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Looking at algorithmic trading and dark pools.

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THE JOURNAL OF TRADING 9 FALL 2013

Optimal Trading Algorithm

Selection and Utilization:

Traders Consensus versus

Reality

JINGLE LIU AND KAPIL PHADNIS

JINGLE LIU

is a quantitative researcher

for algorithmic trading

at Bloomberg Tradebook

LLC in New York, NY.

jliu320@bloomberg.net

KAPIL PHADNIS

is a quantitative researcher

for algorithmic trading

at Bloomberg Tradebook

LLC in New York, NY.

kphadnis3@bloomberg.net

T

he market impact of orders cannot

be directly observed and is typi-

cally inferred from the data. Aca-

demic literature proposes various

models to describe market impact cost curves

and shows how real-world data can be fitted

into these models. Market impact curves

versus order size have been observed as con-

cave, indicating lower proportional impact

for larger orders. The market structure has

changed quite a bit in the last decade and is

constantly evolving. The U.S. equities market

is extremely fragmented, with 14 exchanges

and numerous dark pools. Market impact

models have traditionally looked at macro

factors, including average daily volume,

average spread, and volatility, among others,

to explain the cost of a trade. As algorithmic

tradings popularity increases, algorithm

types and their parameters become very

relevant factors affecting an orders market

impact. Institutional buy-side traders use

broker algorithms to execute orders in the

markets. These algorithms and their effect on

execution costs are the focus of this article.

Trading algorithms slice big orders into

smaller individual suborders in various styles

and route them to different venues using smart

order routing. Algorithms vary by a traders

specific objectives, which could be to trade at

a particular percentage of volume, to follow

volume-weighted average price (VWAP), to

use volume prof ile, and so on. Algorithms

also try to minimize their footprints while

extracting available liquidity eff iciently by

reacting to real-time market activities. For

buy-side traders, however, using trading

algorithms alone does not guarantee better

order execution performance. Understanding

the characteristics and performance of various

types of algorithms provided by sell-side bro-

kers is crucial to selecting optimal algorithms

for certain orders under certain market con-

ditions to better achieve investment objec-

tives. Past studies compare the performance

of different types of algorithms (Domowitz

and Yegerman [2006]; Kissell [2007]).

In this article, we investigate execution

performance of four types of commonly used

trading algorithms provided by brokers. Dis-

tribution of trade cost (average traded price

versus midpoint price at arrival of the order) is

used to quantitatively evaluate the execution

performance. We present results of a study

on traders consensus patterns for selecting

algorithms and compare those results with

actual algorithm performance. Furthermore,

we explore the dependence of performance

on order size, participation rate, limit prices,

and algorithm type. These results can be

useful to buy-side traders, helping them to

further improve their algorithmic decision-

making process and select optimal algorithm

parameters.

The following section introduces the

dataset for this study and describes termi-

JOT-LIU.indd 9 9/18/13 7:31:00 AM

THE JOURNAL OF TRADING 9 FALL 2013

Optimal Trading Algorithm

Selection and Utilization:

Traders Consensus versus

Reality

JINGLE LIU AND KAPIL PHADNIS

JINGLE LIU

is a quantitative researcher

for algorithmic trading

at Bloomberg Tradebook

LLC in New York, NY.

jliu320@bloomberg.net

KAPIL PHADNIS

is a quantitative researcher

for algorithmic trading

at Bloomberg Tradebook

LLC in New York, NY.

kphadnis3@bloomberg.net

T

he market impact of orders cannot

be directly observed and is typi-

cally inferred from the data. Aca-

demic literature proposes various

models to describe market impact cost curves

and shows how real-world data can be fitted

into these models. Market impact curves

versus order size have been observed as con-

cave, indicating lower proportional impact

for larger orders. The market structure has

changed quite a bit in the last decade and is

constantly evolving. The U.S. equities market

is extremely fragmented, with 14 exchanges

and numerous dark pools. Market impact

models have traditionally looked at macro

factors, including average daily volume,

average spread, and volatility, among others,

to explain the cost of a trade. As algorithmic

tradings popularity increases, algorithm

types and their parameters become very

relevant factors affecting an orders market

impact. Institutional buy-side traders use

broker algorithms to execute orders in the

markets. These algorithms and their effect on

execution costs are the focus of this article.

Trading algorithms slice big orders into

smaller individual suborders in various styles

and route them to different venues using smart

order routing. Algorithms vary by a traders

specific objectives, which could be to trade at

a particular percentage of volume, to follow

volume-weighted average price (VWAP), to

use volume prof ile, and so on. Algorithms

also try to minimize their footprints while

extracting available liquidity eff iciently by

reacting to real-time market activities. For

buy-side traders, however, using trading

algorithms alone does not guarantee better

order execution performance. Understanding

the characteristics and performance of various

types of algorithms provided by sell-side bro-

kers is crucial to selecting optimal algorithms

for certain orders under certain market con-

ditions to better achieve investment objec-

tives. Past studies compare the performance

of different types of algorithms (Domowitz

and Yegerman [2006]; Kissell [2007]).

In this article, we investigate execution

performance of four types of commonly used

trading algorithms provided by brokers. Dis-

tribution of trade cost (average traded price

versus midpoint price at arrival of the order) is

used to quantitatively evaluate the execution

performance. We present results of a study

on traders consensus patterns for selecting

algorithms and compare those results with

actual algorithm performance. Furthermore,

we explore the dependence of performance

on order size, participation rate, limit prices,

and algorithm type. These results can be

useful to buy-side traders, helping them to

further improve their algorithmic decision-

making process and select optimal algorithm

parameters.

The following section introduces the

dataset for this study and describes termi-

JOT-LIU.indd 9 9/18/13 7:31:00 AM

10 OPTIMAL TRADING ALGORITHM SELECTION AND UTILIZATION FALL 2013

nology used in the rest of the article for results around sta-

tistics and algorithms. Next, we analyze the main results

of our study and present data supporting our hypothesis

for optimizing algorithm usage. The final section sum-

marizes the article and highlights the main conclusions.

TRADES CONSENSUS

AND ACTUAL PERFORMANCE

Data Summary of Algorithm Characteristics

Our dataset consists of more than 270,000 buy-side

orders executed using trading algorithms provided by

Bloomberg Tradebook in the U.S. equity market. The

dataset encompasses a time frame large enough to incor-

porate a variety of market conditions. All algorithms

were executed during regular market hours and exclude

all stocks listed as pink sheets and the OTC Bulletin

Board stocks. The dataset consists of more than 4,500

tickers distributed across all market capitalizations and

sectors.

We categorize the algorithms into four groups:

scheduled, participation rate, dark, and implementa-

tion shortfall. Scheduled algorithms are also known as

VWAP algorithms because their goal is to achieve an

average trade price as close as possible to the VWAP for

the duration of the order. Participation rate algorithms

aim to participate in the market at specified rate with

respect to the market volume. Dark algorithms restrict

participation to venues known as dark pools. Dark

pools are reported to execute 14.26% of consolidated

U.S. volume as of February 2013 (Rosenblatt [2013]).

Implementation shortfall algorithms aim to be oppor-

tunistic with respect to arrival price benchmark while

minimizing market impact.

We summarize percentage distribution of orders in

each category as shown in Exhibit 1, grouped by average

daily volume (ADV, 30 day), order size as percentage

of ADV, participation rate based on fill quantity over

market volume in price, and algorithm duration. We

group the properties mentioned above into three buckets

each, where each bucket specifies a range that is deter-

mined based on data properties. We describe the table

data by grouped properties below.

We def ine low (0 to 1 million shares), medium

(1 million to 10 million shares), and high (greater than

10 million shares) ADV levels as shown in Exhibit 1.

Scheduled, participation rate, and implementation short-

fall algorithms are more popular for trading stocks that

trade 1 million to 10 million shares a day. In contrast,

more than 55% of time dark algorithms are being used

for equities of low ADV. This observation aligns with

the common belief that traders are more inclined to

trade less liquid equities in dark pools.

Order size is normalized using the stocks 30-day

ADV to make the statistics across different stocks more

comparable. This category is also broken into three

groups: small orders (0% to 1%), medium orders (1%

E X H I B I T 1

Mean of Stock ADV, Order Size, Participation Rate, and Duration of Four Classes of Algorithms

Note: Percentage normalized within each property and algorithm type.

JOT-LIU.indd 10 9/18/13 7:31:00 AM

THE JOURNAL OF TRADING 11 FALL 2013

to 10%), and large orders (10% to 100%). Among all

algorithms, more than 60% of all the orders have an

order size smaller than 1% of ADV, and more than 95%

of all the orders have an order size smaller than 10% of

ADV. This result suggests that cautious and risk-averse

traders inherently chop parent orders into smaller pieces

to avoid leaking their intentions to the market during

the execution of the parent order.

To further confirm this argument, we counted the

number of suborders within traders parent orders. Parent

orders were constructed by combining all the suborders

sent to a broker together based on same trader, ticker,

and side during the same day. Our finding shows that

parent orders larger than 10% of ADV are typically split

into two or three smaller orders by tradersconsistent

with the argument herein.

More than 90% of implementation shortfall algo-

rithms were traded on orders smaller than 1% ADV.

Thus, for small orders, traders prefer to have the order

done quickly by extracting maximum liquidity via

implementation shortfall algorithms. In the meantime,

for very large orders (>10% of ADV), traders rely on

scheduled algorithms to spread out the trade over the

day to minimize the market impact or rely on dark algo-

rithms to take advantage of block liquidity periodically

available in dark pools.

The participation rate is the ratio of algorithms

filled quantity to the market volume within the limit

price during that period of the execution. Participation

rate is strongly related to order size and duration. It

consists of three groups: low (0% to 5%), medium (5%

to 20%), and high (20% to 100%). Dark algorithms,

at 62.9%, have the highest percentage of orders falling

in the highest participation rate category, followed

by implementation shortfall, participation rate, and

scheduled algorithms. This finding could indicate that

traders are finding a high percentage of the liquidity in

dark pools regardless of the average percentage of dark

volume. We surmise that dark liquidity begets more dark

liquidity, and the average dark liquidity might not be the

entire story. We are working on a study to determine if

dark liquidity tends to be autocorrelated in nature, thus

leading to an understating on averages. Participation

rate algorithms are more likely to be used by traders

for targeting a certain level of participation; hence, the

majority fall in the 5%20% participation rate bucket.

Algorithm duration is the time between the algo-

rithms initialization and the time the order is completed

or canceled. Scheduled algorithms typically are used to

work through relatively long periods, with 67.4% of

orders lasting longer than 30 minutes. In contrast, 65.1%

of orders using a dynamic algorithm are finished within

five minutes because of the relatively smaller order size

and higher participation rate.

Data Summary of Trade Cost

Using a meaningful yardstick is important for

algorithmic performance analysis. In this study, we use

implementation shortfall (IS) as a trade cost measure

because practitioners use it widely as a benchmark to

evaluate execution performance. IS is measured as the

difference between the assets prevailing market price

at the time of the investment decision and the realized

average trade price. The normalized trade cost, TC, can

be expressed as

=

( )

avg arrival

arrival

TC S

P

(1)

where P

arrival

is the midpoint quote (average of bid/ask

price) at the point of order entry and P

avg

is the average

traded price of the algorithm. S is the order side and has

a value of +1 for buy orders and 1 for sell orders. All

values are in basis points. We will refer to this statistic

as trade cost for the remainder of the article.

Previous studies indicate that an orders size and

aggressiveness play important roles in driving trade

cost performance (Almgren and Neil [2001]). Smaller

orders tend to outperform larger orders, and participa-

tion exhibits a complicated inf luence on implementation

shortfall. To make a fair comparison of implementation

shortfall performance for the four common algorithms

listed here, we compare them by each pair of order size

bucket and participation rate bucket. Therefore, we

have, in total, 3 3 = 9 categories if we divide order

size and participation rate into three buckets, respec-

tively, as shown in Exhibit 2.

Order size increases from left to right, and partici-

pation rate increases from bottom to top. At each order

size and participation rate category, we calculate usage-

based percentages, which are the ratios of order counts

for each algorithm to the total count for all algorithms,

along with the mean and standard deviation of trade cost.

Exhibit 2 summarizes those numbers. Mean of trade cost

measures expected algorithm performance against arrival

JOT-LIU.indd 11 9/18/13 7:31:01 AM

12 OPTIMAL TRADING ALGORITHM SELECTION AND UTILIZATION FALL 2013

price, and standard deviation of trade cost is an indicator

of pricing risk, or the probability that the average price

is away from the expected value. Both should be consid-

ered for performance evaluation and comparison.

For small orders (<1% of ADV), traders tend to use

scheduled algorithms with a low aggressive level (low

participation rate) or use participation algorithms with a

mid/high aggressive level (mid/high participation rate)

while choosing dark algorithms to search for large fills

and quickly finish the order.

For medium-size orders (1% to 10% of ADV), traders

prefer scheduled or participation algorithms with low or

mid aggressiveness (low/mid participation rate) while

preferring to leverage block liquidity by using dark algo-

rithms to achieve a decent trade rate.

For large orders (>10% of ADV), traders rely on

the scheduled algorithms (34.5% for high participation

rate and 60.9% for medium participation rate) or block

trade opportunities from the dark pools to minimize

their footprints and stay away from predatory (48.1% for

high participation rate). Large orders with low participa-

tion rates have few data points because, naturally, most

of those large orders have >5% participation rate in the

market to get the order done by the end of day.

The usage percentage statistics in Exhibit 2 represent

a consensus of traders opinions about which algorithm(s)

to use based on nature of order itself and urgency level.

Interestingly, the results of trade cost performance do not

necessarily agree with the consensus of algorithm usage.

For example, 77.2% of small orders with low participation

level were done using scheduled algorithms even though

implementation shortfall algorithms provide better average

performance and smaller pricing risk. Compared with the

planned allocation scheme used by scheduled algorithms,

implementation shortfall algorithms can better adjust sub-

order allocation and aggressiveness based on real-time

market price movement and liquidity availability and,

therefore, can achieve lower trading cost, on average.

Implementation shortfall algorithms can immediately

extract continuous liquidity from lit exchanges, but dark

algorithms depend on the discrete liquidity in dark pools.

The continuous filling profile leads to a small variation

of the trade cost of implementation shortfall algorithms.

After finding the matching opposite sides in the dark

pools, however, dark algorithms can trade at a higher par-

ticipation rate without moving the market compared with

algorithms relying on lit exchanges. This result might

explain why dark algorithms are able to achieve lower

average trade cost at mid/high participation rates but not

at the smallest variance.

For medium-size orders (1% to 10% of ADV), dark

algorithms perform the best, while scheduled algo-

rithms perform the worst for mid/high participation

rate; participation algorithms perform the worst for low

participation rate. Best performance of algorithm over-

laps with most-used algorithms for high participation

rate but not for mid/low participation rate.

For large orders (>10% of ADV), dark algorithms

have the highest trade cost performance and smallest

standard deviation, while scheduled algorithms turn in

E X H I B I T 2

Trade Cost Performance for Four Groups of Algorithms for Various Order Sizes and Participation Rates

Notes: Algorithm groups in each category with sampling size of less than 200 are marked in gray and are not taken into consideration for comparison.

Highest-usage-based percentage and best performance in each category are marked in bold.

JOT-LIU.indd 12 9/18/13 7:31:01 AM

THE JOURNAL OF TRADING 13 FALL 2013

the worst mean performance. The poor performance of

scheduled algorithms for large, highly aggressive orders

is likely attributable to the fact that the imposed schedule

reduces the chance of participating in the liquidity event

while increasing the chance of trading too much during

inactive market periods.

High-frequency trading activity in the frag-

mented markets is also considered to play a role in the

performance of a brokerages algorithms. Such preda-

tory strategies estimate the probability of forthcoming

big orders or those under way by watching the tape

and front-running those orders to amplify the market

impact. Scheduled algorithms, which trade in a predict-

able fashion, tend to be more easily spotted by preda-

tory gamers and, therefore, become more susceptible

to technological adverse selection (Agatonovic et al.

[2012]). Opportunistic and dynamic algorithms are

less susceptible to predatory strategies because of the

nature of high dynamics and unpredictability, which

might partly explain the lower market impact of dark

and implementation shortfall algorithms compared with

scheduled and participation algorithms.

ALGORITHMIC PERFORMANCE FACTORS

Order Size

The persistence of order f low is overwhelmingly

attributable to order splitting (Toth et al., [2011]). Order

E X H I B I T 3

Trade Cost Dependence on Order Size

E X H I B I T 3 (Continued)

Note: In Panel C, the vertical line indicates the mean of the distribution.

JOT-LIU.indd 13 9/18/13 7:31:02 AM

14 OPTIMAL TRADING ALGORITHM SELECTION AND UTILIZATION FALL 2013

size is a major factor contributing to trade costs because

the market impact generated by the executed shares

during the early part of the order might affect the later

part of the order execution. Other factors mentioned

earlier have a more complex dependency on order size.

For example, duration depending on order size can affect

trade costs but is also algorithm-dependent.

In this section, we study the conditional distribu-

tion of trade cost with respect to order size as well as the

type of algorithm. Panels A and B of Exhibit 3 show the

mean and standard deviation of trade cost against order

size as a percentage of 30-day average daily volume.

We plot trade cost versus grouped percentage order

size in six intervals given by [0%, 1%], [1%, 3%], [3%,

10%], [10%, 20%], [20%, 40%], and [40%, 100%]. The

boundaries of intervals are selected based on having a

relatively uniform distribution of data density for each

group as well as enough data resolution to show cost sen-

sitivity in relation to order size. We find that the order

size dependence can be fitted by an exponent function

mean(TC) O

exponent. The result of least square regression based on

empirical data is = 0.4761, which agrees with previous

studies that show market impact to be a concave function

of order size (Almgren et al. [2005]). Pricing riskthat

is, the standard deviation of the trade costis also fit

by an exponent function sd(TC) O

fit value for is 0.21.

We also provide a unique way to look at the distri-

bution of trade cost with varying order sizes. Exhibit 3,

Panel C illustrates the distribution profiles of the trade

cost for order size intervals. From bottom to top, each

density represents the trade cost for an interval of

order sizes. The vertical line indicates the distributions

meanwe can clearly see it shift higher with order size.

We also observe that the density distribution becomes

less peaked as we go from bottom to top or as percentage

of order size increases. This observation indicates, and

we verify, a substantial change in the third and fourth

momentsthat is, a decrease in kurtosis and an increase

in the positive skew of the distribution along with an

increase in standard deviation. This dynamic indicates

that trading costs become quite uncertain as the order

size goes up. We confirm by estimating standard errors

for these statistics that are robust estimates. The distri-

bution profile changes quickly as order size increases to

20% of ADV and changes less significantly as the order

size rises above 20%.

Exhibit 4 shows the relationship between order size

and estimated mean and standard deviation of trade cost

distribution by algorithm type. Scheduled, participa-

tion rate, dark, and implementation shortfall algorithms

exhibit monotonically decreasing performance with

order size at different rates. Among these algorithms,

scheduled algorithms have the worst performance and

their trade cost curve falls off the fastest compared with

E X H I B I T 4

Trade Cost Dependence on Order Size for Each

Algorithm Class

JOT-LIU.indd 14 9/18/13 7:31:03 AM

THE JOURNAL OF TRADING 15 FALL 2013

the other algorithms. In part, this occurs because

scheduled algorithms typically have more fixed share-

allocation schedules, which does not allow for f lexibility

to adjust the participation rate over the course of trading

and, therefore, cannot capture the occasional excessive

surging liquidity. Another reason is that traders typi-

cally set schedule algorithms to longer periods, leading

to longer algorithm duration and higher pricing risk.

Therefore, for medium and large orders, traders should

be discouraged from using scheduled algorithms when

trade costs are measured with respect to arrival price.

Participation rate algorithm trade cost falls off

before that of dark and implementation shortfall algo-

rithms. Using this curve, we can also estimate a favor-

able order size to use for participation rate algorithms on

the impact curve. Implementation shortfall algorithms

exhibit greater ability to incur lower trade costs because

of the allocation design, which balances market impact

and pricing risk.

Finally, dark algorithms are much less dependent

on order size than the other three and exhibit consis-

tently lower trade cost across the whole range of order

size. This result suggests that trading in dark pools could

be very benef icialespecially for very large orders,

which would not incur the large trade cost of other

algorithms. If certain equity has a decent number of

shares traded in dark historically, traders should strongly

consider using the liquidities in dark pools before or

at the same time that they trade in a lit exchange. We

caution that this result applies only for Tradebooks dark

algorithms. Because dark algorithms are not standard-

ized across brokersthat is, their logic and access to

dark pools is highly broker-dependentresults may vary

across broker/dealers.

The standard deviation of the trade cost of sched-

uled and participation rate algorithms increases much

faster than trade costs incurred when using dark and

implementation shortfall algorithms. For order sizes

larger than 20% of ADV, the standard deviations of the

trade cost of dark and implementation shortfall algo-

rithms are more than 30% lower than that of scheduled

and participation rate algorithms, as shown in Exhibit 4,

Panel B. Because of the relatively fixed time schedule

or participation rate, schedule and participation rate

algorithms tend to last longer and have more pricing

uncertaintythat is, the effect of trade cost standard

deviation is conditional on other factors.

Participation Rate

Participation rate is another important factor that

affects algorithm performance. Higher participation rate

takes away more liquidity from the market, leading to

a larger market impact that will affect the execution

price of the orders remaining shares. Exhibit 5 shows

the trade cost distribution at different participation rate

ranges for all the algorithms. The profile width decreases

as the participation rate increases from 0% to 20% and

then stays relatively the same at above 20% participation

rate. Kurtosis (peakedness) increases as the participation

rate increases.

Exhibit 6 illustrates mean and standard deviation

of execution performance for each individual algorithm

type. Scheduled algorithms performance shows much

E X H I B I T 5

Distribution of Trade Cost Performance against

Arrival Price for Various Participation Rate Ranges

JOT-LIU.indd 15 9/18/13 7:31:03 AM

16 OPTIMAL TRADING ALGORITHM SELECTION AND UTILIZATION FALL 2013

greater sensitivity to participation rate than that of the

other algorithms. Again, this high sensitivity can be

attributed to the rigid share-allocation schedule imposed

by the scheduled algorithm. Interestingly, no significant

pattern of relationship appears between participation rate

and variance of the performance. The participation rate

dependence of performance standard deviation is rela-

tively f lat for all of the algorithms.

Limit Price

Traders typically use limit prices in algorithms to

manage price risk when routes are sliced from larger

orders to brokers. In our dataset, more than 90% of

algorithms are used with a limit price. Limit price affects

both participation rate and trade costs. Our hypoth-

esis is that setting a too aggressive or marketable limit

price would make the execution faster but provide very

little price improvement. On the other hand, setting a

too passive or unmarketable limit price would lead to a

big price improvement but could not guarantee the full

fill. We analyze the trade-off between participation rate

with marketable limit price and trade cost, and we find

optimal curves for the trader to choose limit price based

on the level of order urgency.

All the algorithms with a user-set limit price are

grouped into buckets based on the normalized differ-

ence between arrival price and limit, P

lmttoarrPx

calcu-

lated as

P P

P

lm

PP

t a

P

rrPx PP

a

P

rrPx PP

where the sign of buy order is positive

and the sign of sell order is negative. The more positive

the difference, the more marketable the order. Panel A

of Exhibit 7 plots the trade cost distribution of all the

algorithms with limit price. When limit price is passive

or unmarketable, the distribution has positive average

performance with a long negative tail. When limit price

is set close to arrival price, the distribution has slightly

worse average performance with smaller standard devia-

tion and larger positive skewness, which indicates that

trade cost is tightly concentrated around arrival price.

When the limit price is aggressive or marketable, distri-

bution widens again, with a long positive tail and worse

average performance. Panel B of Exhibit 7 presents the

mean of the trade cost within each bucket. The trade cost

performance gradually decreases as P

lmttoarrPx

becomes

larger, but not at a constant rate. It increases quickly as

limit price changes from passive to neutral, and slowly

as limit price changes from neutral to aggressive.

Panel A of Exhibit 8 shows how the mean of trade

cost changes with limit price for each algorithm type.

In the unmarketable zone, all the algorithms exhibit

similar dependence. In the marketable zone, dark algo-

rithm performance decreases the fastest with limit price,

while scheduled algorithm performance decreases the

slowest. In other words, the average performance of

the dark algorithm is more sensitive to the limit price.

E X H I B I T 6

Trade Cost Dependence on Participation Rate

JOT-LIU.indd 16 9/18/13 7:31:04 AM

THE JOURNAL OF TRADING 17 FALL 2013

The standard deviation of the performance is the lowest

as limit price is set close to arrival and increases linearly

as the price moves away from arrival in either direc-

tion as shown in Exhibit 8, Panel B. Therefore, if a trader

wants to reduce the variance of his or her algorithmic

performance, setting limit price close to arrival price

will help achieve this objective.

To characterize traders behavior while setting

limit prices, and limit prices inf luence on participation

rate, we measure the ratio of missing interval volume

to volume in price, which can be calculated as

V V

V

inPx all

inPx

,

where V

all

and V

inPx

are total volume within order exe-

cution horizon and volume in price, respectively. This

measure indicates how much liquidity traders would

miss by setting a limit price on the algorithms. We call

this liquidity loss ratio. Panel C of Exhibit 7 plots the

liquidity loss ratio as a function of distance of limit price

from arrival in percentage points. A sharp increase is

observed as the limit price approaches the arrival price,

and then the liquidity loss ratio increases slowly all the

way to 0 as the limit price is set more marketable. To

achieve optimal balance between price improvement and

liquidity loss ratio, the utility objective function should

be maximized with respect to limit price, as shown in

the following equation:

( ) max( (2)

E X H I B I T 7

Trade Cost Performance against Arrival Price for

Various Limit Price Ranges

E X H I B I T 7 (Continued)

JOT-LIU.indd 17 9/18/13 7:31:06 AM

18 OPTIMAL TRADING ALGORITHM SELECTION AND UTILIZATION FALL 2013

for the implementation shortfall algorithm, the trader

is willing is to give up a lot of liquidity to get fills at his

or her price. This is less so for participation rate algo-

rithms (i.e., only when they become marketable), and

even less so for dark and scheduled algorithms. Traders

are more inclined to give up liquidity for opportunistic

algorithmsthat is, they are hopeful of getting a favor-

able price.

CONCLUSION

Quantitative analysis of algorithms performance

plays an important role in algorithmic trading. We ana-

lyze trader usage of execution algorithms and extract

consensus patterns. We use these patterns to offer

insights that can help traders make optimal decisions

when selecting algorithms and determining their param-

eters to achieve reduced implicit trade costs.

Analyzing more than 150,000 trading algorithms

executed via Bloomberg Tradebook in varied market

conditions, we provide a comprehensive picture of buy-

side traders usage patterns. By looking at statistics around

algorithm and trade cost parameters, we describe the

type of algorithms and the conditions the traders select

to execute their orders. Statistics we comprehensively

study are ADV, size, participation rate, and duration,

as well as implicit trade costs for four different types of

where L(P

lmt

) is the liquidity loss ratio and is a constant

that depends on the traders risk aversion or the order

urgency level.

Panel C of Exhibit 8 plots trader behavior as a

trader compares normalized limit price (versus arrival

price) with liquidity loss ratio. Here, we characterize how

limit prices are set by traders for different algorithms

potentially giving us insight into the traders perception

of the different algorithms. Interestingly, we see that

E X H I B I T 8

Trade Cost Dependence on Limit Price for Each

Algorithm Class

E X H I B I T 8 (Continued)

JOT-LIU.indd 18 9/18/13 7:31:08 AM

THE JOURNAL OF TRADING 19 FALL 2013

algorithms. By comparing this empirical dataset of usage

patterns with implementation shortfall performance, we

offer insights on using optimal parameters for different

algorithms.

We find that our implicit trade cost curve is con-

cave, scaling as power law with an exponent of close

to 0.5 for all strategies. When examined by strategy

type, trade cost curves are conditional on strategy type.

Scheduled algorithms have the largest exponent, and

dark and implementation shortfall strategies have smaller

exponents. Standard deviation of the estimate of trade

cost also increases with order size and differs for different

strategy types.

We describe different ways of looking at trade cost

distribution versus participation rate, including using

higher moments of trade cost and conditional histo-

grams for various buckets of participation rates. Sched-

uled algorithms exhibit high trade costs as participation

rates increase, but surprisingly, other algorithms show

f latter curves as participation rates increase. We intend

to research this dynamic further, but we anticipate that

other factors are confounding elements in these curves,

including duration, volatility, and the microstructure of

individual stocks.

We construct a metric called the liquidity loss ratio

based on limit prices set on various types of algorithms.

This metric analyzes the usage of limit prices with respect

to loss in volume over the duration of the algorithm. We

will quantify this relationship in a future article, but we

point out the importance of setting limit prices and their

performance impact for different algorithms.

REFERENCES

Agatonovic, M., V. Patel, and C. Sparrow. Adverse Selection

in a High-Frequency Trading Environment. The Journal of

Trading, Vol. 7, No. 1 (2012), pp. 18-33.

Almgren, R., and C. Neil. Optimal Execution of Port-

folio Transactions. Journal of Risk, Vol. 3, No. 2 (2001), pp.

5-39.

Almgren, R., T. Chee, H. Emmanuel, and L. Hong. Equity

Market Impact. Risk, ( July 2005), pp. 57-62.

Domowitz, I., and H. Yegerman. The Cost of Algorithmic

Trading: A First Look at Comparative Performance. The

Journal of Trading, Vol. 1, No. 1 (2006), pp. 33-42.

Kissell, R. Statistical Methods to Compare Algorithmic

Performance. The Journal of Trading, Vol. 2, No. 2 (2007),

pp. 53-62.

Rosenblatt Securities. Rosenblatts Monthly Dark Liquidity

Tracker. March 2013.

Toth, B., I. Palit, F. Lillo, and J.D. Farmer. Why Is Order

Flow So Persistent? arXiv: 1108.1632 (2011). http://arxiv.

org/abs/1108.1632

To order reprints of this article, please contact Dewey Palmieri

at dpalmieri@iijournals.com or 212-224-3675.

JOT-LIU.indd 19 9/18/13 7:31:10 AM

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