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An Algorithmic Trading Strategy
An Algorithmic Trading Strategy
41
Chapter 4
Choosing the right algorithm for your trading strategy
51
Chapter 5
Anonymity and stealth
59
Chapter 6
Customising the brokers algorithms
Chapter 4
Honing an algorithmic trading strategy
Algorithmic choice
When deciding if you can utilise
an algorithm to execute a particular order a number of questions
need to be answered. Besides the
obvious question of what is my
benchmark? other factors will
ultimately dictate whether algorithmic trading is an option and,
if so, what type of algorithm and
which parameters to apply.
First, you need to assess
whether the stock is suitable. Blue
chip liquid names that trade a
large percentage of their volume
on the order book will be good
candidates. Small/mid cap stocks
that trade a very small percentage
on the order book are only suitable with correct parameterisation. The reasons for this are obvious, a computer can only react to
ALGORITHMIC TRADING
A BUY-SIDE HANDBOOK
41
**Owain Self ,
executive director
Equities,
UBS Investment Bank
*Tracy Black,
executive director
European Sales
Trading,
UBS Investment Bank
Chapter 4
Honing an algorithmic trading strategy
42
A BUY-SIDE HANDBOOK
Chapter 4
Honing an algorithmic trading strategy
ALGORITHMIC TRADING
8.00
2004/07/12
2004/10/1
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2004/07/12
2004/10/1
2005/07/29
Da
2005/07/29
2,800,000
Volume
2,800,000
2,400,000
2,000,000
2,400,000
2,000,000
1,600,000
1,600,000
1,200,000
1,200,000
800,000
800,000
400,000
400,000
8.00
Time
16.35
43
8.00
2004/07/12
20,050,111
2005/01/11
te
2004/07/12
2005/01/11
2005/07/25
Da
2005/07/25
800,000
800,000
Volume
400,000
400,000
8.00
Time
16.35
Chapter 4
Honing an algorithmic trading strategy
44
A BUY-SIDE HANDBOOK
Chapter 4
Honing an algorithmic trading strategy
45
Chapter 4
Honing an algorithmic trading strategy
46
A BUY-SIDE HANDBOOK
Chapter 4
Honing an algorithmic trading strategy
47
Chapter 4
Honing an algorithmic trading strategy
Probability density
Figure 3
Arrival
Price
Implementation
Shortfall
Price achieved
48
A BUY-SIDE HANDBOOK
Order execution
The proportion of your order executed via an algorithm is also
important. If you are executing a
high frequency of smaller orders,
the generation of which are often
triggered by the price of the stock,
Implementation Shortfall algorithms are the most suitable. Given
the entirety of the order the algorithm can work out how best to
optimise execution and minimise
the shortfall on average. However,
if you had a large order that was
also measured relative to the price
at which the investment decision
was made, a standard
Implementation Shortfall algorithm may not be suitable; one reason being optimal execution may
take several days. The algorithm
will need to know completion is
not required by the end of day one
and each day following, it would
need to know all the details of the
previous algorithms.
In this scenario we dont necessarily have to rule out algorithmic
execution, it just means more control will need to be taken. You can
still utilise a combination of algorithms to achieve the desired
results. Many people will start
trading aggressively with a small
part of their order using an Arrival
Price or Inline algorithm. As and
THE TRADE 2005
Chapter 4
Honing an algorithmic trading strategy
A BUY-SIDE HANDBOOK
49
Chapter 5
Honing an algorithmic trading strategy
Anonymity and
stealth
What assurances can the sell-side offer to safeguard the clients alpha
capture and minimise information leakage?
Richard Balarkas*
51
*Richard Balarkas,
global head of
AES Sales, CSFB
Chapter 5
Honing an algorithmic trading strategy
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A BUY-SIDE HANDBOOK
Chapter 5
Honing an algorithmic trading strategy
impression that all broker algorithms are much the same thing
and achieve very similar results.
This is far from true. The construction of trading algorithms
and their further refinement
through practical use is a highly
quantitative process.
Clients clearly believe
anonymity and stealth are
extremely important, and in
seeking to continuously improve
the performance of CSFBs algorithms it would be ideal to disaggregate the performance in order
to focus on those components
where the potential value-add is
the highest. However, the retention of alpha gained through
anonymity and stealth are hard
components for a broker to
measure.
The benefits of anonymity
will be readily understood by
buy-side traders, many of whom
are regularly handling orders
that are on average multiples of
ADV where revealing the size
alone would be sufficient to
move the price.
However, knowing who is
behind a trade has additional
informational value. The better a
money manager is perceived to be
at stock selection and timing, the
greater the informational component of the trade, and the greater
the likelihood that if this information leaks out the market will
ALGORITHMIC TRADING
Anonymity
Early attempts at
anonymous trading
were not entirely
successful
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Chapter 5
Honing an algorithmic trading strategy
54
A BUY-SIDE HANDBOOK
Chapter 5
Honing an algorithmic trading strategy
Game theory
Although game theory has been studied since the 1940s, it has only recently been
applied to the world of finance. Game theory champions garnered the 1994 Nobel
Prize in Economics, and, today, this theory is used to analyse everything from the
baseball strike to auctions. Increasingly, game theory is making its mark as a potent
tool for traders.
In simple terms, game theory is the study of conflict based on a formal approach
to decision-making that views decisions as choices made in a game. Whether
playing individually or in a group, each player in a conflict has more than one course
of action available to him, and the outcome of the game depends on the interaction
of the strategies pursued by each party. Algorithms can take advantage of the fact
that game theory and probability often have the edge over human intuition. To
illustrate this, here are some problems where the answer does not appear to be
intuitive, and in one case is actually counter-intuitive (for answers and explanations,
see pages 56 and 57):
Problems
55
Example 1.
If you throw a die until the running total exceeds 12, what is the most likely final
total?
Example 2.
This is a demonstration of the power of faith in random decision-making over simple
logic and probability. It was inspired by the format of an old USA TV gameshow Lets
Make A Deal, hosted by Monty Hall.
The conundrum is that you are on a game show and given the choice of three
doors: Behind one door is 1million, behind the others nothing. You are invited to
pick a door. The host, who knows whats behind the doors, opens one of the two
remaining doors to reveal there is nothing behind it. He then invites you to pick again
between the two remaining doors. Is it to your advantage to switch your choice?
Example 3.
You are in a game of Russian roulette, but this time the gun (a six-shooter revolver)
has three bullets in sequence in three of the chambers. The barrel is spun only once.
The two players then take it in turn to pull the trigger. If they live, the gun is passed
to the other player who then pulls the trigger, etc. Would you rather be first or
second to shoot?
Continues overleaf
ALGORITHMIC TRADING
A BUY-SIDE HANDBOOK
Chapter 5
Honing an algorithmic trading strategy
56
Example 2.
Answer: You should change your choice.
The problem is called counter-intuitive, because the answer seems for many to defy
instinct and logic, even after its been explained several times. Most contestants on
Monty Halls show were apparently reluctant to change their original choice for fear
that it was right, or because intuitively they felt that probability could not be altered
by revealing one of the losing doors.
The door you originally chose was a 1-in-3 chance i.e., the likelihood of your
guessing the winning door was 1-in-3. The other door is now a 1-in-2 chance, and
the likelihood of your guessing the other door to be the winning door is 1-in-2. You
are 50% more likely to correctly guess a 1-in-2 chance than a 1-in-3 chance, so pick
the other door in preference to your original choice of door.
If youre still in doubt, imagine there are 20 doors one has the money, the
others nothing. You pick a door. Then 18 doors are opened revealing nothing, leaving
your choice and the one other door. Would you change your choice now? By
switching doors youd improve your chances from 1-in-20, to 50:50 evens, or
(depending on how you look at it) arguably 19-in-20. Still sceptical? How about 100
doors? Pick a door. Open 98 revealing nothing, leaving two doors, one a winner and
the other a loser. Would you still prefer your original 99-to-1 shot compared to the
alternative that is at worst 50:50, and arguably a massive 99% chance?
ALGORITHMIC TRADING
A BUY-SIDE HANDBOOK
Chapter 5
Honing an algorithmic trading strategy
Game theory
Answers & explanations
Example 3.
Answer: Player 2 is preferable.
All you need to consider are the six possible bullet configurations:
BBBEEE
EBBBEE
EEBBBE
EEEBBB
BEEEBB
BBEEEB
player 1 dies
player 2 dies
player 1 dies
player 2 dies
player 1 dies
player 1 dies
57
ALGORITHMIC TRADING
A BUY-SIDE HANDBOOK
Chapter 6
Honing an algorithmic trading strategy
59
*Richard Balarkas,
global head of AES
Sales, CSFB
Chapter 6
Honing an algorithmic trading strategy
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A BUY-SIDE HANDBOOK
Chapter 6
Honing an algorithmic trading strategy
ALGORITHMIC TRADING
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Chapter 6
Honing an algorithmic trading strategy
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FAQ
Customisation has been around
from the start. Indeed, it is hard to
see how the product could have
worked had it not. There is a view,
inaccurate in our opinion, that broker algorithms are canned and
therefore inflexible. Hopefully, the
examples that have been outlined
prove otherwise. There are also
views expressed that all broker algorithms deliver the same performance, that they are commoditised.
We have not been presented with
evidence that shows this to be the
case, but it is understandable how
this viewpoint might add weight to
the argument that the only valuable
algorithm is a customised algorithm. In our experience, even using
the plain vanilla versions of our
algorithms, different clients achieve
different results from good to
excellent!
As with all aspects of the buyside/sell-side relationship, be it
research, trading or the development and use of trading
ALGORITHMIC TRADING
A BUY-SIDE HANDBOOK
There is a view,
inaccurate in our
opinion, that broker
algorithms are canned
and therefore
inflexible.