Simple orders 9% 18% Experiment 16% 15% 13% 11% 11% Trading strategy 17% Analysis 17% 57% 2004 14 Source: TABB Group study ‘Institutional Equity Trading 2005: A Buy-Side Perspective’ that the more the industry learns about different algorithms the more often we will see implementation of strategies incorporating algorithmic trade models. The number of strategies employed by a firm is a good proxy for its level of algorithmic ■ ALGORITHMIC TRADING ■ A BUY-SIDE HANDBOOK sophistication. This high level of competition raises the bar for all algorithm providers and can propel the ones that are first to offer this to a role of market leader. As firms become more sophisticated about algorithms. and each one must be measured against its own benchmark. customised products will increase. most firms still are unable to break entirely free of their brokers for algorithmic trad■ THE TRADE 2005 . Secondly. rather than relying on their brokers. However.

The move to broker algorithms is based on four major factors: reduced market impact. Volume Weighted Average Price (VWAP) executed trades will continue to be a staple in the algorithmic trader’s portfolio. especially by large firms that are looking for ways to execute their large orders while minimising the impact they have on the marketplace. that using algorithms to break down large trade orders results in reduced market impact. or orders that are executed. Not only is the order more likely to be filled using this ■ A BUY-SIDE HANDBOOK ■ THE TRADE 2005 15 . firms with large order trades to settle look to algorithms to break apart the original trade into many smaller fills. Fewer traders will be accepting of its ‘at the market’ benchmarking strategy and instead will seek algorithms that encourage swinging for the fences. thereby hitting the markets with many small orders that find liquidity in different places rather than filling one large order from only one source. Until the majority of market participants develop a more complete understanding of and a higher comfort level with the use of algorithmic models. and lower cost (see Exhibit 2 overleaf). better alignment between strategy and execution. new strategies are being created. It remains one of the simplest algorithms. Factors for growth Algorithms will grow at a 34% rate through 2007. As a result. such as Guerilla and Liquidity Forecast will help attract the more aggressive traders. who ■ ALGORITHMIC TRADING ■ “As algorithm use grows more pervasive throughout the industry. The perception is held. intensifying the competition among providers. the race to the top will be based on differentiation and ability to disguise intent to prevent gaming.■ Chapter 1 Market and mechanics ing. As more customisable and client-specific alternatives to VWAP algorithms – such as Arrival Price. which has 24% of the market share for algorithmic trade strategies and is a close second to the 27% market share held by VWAP trading – continue to gain ground in the algorithmic trading space. Newer strategies. and simultaneously the most used and the most hated of them.” are racing to offer more unique and differentiated models and strategies. increased trading efficiency. TABB Group expects VWAP to lose more of its lustre and become one among many strategies employed. As brokers compete for algorithmic order flow.

algorithmic ■ THE TRADE 2005 . they are tools to help increase efficiency. but the impact as the smaller trades hit the market is decreased. which is information leakage. However. algorithms ■ ALGORITHMIC TRADING ■ A BUY-SIDE HANDBOOK are not a means by which to achieve alpha.■ Chapter 1 Market and mechanics Exhibit 2: The advantages of algorithms Anonymity Lower cost of trading Automate easy orders Decrease market impact Ease of use Best execution Control Solves fragmentation Hit benchmarks 7% 7% 7% Response: 65% 9% 9% 14% 14% 16% 18% 16 Source: TABB Group study ‘Institutional Equity Trading 2005: A Buy-Side Perspective’ method. Rather. which it can achieve to some degree as brokers increasingly make their algorithmic trades more customisable in order for clients to put specific limitations or definitions in place for particular trades. the anonymity of algorithms offers a significant advantage over the human element and solves the buy-sides’ biggest complaint about brokers. Incredibly. remain anonymous and trade effectively in an environment where large blocks of shares are unavailable. Another reason behind the increase in the use of broker algorithms is the idea that they increase the efficiency of trading by automating the execution of less complicated orders and freeing traders to concentrate on their most difficult trades. There also is the desire of the buy-side to achieve better alignment between strategy and execution. In addition.

■ Chapter 1 Market and mechanics offerings are so critical to firms’ market positions that the quantitative engineers who are developing algorithms are more highly cherished than many traders. The brokerages with the keenest vision. Hence. commissions will decrease with the increased use of algorithms since they offer a relatively lowcost means of efficient execution. as broker algorithms allow firms to retain overall market share while eliminating fixed costs. the winning firms will be those that effectively help their clients navigate the challenging markets. In addition. the increase in the use of broker algorithms is rising at a pace faster than that of proprietary algorithms – or even third party algorithmic providers – despite the buy-side’s discomfort with its reliance on brokers. Another advantage to using algorithmic strategies is their ■ ALGORITHMIC TRADING ability to satisfy regulatory compliance. In addition. the best tools. broker algorithm market share has been dominated by those with the quickest time to market. Due to the methodological documentation that occurs during the algorithmic trading process. Among the distinct advantages offered by broker algorithms is the ability to maintain a lower cost structure than a humanbased trading floor. Instead. in the least complex manner and at the lowest possible cost. The ‘first-mover’ advantage is valuable. this mechanism offers a regulatory solution through the trail of information that is a result of the transactions. as well as a superior view of the execution quality of their trades. buy-side firms will continue to prefer that option. In its short history. it offers the buy-side trader improved monitoring capabilities over the impact of their trades on the marketplace. but as the algorithmic space becomes more crowded. Hence.and notouch offerings is critical to their business. Many firms also believe that the success of their low. ■ A BUY-SIDE HANDBOOK ■ THE TRADE 2005 17 . the game is changing. the most comprehensive support and the sharpest pencil will win. It will no longer be the case that the first to market will get the spoils. Buy-side firms are now placing increased importance on how brokers package additional trading tools into the most compelling electronic trading value proposition. unlike manual trades that are carried out on the floor. it is easier for a broker to shut down an inefficient algorithm than it is to fire a person. Since broker algorithms are far less expensive and risky than developing and implementing proprietary ones.

and even fixed income. The recent passage of Reg NMS also will have its own impact on the order flow as. there will always be a place for ■ THE TRADE 2005 . until the buy-side has the knowledge and the capital of the brokers in order to develop and maintain their own systems. However. This will be the case especially as brokers increasingly make attempts to supply the buy-side with updated and additionally customisable models with which to trade. customisable and efficient algorithmic trade models. but across other asset classes as well. as we see algorithmic trading penetrate further into the marketplace to incorporate foreign exchange. As participants in the marketplace realise the market structure itself is not to blame for such market conditions as increased fragmentation. use of algorithmic and other electronic ■ ALGORITHMIC TRADING ■ A BUY-SIDE HANDBOOK 18 forms of order routing will increase. even as they decrease the number of brokers with whom they do business and develop more integrated relationships with the ones they do maintain.■ Chapter 1 Market and mechanics ■ “Until the buy-side has the knowledge and the capital of the brokers in order to develop and maintain their own systems. with the increasing electronic capabilities of the marketplace. rather it is the increased use of electronic trading strategies and technologies to effectively hide and seek liquidity within the marketplace. Order flow will maintain its surge – not only in equities. there will always be a place for those brokers who stay on the leading edge of technology and provide the marketplace with more advanced. even if it means routing their orders through broker algorithms in increasing numbers as they look for ways to reduce costs. The buy-side’s lack of trust for the brokers will not subside. traders will continue to adopt algorithmic trading models out of competitive necessity. as players in these markets look for anonymous trading and search for hidden liquidity – providing vendors with opportunities to shine as increased demands for more sophisticated technology are made by brokers and the buy-side alike.” The future The buy-side will continue to grasp more control over its order flow as algorithms become more enhanced and readily available. derivatives.

” traction. the importance of a link to DMA will become critical to DMA’s acceptance and growth. Transaction cost analysis will grow in use and importance as the marketplace will look to historical data to determine the most effective trade methods and to develop better ones. Since DMA platforms will likely be the vehicle that wraps and delivers all trading tools to the buy-side trader. ■ 19 ■ A BUY-SIDE HANDBOOK ■ THE TRADE 2005 . the marketplace and the way it functions will transform into what we expect will be a more efficient and effective place to trade. algorithms will increasingly seek more effective associations with DMA providers. Also defining the usage patterns of algorithms will be the linkage between algorithms and direct market access (DMA) platforms as a holistic execution management system is sought. which are being used to increase their own growth potential. in order to remain competitive.■ Chapter 1 Market and mechanics those brokers who stay on the leading edge of technology and provide the marketplace with more advanced. need to unfailingly develop further ways for the brokers to integrate more effectively their particular trade methodologies at an always more efficient rate of trade processing. We are already seeing this become more evident in platforms such as Goldman Sachs’ REDIPlus® and Morgan Stanley’s Passport. As it grows and becomes more widely used. Algorithmic trading is still young and in its developmental phases. the order management system vendors. as buy-side firms strive for that competitive edge. In addition. customisable and efficient algorithmic trade models. understood and accepted. Since algorithmic trading is rapidly gaining ■ ALGORITHMIC TRADING ■ “Defining the usage patterns of algorithms will be the linkage between algorithms and direct market access (DMA) platforms as a holistic execution management system is sought.

Time Weighted Average Price (TWAP). typically Volume Weighted Average Price (VWAP). and algorithmic trading products based on robust statistical models of market microstructure. and smart order routing require minimal quantitative input.■ Chapter 2 Market and mechanics Understanding how algorithms work Where does time slicing and smart order routing end and randomising your orders through complex algorithms begin? Dr Tom Middleton* re we witnessing a revolution in A trading or are algorithms little more than a novelty that can be readily outperformed by the average human trader? To answer this question. that have been found to increase trader productivity in both buyside and sell-side firms. overleaf). Implementation Shortfall (IS). This chapter aims to shed some light on the relatively opaque world of these algorithms. head of European Algorithmic Trading. With such a multitude of choices. While these facilities add value to trading desk capabilities and performance. Choices abound in algorithmic trading. Risk and reward Central to any investment process is the trade off between risk and ■ A BUY-SIDE HANDBOOK ■ THE TRADE 2005 *Dr Tom Middleton. their behaviour is fairly easy to understand. ■ ALGORITHMIC TRADING Enhanced DMA strategies (see Table 1. Algorithms that require quantitative input are generally designed to minimise execution risk against a user-specified benchmark. and how they can optimise the performance of a trading desk. Participate. Citigroup 21 . even in its current nascent state. or Market on Close (MOC). clarifying the thought process of their designers and the inputs of the models. and third-party providers are now stepping in to offer various ‘customisable’ and niche products. Any broker worth its salt now offers a diverse suite of algorithms and parameters. and the trader does not delegate any real decision-making to the algorithm. it is important to differentiate between algorithmic trading engines that are essentially enhanced Direct Market Access (DMA). we need to determine which algorithms are ‘smart’. such as pegging. ‘iceberging’. what makes them smart.

With Volume. this applies to algorithmic trading – a smart algorithm will maximise performance for a given level of tracking error against a chosen benchmark. Aims to match the Time Weighted Average Price. Similar to simple time slicing. emphasising the difference between algorithms that require quantitative market microstructure modelling and simpler enhanced DMA strategies. Aims to be a user-specified fraction of the volume traded in the market. but aims to minimise spread and impact costs. Pegging Smart order routing Simple time slicing Simple Market on Close (MOC) Quantitative algorithms VWAP 22 TWAP Participate MOC Implementation Shortfall (aka Execution Shortfall or Arrival Price) Attempts to minimise tracking error while maximising performance versus the Volume Weighted Average Price traded in the market. Naturally. Enhanced DMA strategies Iceberging A large order can be partially hidden from other market participants by specifying a maximum number of shares to be shown. Manages the trade off between impact and risk to execute as close as possible to the mid-point when the order is entered. POV. The order is sent into the closing auction. Follow. possibly starting trading before the closing auction. Enhanced MOC strategy that optimises risk and impact. how often they trade and against which benchmark their performance is evaluated. It makes sense that a small hedge fund with a short time horizon and high trading rate will tolerate higher risk on each individual execution in exchange for enhanced performance. the standard deviation of slippage against the benchmark is as important as the average when comparing the performance of a selection of algorithms.■ Chapter 2 Market and mechanics Table 1: Examples of common algorithmic trading strategies. Just as in portfolio man■ ALGORITHMIC TRADING ■ A BUY-SIDE HANDBOOK agement. reward. the appropriate place on the efficient trading frontier – how much risk a trader is prepared to take in exchange for improved performance – will depend on the nature of their alpha. An order is sent out at the best bid (ask) if buying (selling) and if the price moves the order is modified accordingly. The choice of algorithm and provider depends on the individual user’s benchmark. than a fund that ■ THE TRADE 2005 . The order is split up and market orders are sent at regular time intervals. Thus. style and urgency of trading. Also known as Inline. Mainly a US phenomenon – liquidity from many different sources is aggregated and orders are sent out to the destination offering the best price or liquidity.

Implementation Shortfall will involve some sort of impact/risk optimisation. Implementation Shortfall – the midpoint when the trade is started – is perhaps the most logical benchmark to use. that when aiming to trade one third of the volume. Managing the trading schedule is particularly important in Participate algorithms. balance between average execution performance and its variance is essential to the design of algorithmic trading models. This methodology pervades every aspect of model development. Whether implicitly or explicitly. in designing a Participate algorithm.■ Chapter 2 Market and mechanics trades much less frequently with a longer time horizon. possibly with some dynamic ■ ALGORITHMIC TRADING adjustment. As an order traded in this way would typically create a significant amount of impact. One could envisage a ‘not-very-smart’ algorithm. a well-designed strategy will optimise this trade off to deliver the best performance possible for a given level of risk. Thus. It is difficult to pick up an article or attend a conference without seeing a graph illustrating the fall of the average trade size in recent years. Furthermore. Some providers have apparently repackaged VWAP ■ A BUY-SIDE HANDBOOK ■ THE TRADE 2005 23 . every trade represents a piece of information leaked to the market. but perhaps opinions about the optimal trading strategy are the most diverse. defeating one of the principal objectives of algorithmic trading in the first place. it is important to allow the user to specify the urgency of the order – a stop-loss 1/3 of volume order should be executed differently to an order where the trader is prepared to tolerate much more tracking error against volume in exchange for better performance through less impact and more intelligent. Ever-smaller slices? The first component of an algorithm is the trading schedule – the rate at which the model aims to execute the order as a selection of smaller slices. The trading schedule is essentially dictated by the benchmark describing the trading strategy – it is fairly obvious that a VWAP algorithm will execute volume according to a historical volume profile. opportunistic type trading. Participate will track current volume. fired out a market order for one share for every two that printed elsewhere. Thus. this would result in poor execution performance for the user. Will we all be trading in one-lots in 10 years’ time? Clearly not – there must be a level at which transaction costs become prohibitive. Not only would this generate a huge number of tickets but would be incredibly easy for a predatory proprietary algorithm to ‘sniff out’ and front run.

while buying rising stocks more gradually. Ultimately. Ideally.06 24 0. taking into account both the need to unwind more rapidly than VWAP and the likely liquidity in the market.04 0.00 8: 25 8: 50 9: 15 9: 40 10 :0 5 10 :3 0 10 :5 5 11 :2 0 11 :4 5 12 :1 0 12 :3 5 13 :0 13 0 :2 5 13 :5 0 14 :1 5 14 :4 0 15 :0 5 15 :3 0 15 :5 5 16 :2 0 8: 00 or Participate algorithms with a participation rate or end-time determined by a model rather than by the user.02 0.12 VWAP 0. consistent with any pretrade employed: but still allow the user the flexibility to specify any dynamic constraints or parameters to take advantage of price or liquidi■ THE TRADE 2005 .08 0. an IS algorithm should obtain an end-time and trading schedule statically from an impact cost model. 0. The IS profiles are calculated in ‘Volume Time’. it ■ ALGORITHMIC TRADING ■ A BUY-SIDE HANDBOOK depends on the underlying investment style and the trader’s objectives which Implementation Shortfall strategy is the most appropriate. The danger with opportunistic strategies is that one can end up cutting winners and letting losers run – buying falling stocks aggressively.10 IS active IS passive 0. while others have built entirely different algorithms that react to price and liquidity in an opportunistic manner. a passive IS strategy and an active IS strategy.■ Chapter 2 Market and mechanics Figure 1: Example trading schedules for VWAP.

Hauptmann and H. (iii) Wait outside the order book and wait for a tight spread or a liquidity opportunity. according to their own risk and impact tolerances. the variables that we need to consider here are spread. volatility and liquidity on the electronic order book. there are three categories of stock. This strategy would have very low tracking error against the target volume. ■ ALGORITHMIC TRADING The question that we are attempting to answer in a logical. and the ratio of median3 bid/ask spread to volatility. However. In the formulation of our decision logic. where appropriate. namely whether to (if buying): (i) Pay the offer. At Citigroup we use an impact cost model1 to determine an optimal end-time and optimal trading schedule based on the user’s risk aversion – typically an accelerated initial trading rate compared to a VWAP profile (see Fig. quantitative and statistical fashion is what a successful human trader deals with instinctively hundreds of times a day. A dumb algorithm might send out market orders every time it wants to trade. . The reward that we expect for taking this risk is decreased spread and impact cost. C. Li. while that with the minimum impact is a VWAP trade. Risk. July 2005.■ Chapter 2 Market and mechanics ty if appropriate. options (ii) and (iii) both increase our execution risk relative to option (i). Essentially. as we are simply interested in classifying the stocks according to their rankings by these two ratios. starting as early as possible. (ii) Wait on the bid side of the order book. and so is also the minimum possible bid/ask spread during continuous trading 3 The median is a method of estimating the average by choosing the middle value of the sorted dataset. Thum. Obviously. 1). E. Almgren. The trade schedule for an enhanced MOC is obtained in a similar way to Implementation Shortfall – but in reverse. this static strategy can be enhanced as required with parameters that constrain the order or allow it to take liquidity or price-related opportunities – if these modify the schedule we re-optimise the profile in real time. The method used to estimate volatility is not important here. most users will choose a schedule intermediate between these two strategies. The strategy with the least tracking risk against the close price places the whole order in the closing auction. In a risk-reward framework. Managing each slice The second major component of an algorithm is how each slice of an order is managed. but would pay the spread irrespective of whether it was necessary to do so. Equity Market Impact. illustrated in Table 2 (overleaf). The trading behaviour of diverse stocks across the world can be simplistically classified according to two simple ratios – the ratio of tick size2 to volatility. A well-researched trading model will adapt its behaviour according ■ A BUY-SIDE HANDBOOK ■ THE TRADE 2005 25 1 R. Its advantage over using the mean is that it is affected less by very large or small ‘outlying’ values. 2 The tick size is the minimum price increment allowed.

relative to average trade size or average daily volume. in order to stand a chance of capturing spread. If an adverse move is predicted on this basis. the optimal spread capture strategy in this case is to be patient – waiting on the order book. small is not beautiful for this type of stock. Thus. High tick size/volatility. it is important to get liquidity on the order book as soon as possible to stand a chance of trading on the right side of the spread. Stocks whose behaviour is constrained by the tick size in this way characteristically have large amounts of liquidity at the best bid and ask. less liquid stocks with volatile spreads. Algorithmic trading adds huge value for this class of stock. The large amounts of stock on the best bid and ask also mean that the effect of adding more liquidity is unlikely to significantly affect the supply/ demand imbalance. as a computer is able to constantly monitor liquidity on the order book. The correct strategy here is to trade opportunistically and take advantage of spread and liquidity ■ THE TRADE 2005 . Tick size/volatility High Low Low Median spread/volatility High High Low Example Ericsson EMI Deutsche Telekom to the type of stock that it is attempting to trade. sometimes for hours. and so there is unlikely to be adverse price movement as a consequence of our adding to the order book.■ Chapter 2 Market and mechanics Table 2: Three-way classification of stocks. this is swamped on short timescales by its enormous tick size – approximately 36 bps as I write. The counter-argument to this is that these are also the stocks where information leakage can be the most damaging and so while trading them electronically can be problematic at least anonymity is maintained. according to spread and volatility behaviour. using the supply/demand imbalance as an indicator of future price movement. high median spread/volatility This type of stock is well represented by Ericsson. owing to the difficulty of achieving high quality performance. Although it is reasonably volatile. Many providers do not recommend that this type of stock should be traded on the engines. ■ ALGORITHMIC TRADING ■ A BUY-SIDE HANDBOOK 26 As queuing time is generally long. high median spread/volatility These stocks are typically mid-capitalisation. with examples. Low tick size/volatility. then the model should pay the spread – otherwise patience is key. In terms of a slicing strategy.

low median spread/volatility The final class of stock tend to be liquid. Balancing risk and return Algorithmic trading models may remain somewhat opaque to many users – and many brokers are unwilling to disclose too much information about what is ‘under the hood’. While this should be apparent in performance statistics. Algorithms must be designed to manage the risk-return trade off in an optimal way. a wider spread has to be accepted in order to keep up with the required trading rate. Low tick size/volatility.■ Chapter 2 Market and mechanics opportunities within the blink of an eye. and the waiting time on the order book is relatively short. The taking of opportunities does not preclude adding liquidity to the order book – but care has to be taken to avoid leaking information to the market by creating a supply/demand imbalance that may create an adverse price movement. Furthermore. These orders should be sliced relatively finely to avoid excessive execution risk. blue-chip stocks with low tick sizes and median spreads relative to volatility. As time passes. the risk involved in waiting at the best bid or offer is unlikely to be rewarded sufficiently to justify passing on the opportunity of executing immediately on the other side of the spread. ■ 27 ■ A BUY-SIDE HANDBOOK ■ THE TRADE 2005 . as the reward for capturing the spread is relatively small compared to the volatility ■ ALGORITHMIC TRADING risk to which the trader is exposed waiting on the bid or ask. Thus. I hope in this chapter I have managed to communicate at an intuitive level how a successful algorithm should help the user achieve the best possible outcome in executing their trades. both in the way that trading is scheduled and the way in which each slice of an order is managed. that are efficiently priced and easy to trade by both human beings and algorithms – orders in these stocks tend to be referred to as ‘low-touch’ or commoditised. algorithms should be transparent in the way that they are designed to balance risk and return so that the user can choose the appropriate strategy and provider that best suits their trading and investment styles. Algorithms add value in the trading of these stocks as they allow traders to focus on more difficult trades in less efficiently priced stocks. A tight spread with good liquidity on this type of stock suggests that the stock is fairly priced and the spread represents ‘good value’. the mathematics of how they operate is often rather intractable and poorly explained.

InfoReach . In addition. the second one focuses on their implementations. What are algorithms? Automation of trading processes can be grouped into two general categories – automation of trading (what to trade) and automation of execution decisions (how to trade). They also eliminate the emotional aspect of the trading process. Algorithms benefit from the speed of computers and therefore can follow the market more closely than traders. While the first one deals primarily with investment decisions. At the same time traders are able to focus their attention on the instruments that are difficult to trade. Being interdependent in nature. the advancements in one area force other areas to evolve. They give traders the ability to handle larger sets of securities. the landscape of trade execution. while letting algorithms take care of more liquid names. but for the purpose of this chapter we will define them as alpha models and execution algorithms or simply algorithms. To that extent the automation of electronic trade execution can be seen as the ‘first violin’. CEO.■ Chapter 3 Market and mechanics Build or buy? What are the relative merits of broker-driven versus broker-neutral algorithms? Understanding the trade off between cost and performance Allen Zaydlin* ince the introduction of elecS tronic trading. There is no ■ ALGORITHMIC TRADING market consensus on the precise definition of each category. for instance illiquid stocks. algorithms help reduce information leakage. risk management and market access has undergone significant and rapid changes. because the increasing demand in execution speed. throughput and low latency on one hand requires more efficient market access and risk management on the other. resulting in more consistent performance. Algorithms – when used appropriately – can improve multiple facets of the investment cycle. All of the above can be summarised in a single statement: ■ A BUY-SIDE HANDBOOK ■ THE TRADE 2005 29 *Allen Zaydlin.

■ THE TRADE 2005 30 . Furthermore.” “Algorithms are a more efficient way to trade in an environment where cost. consistency and the prevention of information leakage are crucial in attaining alpha” Survival of the fittest In recent years. as algorithmic execution becomes increasingly popular. and will also assist in separating the marketing hype from the algorithms. A: “Great! Then you should be able to send any buy and sell orders of the same symbol to this VWAP algorithm simultaneously and enjoy positive P&L every day. 2. however. Develop proprietary algorithms. algorithms were offered by only a handful of brokers to the larger buy-side firms that were willing to pay higher commissions. The first thing you will need to do in your quest to select an algorithmic provider is to think clearly and objectively. as well as the means available can yield surprisingly unexpected results. Simple analysis and adequate understanding of the goals that you need to reach. ■ ALGORITHMIC TRADING ■ A BUY-SIDE HANDBOOK the dilemma is quite simple to resolve and comes down to three options: 1. as well as trading system vendors. This will help you avoid the following scenario: Q: “Does your VWAP algorithm guarantee to beat the VWAP? No! The broker I am talking to guarantees their algorithm to beat VWAP every time. This will help you to avoid some common misconceptions about algorithms’ functionality and performance. algorithms have grown to become a common service available from the majority of brokers. Initially. Utilise algorithms provided by brokers. 3. more third-party software vendors are building trading platforms that serve as the foundation for the rapid development of custom algorithms. speed. Utilise ‘broker-neutral’ algorithms provided by third-party vendors. Nevertheless. The increase in algorithmic offerings has made the process of selecting the right algorithm for your trading desk a more exacting task. Since then. execution algorithms have become more prevalent.■ Chapter 3 Market and mechanics ■ “The increase in algorithmic offerings has made the process of selecting the right algorithm for your trading desk a more exacting task.

infrastructure and maintenance cost. This includes quantitative study of historical data. lastly. try to decide which algorithm fits your trading cycle objective. ‘off-the-shelf ’ and custom-built algorithms. ■ ALGORITHMIC TRADING ■ “Confusion on behalf of buy-side portfolio managers and traders comes in part from the lack of consolidated and systematic analysis of algorithmic execution performance and cost ratios. a certain structured quantitative comparison of different options can be accomplished. A: Rest assured our VWAP will do a good job. There is also the ongoing expense in improving the performance of existing models.” Broker-provided Pros ■ Require minimum technological infrastructure on the client side to access execution models. It is also partly from the absence of a single scale that can be applied to compare different options. Nevertheless. Let’s start off by identifying the pros and cons of using broker-provided. Cons ■ Higher commission rates. First of all. about 2000 shares. pick providers that offer algorithms most efficiently. this thinking process should include a better understanding of how different algorithms function and the problems they solve. ■ A BUY-SIDE HANDBOOK ■ THE TRADE 2005 31 . And.■ Chapter 3 Market and mechanics Q: How good is your VWAP? A: What are the average sizes you need to trade? How liquid are your instruments? Q: Liquid. ■ Provide a wider range of advanced algorithms that rely on significant research. ■ Higher risk of information leakage. ■ Fewer algorithmic parameters are exposed to end-users. Secondly. ■ Ability to pay only for usage. Comparing the options Confusion on behalf of buy-side portfolio managers and traders comes in part from the lack of consolidated and systematic analysis of algorithmic execution performance and cost ratios. Execution performance attribution is also somewhat obscure and lacks standardisation. computer hardware and network infrastructure to deal with vast calculation of considerable amounts of real-time market and execution data.

■ Ability to work with multiple brokers simultaneously. ■ Reduced risk of information leakage. off-the-shelf The emergence of various off-theshelf algorithms serves as an indication of the level of commoditisation that has occurred with certain execution models and the depreciation in their relative value. ■ Anonymity. ■ Tighter control. Broker-driven vs. Cons ■ Require more infrastructure on a client side to run. ■ Tighter control over parameterisation of the algorithms. Assuming that the ultimate goal is selecting an algorithm with maximum efficiency – meaning the algorithm that combines best execution performance with lowest cost – one can create a common scale that combines cost and performance into a single unit of mea■ THE TRADE 2005 32 . ■ Risk of failure achieving the execution performance objectives. while keeping trading data consolidated within a single system. ■ Broker neutrality.■ Chapter 3 Market and mechanics ■ “The emergence of various ‘off-the-shelf’ algorithms serves as an indication of the level of commoditisation that has occurred with certain execution models and the depreciation in their relative value. development and enhancement effort. ■ Quicker ability to modify. ■ Increased financial commitment regardless of usage. ■ Tendency to lack more sophisticated algorithms that require a more elaborate infrastructure. A simple comparison of VWAP algorithms provided by brokers and off-the-shelf providers will serve as a guideline on how to compare algorithms in general. ■ ALGORITHMIC TRADING ■ A BUY-SIDE HANDBOOK Custom-build Pros ■ Customised functionality not currently available from other sources. Cons ■ Bear unscalable expense of infrastructure.” Off-the-shelf Pros ■ Lower commission rate by taking advantage of DMA rates. Such off-the-shelf algorithms will have a cost advantage in comparison to their broker-driven siblings.

In determining the cost basis. because poor execution performance can quickly eliminate any advantage of a lower cost algorithm. compared with $11. At the same time.000 with broker-driven versus $13. From what we observe in the market today.” 33 This hypothesis changes however. the breaking-point lies somewhere between one million and two million shares per month.000 with broker-neutral algorithms. what is important is that in every particular case it can be calculated. or between 50. It does not really matter exactly where the breaking-point lies. Applying the same commissions’ rates for 20 million shares per month (one million per day) we will get over $100. where $0. we also need to factor in the cost of the third-party vendor technology which delivers the broker-neutral algorithms that allow you to take advantage of low DMA rates in the first place.■ Chapter 3 Market and mechanics sure. However. it is useful to start with commission rates.0015 is not unheard of. Clearly. brokers’ DMA can offer a very compelling commission rate. ■ ALGORITHMIC TRADING ■ “Assuming that the ultimate goal is selecting an algorithm with maximum efficiency – meaning the algorithm that combines best execution performance with lowest cost – one can create a common scale that combines cost and performance into a single unit of measure. once the number of shares traded via the algorithm increases to two million shares per month. At the same time we need to factor in performance. Now we are looking at $15.500 per month when using a broker-provided algorithm.000 shares per day.0075 per share as a common rate for brokerprovided algorithms. Thus.000 per month for such technology and assume that it is a fixed cost that does not increase with trading volumes. it should not be unreasonable to accept $0.000 and 100.500 when using the broker-neutral equivalent.000 of savings per month (over $1 million per year) – a level of cost saving that most firms would regard as signifi■ A BUY-SIDE HANDBOOK ■ THE TRADE 2005 . we arrive at a commission cost of $7. it does not add up – particularly if information leakage is not a major concern for the firm. The cost basis is vital because if two different algorithms perform alike then cost becomes the main differentiating factor. We will use an average of $10. Taking the example of a firm trading one million shares per month.

the off-the-shelf algorithm has to slip 0. Using VWAP as the example once more.html to run a quick comparison using your own numbers as input. the core finding remains the same: that the performance ratio is driven solely by the commission rates ratio.com/ compare. A quick analysis of the numbers can help us determine where the breakingpoint is in terms of performance.) The chart opposite provides a good indication of the projected differences in execution costs between the two venues relevant to the number of shares traded.047 of a basis point or. To have this advantage nullified due to the better performance of a broker-driven VWAP model. That said.03 of a basis point on 10 million shares traded over a month. and assuming that a brokerdriven algorithm slipped 0. a broker-provided algorithm has to outperform it to a level that can compensate for the difference in their respective commission rates.■ Chapter 3 Market and mechanics ■ “The cost advantage of an off-the-shelf algorithm over a broker-driven model will count for far less if it posts an inferior performance. in terms of the math. the cost advantage of the off-theshelf algorithms was around $50. For the sake of objectivity. The cost advantage of an off-the-shelf algorithm over a broker-driven model ■ ALGORITHMIC TRADING ■ A BUY-SIDE HANDBOOK 34 will count for far less if it posts an inferior performance. If this approach is calculated using different monthly trading volumes and average stock prices only. In order to be on par with a broker-neutral algorithm. it is well known that various VWAPs produce results only marginally different from one another. we also need to factor in the performance of the algorithms we are comparing. (Go to http://www.000 based on 10 million shares traded per month.000. A quick analysis of the numbers can help us determine where the breakingpoint is in terms of performance.in4reach. under-perform by 156%. ■ THE TRADE 2005 . by using this approach and calculating your own numbers you can easily find the point at which the cost benefit of introducing broker-neutral algorithms is going to start making sense to your business. As outlined in the Chart 1. the value of slippage is $90. While for the purpose of this exercise the numbers have been rounded off. in ‘real-world’ trading.” cant. This is key. and using $30 per share as an average stock price.

For example. percentage of the volume. if you need to trade a sector neutral basket of stocks there is no easy way to make broker-provided TWAP understand your criteria of sectors – which can be totally specific to you – and the threshold of intra-day imbalance between sectors.0 . In contrast.0 .0 00 00 . plus three or five others. Furthermore. aggressiveness. Most broker-provided algorithms reveal only a limited number of parameters for buy-side traders to manipulate.0 00 .0 . off-the-shelf algorithms provide significantly more options – in some cases as many as 30 para■ ALGORITHMIC TRADING meters – fine-tuned for each individual order.0 .■ Chapter 3 Market and mechanics Chart 1: Commissions comparison 300.0 .0 . Commonly.000 250.0 5.000 200.000 100.0 . ■ A BUY-SIDE HANDBOOK ■ THE TRADE 2005 40 .000 Commissions per month ($) 150. most broker-provided algorithms are not geared to work with lists of orders that have correlations or share constrains. they are: algorithm start and end times.0 0.0 . 00 00 00 00 00 00 00 .0 00 35 . 15 25 20 30 35 Shares per month Broker algorithms rate Broker DMA rate Commissions difference It is simply incorrect to assume that something that costs twice as much performs twice as well.000 0 -50.000 50.000 00 00 00 00 00 00 0 10 .0 .0 00 .0 1.

It is advisable. As outlined earlier in the chapter. since buyside demand for highly sophisticated algorithms varies depending on the trading strategy being deployed and the volumes involved. one clear advantage broker-neutral algorithm will have is that by spreading your trades in smaller sizes across multiple DMA pipes you reduce the risk of information leakage regardless of your level of trust. can be taken as a sign of increasing efficiency in the market place. the cost and performance of existing offerings is fully understood. The fact that more broker-driven algorithms are being made available from thirdparty vendors. that before deciding to build proprietary execution algorithms. The cost of developing more complex algorithms in-house in terms of the network and computer hardware that is required can be prohibitive. wrapped within a brokerneutral model. ■ ■ THE TRADE 2005 . Proprietary algorithms There are several reasons for building proprietary algorithms. at which broker-neutral algorithms deliver clear advantages. it would be hard to justify such a high level of investment in infrastructure. Meanwhile. off-the-shelf and proprietary – there appears to be a breaking-point. wrapped within a broker-neutral model. In some instances. while others call for realtime analysis of market depth and extensive statistical analysis of ■ ALGORITHMIC TRADING ■ A BUY-SIDE HANDBOOK 36 historical data.■ Chapter 3 Market and mechanics ■ “The fact that more brokerdriven algorithms are being made available from third-party vendors. therefore. First among these is control over the functionality and performance of the algorithm. the ongoing operating costs remain constant. can be taken as a sign of increasing efficiency in the market place. However. some algorithms are fairly basic and require minimal infrastructure to run. Having considered the relative merits of execution algorithms – broker-driven.” Reducing information leakage is more a question of trust than an item that can be measured through quantitative analysis. both in terms of cost and performance. followed by lower commission expense by making the algorithm broker-neutral.

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