A buy-side handbook

Algorithmic trading

Published by The TRADE

in association with:
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 ■ A buy-side handbook

Algorithmic trading

Foreword
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 algo-
rithmic 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 bench- 3
mark, 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

■ ALGORITHMIC TRADING ■ A BUY-SIDE HANDBOOK ■ THE TRADE 2005

 ■ A buy-side handbook – Algorithmic trading

Contents

Part 2:
Part 1:
Honing an
Market and
algorithmic
mechanics
trading strategy

page 9 page 41
Chapter 1: Chapter 4:
Algorithmic trading – Choosing the right algorithm
Upping the ante in a more for your trading strategy
competitive marketplace

Wendy Garcia,
analyst,
TABB Group
Tracy Black,
executive director,
European Sales Trading,
UBS Investment Bank

4
page 21
Chapter 2:
Understanding how Owain Self,
algorithms work executive director – Equities,
UBS Investment Bank
Dr Tom Middleton,
head of European
Algorithmic
Trading, page 51
Citigroup
Chapter 5:
Anonymity and stealth

Richard Balarkas,
global head of
AES™ Sales, CSFB

page 29
Chapter 3:
Build or buy? page 59
Chapter 6:
Allen Zaydlin, Customising the broker’s
CEO, algorithms
InfoReach Richard Balarkas,
global head of AES™ Sales,
CSFB

■ ALGORITHMIC TRADING ■ A BUY-SIDE HANDBOOK ■ THE TRADE 2005

 ■ A buy-side handbook – Algorithmic trading

Contents

Part 3: Part 4:
Quantifying and Emerging trends and future
enhancing value direction

page 67 page 97
Chapter 7: Chapter 10:
Measuring and interpreting the performance of Basket algorithms – The next generation
broker algorithms

Ian Domowitz, Henry Yegerman, Anna Bystrik, PhD, Richard Johnson,

managing director, director, research analyst, senior vice president in
ITG Inc. ITG Inc. Miletus Trading charge of Product Sales,
Miletus Trading

page 107
Chapter 11: 5
page 79 The future of algorithmic trading
Chapter 8:
Making the most of third-party transaction
analysis: the why, when, what and how?

Robert Kay,
managing director,
GSCS Information Services Carl Carrie, Andrew Freyre-Sanders,
head of Algorithmic head of Algorithmic
Trading, USA, Trading, EMEA ,
JP Morgan JP Morgan

Robert L Kissell,
vice president,
page 89 Global Execution Services,
Chapter 9: JP Morgan
Enhancing market access

Mark Muñoz,
senior vice president,
Corporate Development,
Nexa Technologies
Appendix
page 115
The TRADE guide to broker algorithms
Mark Ponthier, director –
Engineering, Automated
Trading Systems, page 130
Nexa Technologies Contact information

■ ALGORITHMIC TRADING ■ A BUY-SIDE HANDBOOK ■ THE TRADE 2005

part 1:

Market and mechanics

9 Chapter 1
Algorithmic trading –
Upping the ante in a more competitive marketplace

21 Chapter 2
Understanding how algorithms work

29 Chapter 3
Build or buy?

Algorithmic trading –
Upping the ante in a more
competitive marketplace
What will fuel the growth in algorithmic trading, and what impact
will the widespread adoption of algorithms have on the direction of
order flow?
Wendy Garcia*
t is undeniable that the popular-
Itinues
ity of algorithmic trading con-
to grow. Market partici-
pants, especially those on the buy-
side, have willingly folded algo-
rithmic trading models into their
everyday methodologies in efforts
to effectively and anonymously
find sources of liquidity for their
large orders, while simultaneously
minimising market impact. Over
the past year, adoption of algo-
rithms has grown faster than any
other trading tool. This rapid
acceptance is attributable primari-
ly to changes in market structure,
cost, efficiency, and the need to
achieve best execution. The ques-
tions begin to develop when
examining the market conditions
that are expected to support the
further growth of this particular
■ ALGORITHMIC TRADING
■ Chapter 1
Market and mechanics
electronic trading mechanism, and 9
how its evolution and even deeper
acceptance within the marketplace
will impact the direction of order
flow in the future.
Firms are significantly reallo-
cating the way they route their
orders to the market in response
to a number of interdependent
and unique forces, one of which is
the increasingly difficult struggle
to provide access to liquidity cen-
tres. Brokers and technology
providers are offering better and
more integrated technologies to
both access and utilise low- and
no-touch trading technologies,
making trading easier and more
efficient. This year, TABB Group
has seen tremendous swings in
the way buy-side traders route * Wendy Garcia,
analyst,
their order flow. For example, TABB Group
■ A BUY-SIDE HANDBOOK ■ THE TRADE 2005
 ■ Chapter 1
Market and mechanics
■ “The compound annual
growth rate for algorithm use
from 2004 through 2007 is
projected at 34%.”
overall, buy-side firms routed
17% less order flow over the
phone than they did only one year
ago, and if this trend were to be
projected out to 2007, buy-side
traders will only route 20% of
their flow by phone.
At the same time, we have seen
a sizable increase in FIX-based
10 order flow from 2004 to 2005,
from 7% to 38% of flow.
However, FIX traffic will level out,
remaining steady through 2007.
On a relative basis, we still see
algorithms making the greatest
advances over that same time
period, as the compound annual
growth rate for algorithm use
from 2004 through 2007 is pro-
jected at 34%.
Drivers of algorithmic use
There are a number of drivers
behind the increased use of algo-
rithms, including the changing
dynamics of the relationship
between the buy-side and sell-side,
the more sophisticated needs of the
buy-side trader, and the increasing
presence of order management sys-
tem (OMS) vendors.
■ ALGORITHMIC TRADING ■ A BUY-SIDE HANDBOOK
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 algorithms have
become more widely accepted
and usage has increased, the buy-
side is anxious to trim the num-
ber of broker relationships it
maintains, in part to help reduce
costs as they look to brokers for
execution-only services. It is typi-
cal in today’s markets that, unless
a broker has an improved algo-
rithmic trading model to offer for
order execution, buy-side traders
are not interested in developing
new relationships or even fur-
thering existing relationships.
This reality has significantly
strengthened the competition
among brokers, as well as rede-
fined the basis on which partner-
ships are developed and main-
tained. What used to be seen as
key in holding on to clients,
namely a long-standing trusted
client/broker relationship, is no
longer considered a primary
foothold against the competition.
Currently, a small number of
‘bulge-bracket’ brokers lead the
way in algorithmic trade model
development, with a coterie of
firms vying for valuable scraps.
While in 2004 there were a mere
■ THE TRADE 2005

handful of brokers providing
algorithms, today there is a much
wider selection of broker-based
algorithms on firms’ desks.
Competition in this market will
only become fiercer as more firms
enter the market, additional
strategies are created, buy-side
adoption grows and high com-
mission business becomes more
challenging.
In order to compete more
effectively, many sell-side firms
have developed targeted market-
ing strategies that align their
models with specific customer
segments. While those brokers
who were first off the line with
algorithmic trade models have
succeeded at landing more
clients, others more recently have
focused on model customisation
as a way to gain buy-side favour
in an increasingly competitive
environment. Still other firms
have targeted size, focusing on
either large or small firms, and
design their strategies according
to the particular needs of their
targeted firm size.
The needs of the sophisticated
buy-side trader:
As the buy-side continues to take
a more directive approach to
order flow, the format and direc-
tion of order flows will continue
to shift in accordance to the
speed and fluidity with which the
■ ALGORITHMIC TRADING
■ Chapter 1
Market and mechanics
buy-side makes its needs known
and seeks to address them.
Trading models also enable
traders to better align their exe-
cution strategies against their
goals. As algorithms become
more sophisticated and more
widely adopted, buy-side traders
have an even more compelling
reason for leveraging automated
trading strategies.
In satisfying perceived and
actual buy-side needs for further
algorithmic trade development,
brokers need to look at the desires
clients have for increased customi-
sation, including the ability of
algorithmic trade orders to react – 11
appropriately – to changes in mar-
ket conditions and updates. In
addition, strategy security is a
concern. If the perceived value of
algorithms is derived from
anonymity, then any sign that
traders can ‘reverse-engineer’ these
algorithms would endanger the
entire field. A lesser concern is the
potential of a firm’s proprietary
desk to illegitimately access the
electronic flow.
The increasing presence of the
OMS:
Also changing and impacting the
trading environment and order
flow is the relationship between
clients, brokers and order man-
agement system vendors. One
obstacle to the increased use of
■ A BUY-SIDE HANDBOOK ■ THE TRADE 2005
 ■ Chapter 1
Market and mechanics
■ “The buy-side continues to
look for additional ways to
more efficiently integrate
algorithms into their processes,
including linking them to their
transaction cost analysis tools
and their order management
systems.”
algorithmic trade models is bro-
kers’ use of tags as they continual-
ly search for a competitive edge.
12 Tags, which are how different
algorithms are electronically
marked as they are sent through
the electronic trade process, give
brokers the ability to offer cus-
tomisable algorithmic trades to
clients. However, although the
generic tag for, say, a VWAP or
Market-On-Close algorithmic
trade strategy may be similar
across brokers, it is not yet possi-
ble to standardise the systems
with the availability of algorith-
mic customisation. Buy-side and
sell-side traders are in favour of
standardising systems for consis-
tency in parameters such as
aggressiveness and time con-
straints. In these instances the
tags differ from trade to trade
across brokers, and brokers are
looking to the OMS providers to
■ ALGORITHMIC TRADING ■ A BUY-SIDE HANDBOOK
normalise the data or provide an
internal matching system in order
to make the trade process more
efficient.
The buy-side continues to look
for additional ways to more effi-
ciently integrate algorithms into
their processes, including linking
them to their transaction cost
analysis tools and their order
management systems. The recent
acquisition of Macgregor by ITG
illustrates the value of a more
seamless integration of OMS and
advanced trading tools. As traders
seek a more holistic trade man-
agement system, TABB Group sees
this integration becoming a more
important driver of algorithms’
growth. However, 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 imple-
mentation and integration that
initially drew a buy-side trading
desk to use a particular OMS to
begin with.
As usage increases, buy-side
firms are aiming to integrate algo-
rithms more tightly into the trad-
ing process by linking their OMS
directly to the algorithmic server.
The advantages of tight integra-
tion are twofold. If traders enter
orders through a separate web-
service or desktop application,
fills must be either manually
■ THE TRADE 2005

entered into the OMS, or import-
ed into Excel and then uploaded
to the OMS. In addition, third-
party applications may not offer
all the variables of a direct con-
nection. Large firms, defined as
those with over $50 billion in
assets under management, are
twice as likely to have OMS algo-
rithm links as smaller firms, 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. As the number of relation-
ships decreases, the percentage of
brokers connected to the invest-
ment manager’s order manage-
ment system is rising. Indeed,
connecting to the OMS is a
requirement for doing business.
For all the benefits of electronic
trading, the downside for brokers
is that the OMS/FIX infrastruc-
ture is the stepping-stone to alter-
native execution vendors and has
been an integral cause of the liq-
uidity shift. TABB Group has
found that quantitative firms are
deeply engaged in optimising the
trading process, not surprising
considering they traditionally
have a broader knowledge base
about how the algorithmic trade
systems function, thereby increas-
ing their usage comfort level sig-
nificantly. Buy-side quant firms
on average have five OMS algo-
■ ALGORITHMIC TRADING
■ Chapter 1
Market and mechanics
rithm links, double the number of
fundamental and mixed firms.
The automation of almost every
process is a key component to the
quantitative business model.
Algorithmic trade strategies
In a short time period, the buy-
side has graduated from basic
users of algorithms to fickle
clients, growing more selective of
the algorithms they deploy and
even building strategies around
them. The buy-side now is ques-
tioning with more frequency
where and how algorithms can
add value to the trade process. As
more options are made available, 13
such as increases in algorithmic
trade options and crossing net-
works, the buy-side trader is
maintaining growth in control
over its order flow. Indeed, 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,
given the use of trial and error a
year ago (see Exhibit 1 overleaf).
TABB Group can cite several rea-
sons for this progression. With
some measurable time under their
belts in using algorithms, traders
are now better equipped to use
historical information from pre-
and post-trade analysis with
enough confidence to develop
trade methodologies based on past
performance. It follows logically
■ A BUY-SIDE HANDBOOK ■ THE TRADE 2005
 ■ Chapter 1

Market and mechanics

Exhibit 1: How algorithms are selected – two-year comparison

Trader’s PM 18%
discretion
Experiment 57%
TCA 16%
Order 15%
objectives
Analysis 17%
Stock 13%
characteristics
Market 11%
conditions
Trading strategy 17%
Liquidity 11%
As any 9%
destination
Simple orders 9%
Flexibililty 7%

2005 2004
Response:
65%

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 implemen-
tation of strategies incorporating
algorithmic trade models.
Secondly, as algorithm use grows
more pervasive throughout the
industry, the race to the top will
be based on differentiation and
ability to disguise intent to pre-
vent gaming. This high level of
competition raises the bar for all
algorithm providers and can pro-
pel the ones that are first to offer
this to a role of market leader.
The number of strategies
employed by a firm is a good
proxy for its level of algorithmic
sophistication. Each strategy has
its own pros and cons, and each
one must be measured against its
own benchmark. As firms become
more sophisticated about algo-
rithms, their demands for more
flexible, customised products will
increase. 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,
rather than relying on their
brokers.
However, most firms still are
unable to break entirely free of
their brokers for algorithmic trad-

■ ALGORITHMIC TRADING ■ A BUY-SIDE HANDBOOK ■ THE TRADE 2005


ing. Until the majority of market
participants develop a more com-
plete understanding of and a high-
er comfort level with the use of
algorithmic models, Volume
Weighted Average Price (VWAP)
executed trades will continue to be
a staple in the algorithmic trader’s
portfolio. It remains one of the
simplest algorithms, and simulta-
neously the most used and the
most hated of them. Fewer traders
will be accepting of its ‘at the mar-
ket’ benchmarking strategy and
instead will seek algorithms that
encourage swinging for the fences.
As brokers compete for algorith-
mic order flow, new strategies are
being created. Newer strategies,
such as Guerilla and Liquidity
Forecast will help attract the more
aggressive traders. As more cus-
tomisable and client-specific alter-
natives to VWAP algorithms –
such as Arrival Price, which has
24% of the market share for algo-
rithmic 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, TABB
Group expects VWAP to lose more
of its lustre and become one
among many strategies employed.
Factors for growth
Algorithms will grow at a 34% rate
through 2007, intensifying the
competition among providers, who
■ ALGORITHMIC TRADING
■ Chapter 1
Market and mechanics
■ “As algorithm use grows more
pervasive throughout the
industry, the race to the top will be
based on differentiation and
ability to disguise intent to
prevent gaming.”
are racing to offer more unique
and differentiated models and
strategies. The move to broker
algorithms is based on four major
factors: reduced market impact,
increased trading efficiency, better
alignment between strategy and 15
execution, and lower cost (see
Exhibit 2 overleaf).
The perception is held, espe-
cially by large firms that are look-
ing for ways to execute their large
orders while minimising the
impact they have on the market-
place, that using algorithms to
break down large trade orders
results in reduced market impact.
As a result, firms with large order
trades to settle look to algorithms
to break apart the original trade
into many smaller fills, or orders
that are executed, thereby hitting
the markets with many small
orders that find liquidity in dif-
ferent places rather than filling
one large order from only one
source. Not only is the order
more likely to be filled using this
■ A BUY-SIDE HANDBOOK ■ THE TRADE 2005
 ■ 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
16
Source: TABB Group study ‘Institutional Equity Trading 2005: A Buy-Side Perspective’
method, but the impact as the
smaller trades hit the market is
decreased.
Another reason behind the
increase in the use of broker algo-
rithms is the idea that they
increase the efficiency of trading
by automating the execution of
less complicated orders and free-
ing traders to concentrate on their
most difficult trades. In addition,
the anonymity of algorithms
offers a significant advantage over
the human element and solves the
buy-sides’ biggest complaint
about brokers, which is informa-
tion leakage. However, algorithms
■ ALGORITHMIC TRADING ■ A BUY-SIDE HANDBOOK
18%
16%
14%
14%
9%
9%
7%
7%
Response:
7% 65%
are not a means by which to
achieve alpha. Rather, they are
tools to help increase efficiency,
remain anonymous and trade
effectively in an environment
where large blocks of shares are
unavailable.
There also is the desire of the
buy-side to achieve better align-
ment between strategy and execu-
tion, 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 particu-
lar trades. Incredibly, algorithmic
■ THE TRADE 2005

offerings are so critical to firms’
market positions that the quanti-
tative engineers who are develop-
ing algorithms are more highly
cherished than many traders.
Many firms also believe that the
success of their low- and no-
touch offerings is critical to their
business.
Among the distinct advantages
offered by broker algorithms is
the ability to maintain a lower
cost structure than a human-
based trading floor, as broker
algorithms allow firms to retain
overall market share while elimi-
nating fixed costs. In addition,
commissions will decrease with
the increased use of algorithms
since they offer a relatively low-
cost means of efficient execution.
Since broker algorithms are far
less expensive and risky than
developing and implementing
proprietary ones, buy-side firms
will continue to prefer that
option. Hence, the increase in the
use of broker algorithms is rising
at a pace faster than that of pro-
prietary algorithms – or even
third party algorithmic providers
– despite the buy-side’s discom-
fort with its reliance on brokers.
In addition, it is easier for a bro-
ker to shut down an inefficient
algorithm than it is to fire a
person.
Another advantage to using
algorithmic strategies is their
■ ALGORITHMIC TRADING
■ Chapter 1
Market and mechanics
ability to satisfy regulatory com-
pliance. Due to the methodologi-
cal documentation that occurs
during the algorithmic trading
process, this mechanism offers a
regulatory solution through the
trail of information that is a
result of the transactions, unlike
manual trades that are carried
out on the floor. Hence, it offers
the buy-side trader improved
monitoring capabilities over the
impact of their trades on the
marketplace, as well as a superior
view of the execution quality of
their trades.
In its short history, broker algo-
rithm market share has been dom- 17
inated by those with the quickest
time to market. The ‘first-mover’
advantage is valuable, but as the
algorithmic space becomes more
crowded, the game is changing.
Buy-side firms are now placing
increased importance on how bro-
kers package additional trading
tools into the most compelling
electronic trading value proposi-
tion. The brokerages with the
keenest vision, the best tools, 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.
Instead, the winning firms will be
those that effectively help their
clients navigate the challenging
markets, in the least complex man-
ner and at the lowest possible cost.
■ A BUY-SIDE HANDBOOK ■ THE TRADE 2005
 ■ 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,
there will always be a place for
those brokers who stay on the
leading edge of technology and
provide the marketplace with more
advanced, customisable and
efficient algorithmic trade
models.”
18
The future
The buy-side will continue to
grasp more control over its order
flow as algorithms become more
enhanced and readily available,
even if it means routing their
orders through broker algorithms
in increasing numbers as they
look for ways to reduce costs.
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.
The recent passage of Reg
NMS also will have its own
impact on the order flow as, with
the increasing electronic capabili-
ties of the marketplace, use of
algorithmic and other electronic
■ ALGORITHMIC TRADING ■ A BUY-SIDE HANDBOOK
forms of order routing will
increase. As participants in the
marketplace realise the market
structure itself is not to blame for
such market conditions as
increased fragmentation, rather it
is the increased use of electronic
trading strategies and technolo-
gies to effectively hide and seek
liquidity within the marketplace,
traders will continue to adopt
algorithmic trading models out of
competitive necessity. Order flow
will maintain its surge – not only
in equities, but across other asset
classes as well, as we see algorith-
mic trading penetrate further
into the marketplace to incorpo-
rate foreign exchange, derivatives,
and even fixed income, as players
in these markets look for anony-
mous trading and search for hid-
den liquidity – providing vendors
with opportunities to shine as
increased demands for more
sophisticated technology are
made by brokers and the buy-side
alike. The buy-side’s lack of trust
for the brokers will not subside,
even as they decrease the number
of brokers with whom they do
business and develop more inte-
grated relationships with the ones
they do maintain.
However, until the buy-side
has the knowledge and the capital
of the brokers in order to develop
and maintain their own systems,
there will always be a place for
■ THE TRADE 2005
 ■ Chapter 1

Market and mechanics

those brokers who stay on the

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

■ ALGORITHMIC TRADING ■ A BUY-SIDE HANDBOOK ■ THE TRADE 2005

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

Market and mechanics

Table 1: Examples of common algorithmic trading strategies, emphasising

the difference between algorithms that require quantitative market
microstructure modelling and simpler enhanced DMA strategies.
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.
Pegging An order is sent out at the best bid (ask) if buying (selling) and if the
price moves the order is modified accordingly.
Smart order routing 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.
Simple time slicing The order is split up and market orders are sent at regular time
intervals.
Simple Market on Close (MOC) The order is sent into the closing auction.

Quantitative algorithms
VWAP Attempts to minimise tracking error while maximising performance
versus the Volume Weighted Average Price traded in the market.
TWAP Aims to match the Time Weighted Average Price. Similar to simple
22 time slicing, but aims to minimise spread and impact costs.
Participate Also known as Inline, Follow, With Volume, POV. Aims to be a
user-specified fraction of the volume traded in the market.
MOC Enhanced MOC strategy that optimises risk and impact, possibly
starting trading before the closing auction.
Implementation Shortfall Manages the trade off between impact and risk to execute
(aka Execution Shortfall or as close as possible to the mid-point when the order is entered.
Arrival Price)

reward. Naturally, this applies to agement, the appropriate place on

algorithmic trading – a smart algo-
rithm will maximise performance
for a given level of tracking error
against a chosen benchmark. Thus,
the standard deviation of slippage
against the benchmark is as impor-
tant as the average when compar-
ing the performance of a selection
of algorithms.
The choice of algorithm and
provider depends on the individual
user’s benchmark, style and urgency
of trading. Just as in portfolio man-
the efficient trading frontier – how
much risk a trader is prepared to
take in exchange for improved per-
formance – will depend on the
nature of their alpha, how often
they trade and against which bench-
mark their performance is evaluat-
ed. It makes sense that a small
hedge fund with a short time hori-
zon and high trading rate will toler-
ate higher risk on each individual
execution in exchange for enhanced
performance, than a fund that

■ ALGORITHMIC TRADING ■ A BUY-SIDE HANDBOOK ■ THE TRADE 2005


trades much less frequently with a
longer time horizon.
Thus, balance between average
execution performance and its
variance is essential to the design
of algorithmic trading models.
Whether implicitly or explicitly, a
well-designed strategy will opti-
mise this trade off to deliver the
best performance possible for a
given level of risk. This methodolo-
gy pervades every aspect of model
development.
Ever-smaller slices?
The first component of an algo-
rithm is the trading schedule – the
rate at which the model aims to exe-
cute the order as a selection of
smaller slices. 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. Will we all be trading in
one-lots in 10 years’ time? Clearly
not – there must be a level at which
transaction costs become prohibi-
tive. Furthermore, every trade repre-
sents a piece of information leaked
to the market, defeating one of the
principal objectives of algorithmic
trading in the first place.
The trading schedule is essen-
tially dictated by the benchmark
describing the trading strategy – it
is fairly obvious that a VWAP algo-
rithm will execute volume accord-
ing to a historical volume profile,
possibly with some dynamic
■ ALGORITHMIC TRADING
■ Chapter 2
Market and mechanics
adjustment; Participate will track
current volume; Implementation
Shortfall will involve some sort of
impact/risk optimisation.
Managing the trading schedule
is particularly important in
Participate algorithms. One could
envisage a ‘not-very-smart’ algo-
rithm, that when aiming to trade
one third of the volume, fired out a
market order for one share for
every two that printed elsewhere.
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. As an order traded
in this way would typically create a 23
significant amount of impact, this
would result in poor execution per-
formance for the user. Thus, in
designing a Participate algorithm, 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,
opportunistic type trading.
Implementation Shortfall – the
midpoint when the trade is started –
is perhaps the most logical bench-
mark to use, but perhaps opinions
about the optimal trading strategy
are the most diverse. Some providers
have apparently repackaged VWAP
■ A BUY-SIDE HANDBOOK ■ THE TRADE 2005
 ■ Chapter 2

Market and mechanics

Figure 1: Example trading schedules for VWAP, a passive IS strategy and

an active IS strategy. The IS profiles are calculated in ‘Volume Time’, taking
into account both the need to unwind more rapidly than VWAP and the
likely liquidity in the market.
0.12
VWAP IS active IS passive

0.10

0.08

0.06

0.04
24

0.02

0.00
00

25
50
15
40

5
0
5
0
5
0
5

13 0
5
0
5
0
5
0
5
0
:0

:5

:4

:3

:2

:1

:0

:5
:3

:2

:1

:0

:5

:4

:3

:2
9:
8:
8:
8:

9:

14
12
10

12

15
10
10

11

13

15
15
11

13

14

16

or Participate algorithms with a par- depends on the underlying invest-

ticipation rate or end-time deter-
mined by a model rather than by the
user, while others have built entirely
different algorithms that react to
price and liquidity in an opportunis-
tic manner. The danger with oppor-
tunistic strategies is that one can end
up cutting winners and letting losers
run – buying falling stocks aggres-
sively, while buying rising stocks
more gradually. Ultimately, it
ment style and the trader’s objectives
which Implementation Shortfall
strategy is the most appropriate.
Ideally, an IS algorithm should
obtain an end-time and trading
schedule statically from an impact
cost model, consistent with any pre-
trade employed: but still allow the
user the flexibility to specify any
dynamic constraints or parameters
to take advantage of price or liquidi-

■ ALGORITHMIC TRADING ■ A BUY-SIDE HANDBOOK ■ THE TRADE 2005

 ■ Chapter 2

Market and mechanics

ty if appropriate. At Citigroup we use The question that we are

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

■ ALGORITHMIC TRADING ■ A BUY-SIDE HANDBOOK ■ THE TRADE 2005

 ■ Chapter 2
Market and mechanics
Table 2: Three-way classification of stocks, with examples,
according to spread and volatility behaviour.
Tick size/volatility Median spread/volatility
High High
Low High
Low Low
to the type of stock that it is
attempting to trade.
High tick size/volatility,
high median spread/volatility
This type of stock is well represent-
ed by Ericsson. Although it is rea-
sonably volatile, this is swamped
on short timescales by its enor-
mous tick size – approximately 36
26 bps as I write. Stocks whose behav-
iour is constrained by the tick size
in this way characteristically have
large amounts of liquidity at the
best bid and ask, relative to average
trade size or average daily volume.
Thus, the optimal spread capture
strategy in this case is to be patient –
waiting on the order book, some-
times for hours, in order to stand a
chance of capturing spread.
Algorithmic trading adds huge value
for this class of stock, as a computer
is able to constantly monitor liquidi-
ty on the order book, using the sup-
ply/demand imbalance as an indica-
tor of future price movement. If an
adverse move is predicted on this
basis, then the model should pay the
spread – otherwise patience is key.
In terms of a slicing strategy, small is
not beautiful for this type of stock.
■ ALGORITHMIC TRADING ■ A BUY-SIDE HANDBOOK
Example
Ericsson
EMI
Deutsche Telekom
As queuing time is generally long, 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. 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, and so there is
unlikely to be adverse price move-
ment as a consequence of our
adding to the order book.
Low tick size/volatility,
high median spread/volatility
These stocks are typically mid-capi-
talisation, less liquid stocks with
volatile spreads. Many providers do
not recommend that this type of
stock should be traded on the
engines, owing to the difficulty of
achieving high quality performance.
The counter-argument to this is that
these are also the stocks where infor-
mation leakage can be the most
damaging and so while trading them
electronically can be problematic at
least anonymity is maintained.
The correct strategy here is to
trade opportunistically and take
advantage of spread and liquidity
■ THE TRADE 2005

opportunities within the blink of
an eye. A tight spread with good
liquidity on this type of stock sug-
gests that the stock is fairly priced
and the spread represents ‘good
value’. Thus, the risk involved in
waiting at the best bid or offer is
unlikely to be rewarded sufficiently
to justify passing on the opportu-
nity of executing immediately on
the other side of the spread. As
time passes, a wider spread has to
be accepted in order to keep up
with the required trading rate. 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 sup-
ply/demand imbalance that may
create an adverse price movement.
Low tick size/volatility,
low median spread/volatility
The final class of stock tend to be
liquid, blue-chip stocks with low
tick sizes and median spreads rela-
tive to volatility, 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 com-
moditised. These orders should be
sliced relatively finely to avoid
excessive execution risk, and the
waiting time on the order book is
relatively short, as the reward for
capturing the spread is relatively
small compared to the volatility
■ ALGORITHMIC TRADING
■ Chapter 2
Market and mechanics
risk to which the trader is exposed
waiting on the bid or ask.
Algorithms add value in the trading
of these stocks as they allow traders
to focus on more difficult trades in
less efficiently priced stocks.
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’. Furthermore, the mathe-
matics of how they operate is often
rather intractable and poorly
explained. I hope in this chapter I
have managed to communicate at 27
an intuitive level how a successful
algorithm should help the user
achieve the best possible outcome
in executing their trades.
Algorithms must be designed to
manage the risk-return trade off in
an optimal way, both in the way that
trading is scheduled and the way in
which each slice of an order is man-
aged. While this should be apparent
in performance statistics, 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. ■
■ A BUY-SIDE HANDBOOK ■ THE TRADE 2005

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 elec-
S tronic trading, the landscape of
trade execution, risk management
and market access has undergone
significant and rapid changes.
Being interdependent in nature,
the advancements in one area force
other areas to evolve. To that extent
the automation of electronic trade
execution can be seen as the ‘first
violin’, because the increasing
demand in execution speed,
throughput and low latency on one
hand requires more efficient mar-
ket access and risk management on
the other.
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). While the first one deals
primarily with investment deci-
sions, the second one focuses on
their implementations. There is no
■ ALGORITHMIC TRADING
■ Chapter 3
Market and mechanics
market consensus on the precise
definition of each category, but for
the purpose of this chapter we will
define them as alpha models and
execution algorithms or simply
algorithms. 29
Algorithms – when used appro-
priately – can improve multiple
facets of the investment cycle. They
give traders the ability to handle
larger sets of securities. At the same
time traders are able to focus their
attention on the instruments that
are difficult to trade, for instance
illiquid stocks, while letting algo-
rithms take care of more liquid
names. Algorithms benefit from
the speed of computers and there-
fore can follow the market more
closely than traders. They also
eliminate the emotional aspect of
the trading process, resulting in
more consistent performance. In
addition, algorithms help reduce
information leakage. All of the
above can be summarised in a sin-
*Allen Zaydlin, CEO,
gle statement: InfoReach
■ A BUY-SIDE HANDBOOK ■ THE TRADE 2005
 ■ 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.”
“Algorithms are a more efficient
way to trade in an environment
where cost, speed, consistency and
the prevention of information
leakage are crucial in attaining
alpha”
Survival of the fittest
30 In recent years, execution algo-
rithms have become more preva-
lent. Initially, algorithms were
offered by only a handful of bro-
kers to the larger buy-side firms
that were willing to pay higher
commissions. Since then, howev-
er, algorithms have grown to
become a common service avail-
able from the majority of brokers,
as well as trading system vendors.
Furthermore, as algorithmic exe-
cution becomes increasingly pop-
ular, more third-party software
vendors are building trading plat-
forms that serve as the foundation
for the rapid development of cus-
tom algorithms. The increase in
algorithmic offerings has made
the process of selecting the right
algorithm for your trading desk a
more exacting task. Nevertheless,
■ ALGORITHMIC TRADING ■ A BUY-SIDE HANDBOOK
the dilemma is quite simple to
resolve and comes down to three
options:
1. Utilise algorithms provided by
brokers.
2. Utilise ‘broker-neutral’ algo-
rithms provided by third-party
vendors.
3. Develop proprietary algorithms.
The first thing you will need to do
in your quest to select an algorith-
mic provider is to think clearly
and objectively. Simple analysis
and adequate understanding of the
goals that you need to reach, as
well as the means available can
yield surprisingly unexpected
results. This will help you to avoid
some common misconceptions
about algorithms’ functionality
and performance, and will also
assist in separating the marketing
hype from the algorithms. 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.
A: “Great! Then you should be able
to send any buy and sell orders
of the same symbol to this
VWAP algorithm simultaneous-
ly and enjoy positive P&L every
day.
■ THE TRADE 2005

Q: How good is your VWAP?
A: What are the average sizes you
need to trade? How liquid are
your instruments?
Q: Liquid, about 2000 shares.
A: Rest assured our VWAP will do
a good job.
First of all, this thinking process
should include a better under-
standing of how different algo-
rithms function and the problems
they solve. Secondly, try to decide
which algorithm fits your trading
cycle objective. And, lastly, pick
providers that offer algorithms
most efficiently.
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. It is
also partly from the absence of a
single scale that can be applied to
compare different options.
Execution performance attribution
is also somewhat obscure and lacks
standardisation.
Nevertheless, a certain struc-
tured quantitative comparison of
different options can be accom-
plished. Let’s start off by identify-
ing the pros and cons of using bro-
ker-provided, ‘off-the-shelf ’ and
custom-built algorithms.
■ ALGORITHMIC TRADING
■ Chapter 3
Market and mechanics
■ “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.”
Broker-provided
Pros
■ Require minimum technological
infrastructure on the client side
to access execution models. 31
■ Provide a wider range of
advanced algorithms that rely
on significant research, infra-
structure and maintenance cost.
This includes quantitative study
of historical data, computer
hardware and network infra-
structure to deal with vast calcu-
lation of considerable amounts
of real-time market and execu-
tion data. There is also the
ongoing expense in improving
the performance of existing
models.
■ Ability to pay only for usage.
Cons
■ Higher commission rates.
■ Higher risk of information
leakage.
■ Fewer algorithmic parameters
are exposed to end-users.
■ A BUY-SIDE HANDBOOK ■ THE TRADE 2005
 ■ 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.”
Off-the-shelf
Pros
32 ■ Lower commission rate by tak-
ing advantage of DMA rates.
■ Tighter control over parameteri-
sation of the algorithms.
■ Reduced risk of information
leakage.
■ Ability to work with multiple
brokers simultaneously, while
keeping trading data consolidat-
ed within a single system.
■ Broker neutrality.
■ Anonymity.
Cons
■ Require more infrastructure on
a client side to run.
■ Increased financial commitment
regardless of usage.
■ Tendency to lack more
sophisticated algorithms that
require a more elaborate
infrastructure.
■ ALGORITHMIC TRADING ■ A BUY-SIDE HANDBOOK
Custom-build
Pros
■ Customised functionality not
currently available from other
sources.
■ Quicker ability to modify.
■ Tighter control.
Cons
■ Bear unscalable expense of
infrastructure, development and
enhancement effort.
■ Risk of failure achieving the exe-
cution performance objectives.
Broker-driven vs. off-the-shelf
The emergence of various off-the-
shelf algorithms serves as an indi-
cation of the level of commoditisa-
tion that has occurred with certain
execution models and the deprecia-
tion in their relative value. Such
off-the-shelf algorithms will have a
cost advantage in comparison to
their broker-driven siblings. A sim-
ple comparison of VWAP algo-
rithms provided by brokers and
off-the-shelf providers will serve as
a guideline on how to compare
algorithms in general.
Assuming that the ultimate goal
is selecting an algorithm with max-
imum efficiency – meaning the
algorithm that combines best exe-
cution performance with lowest
cost – one can create a common
scale that combines cost and per-
formance into a single unit of mea-
■ THE TRADE 2005

sure. The cost basis is vital because
if two different algorithms perform
alike then cost becomes the main
differentiating factor. At the same
time we need to factor in perfor-
mance, because poor execution
performance can quickly eliminate
any advantage of a lower cost algo-
rithm.
In determining the cost basis, it
is useful to start with commission
rates. From what we observe in the
market today, it should not be
unreasonable to accept $0.0075 per
share as a common rate for broker-
provided algorithms. At the same
time, brokers’ DMA can offer a
very compelling commission rate,
where $0.0015 is not unheard of.
However, we also need to factor in
the cost of the third-party vendor
technology which delivers the bro-
ker-neutral algorithms that allow
you to take advantage of low DMA
rates in the first place. We will use
an average of $10,000 per month
for such technology and assume
that it is a fixed cost that does not
increase with trading volumes.
Taking the example of a firm trad-
ing one million shares per month,
we arrive at a commission cost of
$7,500 per month when using a
broker-provided algorithm, com-
pared with $11,500 when using the
broker-neutral equivalent. Clearly,
it does not add up – particularly if
information leakage is not a major
concern for the firm.
■ ALGORITHMIC TRADING
■ Chapter 3
Market and mechanics
■ “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.”
This hypothesis changes howev- 33
er, once the number of shares trad-
ed via the algorithm increases to
two million shares per month. Now
we are looking at $15,000 with bro-
ker-driven versus $13,000 with
broker-neutral algorithms. Thus,
the breaking-point lies somewhere
between one million and two mil-
lion shares per month, or between
50,000 and 100,000 shares per day.
It does not really matter exactly
where the breaking-point lies, what
is important is that in every partic-
ular case it can be calculated.
Applying the same commissions’
rates for 20 million shares per
month (one million per day) we
will get over $100,000 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
 ■ 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. A quick analysis of
the numbers can help us
determine where the breaking-
point is in terms of
performance.”
cant. While for the purpose of this
exercise the numbers have been
34 rounded off, by using this
approach and calculating your own
numbers you can easily find the
point at which the cost benefit of
introducing broker-neutral algo-
rithms is going to start making
sense to your business. (Go to
http://www.in4reach.com/
compare.html to run a quick com-
parison using your own numbers
as input.)
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.
For the sake of objectivity, we
also need to factor in the perfor-
mance of the algorithms we are
comparing. This is key. The cost
advantage of an off-the-shelf algo-
rithm over a broker-driven model
■ ALGORITHMIC TRADING ■ A BUY-SIDE HANDBOOK
will count for far less if it posts an
inferior performance. A quick
analysis of the numbers can help
us determine where the breaking-
point is in terms of performance.
Using VWAP as the example once
more, and assuming that a broker-
driven algorithm slipped 0.03 of a
basis point on 10 million shares
traded over a month, and using
$30 per share as an average stock
price, the value of slippage is
$90,000. As outlined in the Chart
1, the cost advantage of the off-the-
shelf algorithms was around
$50,000 based on 10 million shares
traded per month. To have this
advantage nullified due to the bet-
ter performance of a broker-driven
VWAP model, the off-the-shelf
algorithm has to slip 0.047 of a
basis point or, in terms of the
math, under-perform by 156%.
That said, in ‘real-world’ trading, it
is well known that various VWAPs
produce results only marginally
different from one another.
If this approach is calculated
using different monthly trading
volumes and average stock prices
only, the core finding remains the
same: that the performance ratio is
driven solely by the commission
rates ratio. In order to be on par
with a broker-neutral algorithm, a
broker-provided algorithm has to
outperform it to a level that can
compensate for the difference in
their respective commission rates.
■ THE TRADE 2005
 ■ Chapter 3

Market and mechanics

Chart 1: Commissions comparison

300,000

250,000

200,000
Commissions per month ($)

150,000

100,000

50,000

-50,000
35
00

00

00

00

00

00

00

00
00
,0

,0

,0

,0

,0

,0

,0

,0
0,
00

00

00

00

00

00

00

00
00

,0
1,0

,0

,0

,0

,0

,0

,0
5,

10

15

20

25

30

35

Shares per month 40

Broker algorithms rate Broker DMA rate Commissions difference

It is simply incorrect to assume meters – fine-tuned for each indi-

that something that costs twice as vidual order. Furthermore, most
much performs twice as well. broker-provided algorithms are not
Most broker-provided algo- geared to work with lists of orders
rithms reveal only a limited number that have correlations or share con-
of parameters for buy-side traders strains. For example, if you need to
to manipulate. Commonly, they are: trade a sector neutral basket of
algorithm start and end times, stocks there is no easy way to make
aggressiveness, percentage of the broker-provided TWAP understand
volume, plus three or five others. In your criteria of sectors – which can
contrast, off-the-shelf algorithms be totally specific to you – and the
provide significantly more options – threshold of intra-day imbalance
in some cases as many as 30 para- between sectors.

■ ALGORITHMIC TRADING ■ A BUY-SIDE HANDBOOK ■ THE TRADE 2005

 ■ Chapter 3
Market and mechanics
■ “The fact that more broker-
driven algorithms are being
made available from third-party
vendors, wrapped within a broker-
neutral model, can be taken as a
sign of increasing efficiency in the
market place.”
Reducing information leakage is
more a question of trust than an
item that can be measured through
quantitative analysis. However, one
36 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.
Proprietary algorithms
There are several reasons for build-
ing proprietary algorithms. First
among these is control over the
functionality and performance of
the algorithm, followed by lower
commission expense by making the
algorithm broker-neutral.
As outlined earlier in the chap-
ter, some algorithms are fairly basic
and require minimal infrastructure
to run, while others call for real-
time analysis of market depth and
extensive statistical analysis of
■ ALGORITHMIC TRADING ■ A BUY-SIDE HANDBOOK
historical data. The cost of devel-
oping more complex algorithms
in-house in terms of the network
and computer hardware that is
required can be prohibitive. In
some instances, it would be hard to
justify such a high level of invest-
ment in infrastructure, since buy-
side demand for highly sophisticat-
ed algorithms varies depending on
the trading strategy being deployed
and the volumes involved.
Meanwhile, the ongoing operating
costs remain constant. It is advis-
able, therefore, that before deciding
to build proprietary execution
algorithms, the cost and perfor-
mance of existing offerings is fully
understood.
Having considered the relative
merits of execution algorithms –
broker-driven, off-the-shelf and
proprietary – there appears to be a
breaking-point, both in terms of
cost and performance, at which
broker-neutral algorithms deliver
clear advantages. The fact that
more broker-driven algorithms are
being made available from third-
party vendors, wrapped within a
broker-neutral model, can be taken
as a sign of increasing efficiency in
the market place. ■
■ THE TRADE 2005