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Equity Research Industry Update

January 26, 2009
Sector Weighting: None

High Frequency Trading

Trade Execution - January 2009
The Art of The Trade, Part 1

In this note we explore common aspects of trading processes, key parallels between trading and investment management, and establish a framework for describing and improving the art of trading. The focus of this series will be the improvement of all varieties of trade execution processes. We intend to investigate alternative frameworks for modeling familiar trading processes, risks and costs so that we may recommend meaningful trading process improvements and innovations. A common objective of trading is to determine an optimal division and scheduling of trade execution so that the expected cost and the expected risk are minimized subject to constraints on price, volume and duration. VWAP algorithms minimize market impact effectively but are unlikely to minimize trading risk or the overall cost of execution. Arrival Price algorithms attempt to balance the objectives of minimizing natural price movement, market impact and opportunity cost at the same time.

All figures in Canadian dollars, unless otherwise stated.

09-94342 © 2009

CIBC World Markets does and seeks to do business with companies covered in its research reports. As a result, investors should be aware that the firm may have a conflict of interest that could affect the objectivity of this report. Investors should consider this report as only a single factor in making their investment decision. Derek Euale 1 (416) 594-7874
derek.euale@cibc.com

Matthew Black 1 (416) 594-7576
matthew.black@cibc.com

See "Important Disclosures" section at the end of this report for important required disclosures, including potential conflicts of interest. See "Price Target Calculation" and "Key Risks to Price Target" sections at the end of this report, or at the end of each section hereof, where applicable.
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the most common goal is to achieve an optimal compromise between trading costs and risks within the constraints determined by the trader’s needs and preferences. We intend to investigate alternative frameworks for modeling familiar trading processes. However. They are both problems whose solution should be recalculated and adjusted periodically throughout the execution of the plan in order to remain on target within a setting of continuous change. within constraints that are consistent with the investment strategy. they're both dynamic optimization problems.Trade Execution . the common goal is to execute with the lowest possible cost and risk levels.January 26. This note introduces the key challenges that we will face within the ‘Art of the Trade’ research series during the course of 2009. Our basis for understanding and improving trade execution processes begins with an analogy to investment management. In manual or automated trading. Specifically. 2 . It seems to follow that the most effective trade execution processes should be tightly integrated with the accompanying investment management methodology. In fact. there is common ground. this note will: 1) Reveal common aspects of diverse trading processes. 3) Explore and present practical steps that portfolio managers and traders can take toward tighter integration of trading and investment processes. From a mathematical perspective.January 2009 . From the simplest of trades to the most complex. The focus of this series will be the improvement of all varieties of trade execution processes. 2) Explore key parallels with investment management processes. risks and costs so that we may recommend meaningful trading process improvements and innovations. 2009 Introduction Trading strategies are as diverse as the goals and circumstances of the portfolio managers and traders who establish and implement them. Investment and Trading Parallels Investment management becomes effective through trade execution. It is here that we set the stage for a more thorough investigation of specific improvements and innovations. They are both problems whose solution repeatedly achieves the best balance between complex objectives within practical constraints. In future notes within this series we will: 1) Uncover established cost and risk-reducing enhancements through a systematic examination of industry trading practices in Canada and abroad. 2) Develop and experiment with various models of trade execution in order to recommend specific improvements to manual and automated execution algorithms. In fundamental or quantitative investment programs the most common goal of the investment process is to achieve and maintain an optimal compromise between return and risk within the constraints determined by the investors’ needs and preferences. the problem of investment management and the problem of trading can be viewed as different problems within the same class of problems. and 3) Establish a framework for describing and improving the art and science of trading.

execution alternatives Assess Block. Execute Trading Schedule Begin processing orders according to plan Begin processing fills E D E. Generate Trade Ideas Cr eate a retur n forecast.January 26. Determine Trading Schedule Conduc t Risk Analysis Trade Schedule Construction D. Determine Target Portfolio Conduct Risk Analysis Portfolio Construction D. Review I nvestm ent P erformance Ongoing risk analysis Return and risk expectations vs. Investment Management Key B A C A. Combination Trading C. Pt+1 P t+2 … P t+k Continuous Monitoring and Adjusting A sequence of portfolios implements the investment strategy over time Exhibit 2. Trade Execution Key B A C A.January 2009 . 2009 Exhibit 1.Trade Execution . Review Trade P erformance Real-time cos t and risk analysis Cost and risk expectations vs. Update I nvestm ent O bjectives Review strategy in current market context Determine controls and constraints B . Algorithmic. experience St Source: CIBC World Markets Inc. Execute Trades / Rebalance Portfolio Determine execute trading plan Establish new portfolio equal to the target E D E. experience Pt Source: CIBC World Markets Inc. Update Trade Objectives Review strategy in current market context Determine controls and constraints B . St+1 S t+2 … St+k Continuous Monitoring and Adjusting A sequence of trading schedules implements the trade over time 3 . Generate Alternatives Cr eate a cost forecast. trade ideas Fundamental or Quantitative Model C.

Dr. waiting too long may allow the underlying price to drift unfavorably or may increase opportunity costs during the trade. the essential concerns are the same. The dynamic backdrop of the market ensures that an optimal trading schedule will not satisfy constraints for long. Portfolios are adjusted regularly in order to preserve a justifiable compromise between expected return and risk within suitable constraints. New York University. Robert Almgren. a limit on portfolio turnover. This statement is certainly accurate from one perspective. tracking within 50 basis points of benchmark index weightings. So. as the slow execution of a trade minimizes market impact and therefore reduces trading costs or slippage. a suitable range for tracking error. Achieving the desired outcome typically requires the ongoing maintenance of investment portfolios. an average-sized mutual fund or the largest pension fund. So.January 26. Constraints of the investment process may include a limit on aggregate portfolio long and short positions. nor is any trading schedule likely to remain optimal for a considerable amount of time. a limit on net industry exposures.Trade Execution . Orders are adjusted regularly to preserve a justifiable compromise between expected trading costs and risk within suitable constraints. convincingly points out that the key question in trading is whether to trade quickly. and an authority on trade execution. in the full context of the trade. Adjunct Professor in Financial Mathematics at the Courant Institute of Mathematical Sciences. or whether to trade slowly. This seems to be true whether we consider fundamental or quantitative approaches.January 2009 . the essential benefits of investment management are achieved through the implementation of a sequence of carefully constructed portfolios in time. a typical portfolio rebalance trade or a complex multi-asset relative-value arbitrage trade. Investment management involves entering and exiting specific investments within the complex and dynamic setting of the global financial markets. Constraints of the trading process may include a fixed share volume. Trade execution involves managing order execution within the complex and dynamic environment made up of millions of traders. However. nor is any portfolio likely to remain optimal for a considerable amount of time. or any number of possible criteria that are ultimately expressed as restrictions the on portfolio weights. 2009 Investment Management Whether we are discussing the investment processes of a small hedge fund. Trading Schedules It is often said that a patient trader is a profitable trader. 4 . Trade Execution The essential concerns of trade execution are the same regardless of whether we consider a large single-asset trade. Achieving the desired outcome typically requires the ongoing management of orders and fills. limits on the acceptable trade duration or any number of possible criteria that are ultimately expressed as restrictions on the plan of execution or trading schedule. the essential benefits of trade execution are achieved through the implementation of a sequence of carefully constructed trading schedules in time. The dynamic backdrop of the market ensures that an optimal portfolio will not satisfy portfolio constraints for long. This seems to be true whether we consider manual or automated algorithmic approaches. thousands of assets and multiple trading venues.

000 0 9:30 10:30 11:30 12:30 13:30 14:30 15:30 Source: CIBC World Markets Inc. volume and duration. Exhibit 3. To begin trade execution the trader needs to have decided how best to divide the trade to achieve a balance of objectives. a common objective of trading is to determine an optimal division and scheduling of trade execution so that the expected cost and the expected risk are minimized according to a specified risk aversion level and subject to constraints on price. 5 . 2009 In fact. Determining an appropriate trade schedule is the fundamental problem of trading. Manual Trading Schedules 500.000 2 3 4 100. we consider the factors that will determine the degree of success of a given trade.000 1 200. Algorithmic Trading Schedules 500.000 Remaining Trade Volume (Shares) 300.January 2009 .Trade Execution .000 Remaining Trade Volume (Shares) 300. To understand trading costs and risks within this model. A Trade Schedule is the expected remaining trade volume expressed as a function of time. within the context of investment.000 0 9:30 10:30 11:30 12:30 13:30 14:30 15:30 Source: CIBC World Markets Inc. The specific order-splitting solution that implements trade execution is known as the trade schedule.000 2 3 100.000 400. These include trade constraints and the interrelated risks of natural price movement.January 26.000 1 200.000 400. market impact and missed opportunity. Exhibit 4.

the best choice of trading schedule is not just one that satisfies the constraints. Cost and Risk Factors One objective in the determination of an optimal trading schedule is the minimization of expected trading costs. In each of these examples. If we could repeat an identically specified trade 5. Exhibit 5. etc. 6 .January 26. volume and the duration of the trade. one trader may be motivated to exit a derivative hedge position before an 11 am announcement by selling $1. but one that simultaneously attempts to optimize the cost and risk tradeoff in favour of the trade originator. the traders have considered constraints on execution price.000 different market scenarios. a trader must be able to express his or her intentions through constraints on the trading schedule or. In general.000 times within 5. expected trading costs relative to a benchmark are only part of the picture. constraints can be strict equality constraints or less rigid inequality constraints.000. Example VWAP algorithm with trade duration equal to 1 hour Volume equal to 50. Often our cost expectations are stated in terms of a benchmark. Our objective then is to minimize the slippage or difference between a price benchmark and the realized execution price. equivalently. 2009 Constraints on Trade Execution Before executing any orders. our observations of realized price slippage would form a distribution having an average realized price slippage and a related standard deviation. A second trader may be interested in rebalancing an enhanced index portfolio in the last few hours of the day today by accessing intraday and Market-on-Close market liquidity to achieve the least possible price slippage from closing prices. Of course. those that satisfy all of the constraints are called feasible trading schedules. closing price.000 worth of common shares if the expected execution price is close enough to a relative decision price. Examples of Trade Constraints Equality Constraints D = D0 V = V0 P = P0 Inequality Constraints P D P0 V0 G V G V1 D G D0 Source: CIBC World Markets Inc. may want to modify 100 large single-stock positions over several days and would like to minimize slippage from daily VWAP (VolumeWeighted-Average) prices. an active portfolio manager.000 shares Fill or Kill buy order with a limit below the market Example Limit order to sell if price above $20 Executed volume must be within range Trade duration up to 1 day Trades are characterized by their constraints. For example. However. through detailed constraints on price.January 2009 . Any order-splitting plan or trading schedule that is approved by a trader for execution must be a feasible one. Among all possible trading schedules. such as the same-period VWAP.Trade Execution . Still another trader. decision price. volume and duration.

Market impact is thought to have two components: a temporary price impact due to a temporary increase in the demand for liquidity. Volume Risk: Differences between realized and expected volume can be caused by insufficient liquidity or price movement beyond an acceptable range. The direction and magnitude of natural price movements around the expected price during execution can increase or decrease the realized price slippage and risk of a trade. By this time. an execution plan is developed and initial orders are placed.January 26. the price of the relevant stocks will almost certainly have changed from the time of the trade decision.January 2009 . 2009 Exhibit 6. Distribution of Realized Price Slippage Probability S Realized Price Slippage Source: CIBC World Markets Inc. Opportunity costs represent lost profit due to an inability to completely implement an investment decision. Market Impact The market impact of the trade is the movement in the price of the stock directly caused by the execution of the trade under consideration. What factors determine the size and variance of price slippage and hence the costs and risks of trade execution? Price Risk: Natural Price Movement After a trade is specified. 7 . the risk of a trade may be viewed as the variance of realized price slippage.Trade Execution . Volume differences result in opportunity costs borne by traders. Just as the cost of a trade is most often considered as the slippage from the expected cost. Market impact is the theoretical difference between the stock's price trajectory with the trade and what the price trajectory would have been had the trade not been executed. and a longer-lasting or permanent price impact caused by information communicated by the trade about the state of available liquidity. A trader can get a sense for the distribution of realized price slippage by reviewing a large collection of similar trades on the same stock under different market situations.

POV algorithms simply trade a fixed percentage of market volume in each sub-period during the trade. we find guidance in portfolio theory and in the theoretical existence of an efficient frontier.2000). In trade execution. 2009 Duration Risk: Differences between realized and expected duration can be caused by temporary conditions of insufficient liquidity or price movement beyond an acceptable range. As a third example of the fundamental relationship between risk factors. a largerthan-expected market impact can result in a trade taking longer to execute and hence result in an increased opportunity cost for the trader. The participation rate of Arrival Price algorithms decreases as time progresses so that the execution is weighted toward the price at the time of arrival of the order. volume and duration risk are very tightly coupled. or maximum return for a given risk. higher-than-expected trading volumes can decrease the duration of a trade leaving the trader unable to take advantage of a large favorable price move after the trade is completed. VWAP and POV algorithms minimize market impact effectively but are unlikely to minimize trading risk or the overall cost of execution. These algorithms attempt to balance the objectives of minimizing both market impact and opportunity cost at the same time. To find a balance of risk and return in the determination of an optimal investment portfolio. With fine enough time partitioning. Arrival Price algorithms have a relatively high volume participation rate at the beginning of the execution period. so how can we do it better? Simple suggestions for trading with reduced slippage and trading risks begin with an increased focus on order-splitting algorithms and liquidity seeking. These interrelationships make the objective of trading process improvement notably more complicated. The efficient frontier in portfolio theory is generated by finding a set of portfolios that have minimal risk for a given return. By extending our analogy with investment management. we can determine a set of trading schedules that has minimal risk for a given cost or minimum cost for a given level of risk.January 26. This is because they typically allow for more natural price movement than necessary during the trade. Departure Price algorithms have a relatively high volume participation rate 8 . timing differences can result in opportunity costs borne by traders. Static Trading Algorithms Static order-splitting algorithms have unchanging trade schedules determined at the beginning of the trade and not adjusted throughout the trade duration. Departure Price algorithms are the reverse of Arrival Price algorithms in time. Like volume differences. For example. to find an optimal balance of risk and cost.Trade Execution . VWAP algorithms typically involve tracking an historical average intraday volume profile throughout the duration of the trade. Arrival Price and Departure Price algorithms are also static algorithms. VWAP and POV (Percent of Volume) algorithms are static order-splitting algorithms. Price. we can gain insight into the more general optimization problem. The resulting set of optimal trade schedules has been called the efficient frontier of optimal trading strategies (Almgren and Chriss .January 2009 . Improving Trade Execution Determining an appropriate trade schedule is the fundamental problem of trading. Reduced liquidity can increase the duration of the trade causing an increase in price risk by allowing more time for natural price movement to occur.

and mathematical analysis of a security or a portfolio of securities in an effort to forecast future performance. In this note we have begun to explain the model with which we intend to describe and analyze trade execution. We recommend that clients contact their CIBC World Markets representative to request copies of relevant equity research reports published by fundamental analysts for further information. and N. experiment with various models of trade execution in order to recommend specific improvements to manual and automated execution algorithms." J. and explore practical steps that portfolio managers and traders can take toward tighter integration of trading and investment processes. "Optimal Execution of Portfolio Transactions.Trade Execution . the execution of the order is less detectable. R.January 26. our hope is that each of us might become a better trader. CIBC World Markets may also publish research reports on the issuers discussed herein that may express different or contradictory opinions and recommendations based on a fundamental analysis of their businesses. Adaptive Trading Algorithms Adaptive trading algorithms are characterized by trade schedules that adapt to unexpected price movements and the availability of liquidity throughout the trade. Time-Slice Randomization By changing the length of time-slices within a trading algorithm. Risk 3(2). 2009 at the end of the execution period.. For each adjustment to trade strategy an optimal schedule is calculated for the remaining trade using all available information on changing market conditions at the moment of calculation.January 2009 . The participation rate of Departure Price algorithms increases as time progresses so that the execution is weighted toward the price at the completion of the order. References: Almgren. Adaptive trading algorithms are executed using a sequence of optimal schedules as discussed earlier. Reverse-engineering the size of the total order becomes much more difficult. Chriss. if not impossible. We expect to uncover established cost and risk-reducing enhancements through an examination of industry trading practices. 9 . statistical. Concluding Remarks Institutional investors in Canada have many approaches to trade execution. Quantitative analysis is one of many research methodologies that are useful in analyzing a security or a portfolio of securities. Each re-optimization balances the expected costs and risks of the remaining trade. if the algorithm uses time-slice randomization. In future notes within this series we will continue on our path revealing new ways to understand current trading philosophies and practices. The opinions expressed in this report are based upon quantitative. Liquidity Seeking Many automated algorithms access all available sources of liquidity during execution converting to the desired currency dynamically where required. Both of these algorithms mitigate price risk and opportunity costs by trading more aggressively near the natural location of the benchmark price. (2000). 5-39. Through asking ourselves difficult questions about our own trading practices.

Research analysts do not receive compensation based upon revenues from specific investment banking transactions. futures or other derivative instruments based thereon. or at the beginning of any subsection hereof. as well as more specific disclosures set forth below. related to the specific recommendations or views expressed by such research analyst in this report. In addition to 1% ownership positions in covered companies that are required to be specifically disclosed in this report. director or advisory board member of a company that such analyst covers.January 26. CIBC World Markets generally prohibits any research analyst from serving as an officer. directly or indirectly. may at times give rise to potential conflicts of interest. Potential Conflicts of Interest: Equity research analysts employed by CIBC World Markets are compensated from revenues generated by various CIBC World Markets businesses. related securities or in options. or will be. 2009 IMPORTANT DISCLOSURES: Analyst Certification: Each CIBC World Markets research analyst named on the front page of this research report. CIBC World Markets generally prohibits any research analyst and any member of his or her household from executing trades in the securities of a company that such research analyst covers. Recipients of this report are advised that any or all of the foregoing arrangements. including the CIBC World Markets Investment Banking Department. CIBC World Markets may have a long position of less than 1% or a short position or deal as principal in the securities discussed herein. hereby certifies that (i) the recommendations and opinions expressed herein accurately reflect such research analyst's personal views about the company and securities that are the subject of this report and all other companies and securities mentioned in this report that are covered by such research analyst and (ii) no part of the research analyst's compensation was.January 2009 . is.Trade Execution . 10 . Additionally.

Ratings Distribution*: CIBC World Markets' Coverage Universe (as of 26 Jan 2009) Sector Outperformer (Buy) Sector Performer (Hold/Neutral) Sector Underperformer (Sell) Restricted (as of 26 Jan 2009) Sector Outperformer (Buy) Sector Performer (Hold/Neutral) Sector Underperformer (Sell) Restricted Count 121 158 31 7 Count 0 0 0 0 Percent 38. Stock is expected to underperform the sector during the next 12-18 months.0% 0.0% 0. our system for rating investment opportunities and our dissemination policy can be obtained by visiting CIBC World Markets on the web at http://researchcentral. CIBC World Markets has assigned buy ratings to securities rated Sector Outperformer.. CIBC World Markets does not maintain an investment recommendation on the stock.4% 64.January 2009 . 4th Floor. Stock is expected to perform in line with the sector during the next 12-18 months.1% 49.cibcwm.cibcwm.7% 2.Trade Execution . and the S&P/TSX Composite in Canada. Rating Description Sector Weightings** **Broader market averages refer to the S&P 500 in the U.. 161 Bay Street. "Speculative" indicates that an investment in this security involves a high amount of risk due to volatility and/or liquidity issues. for the purposes of complying with NYSE and NASD rules. Ontario M5J 2S8. 2009 CIBC World Markets Price Chart For price and performance information charts required under NYSE and NASD rules. Ontario M5J 2S8. Sector is expected to underperform the broader market averages. hold and sell recommendations.January 26. CIBC World Markets is restricted*** from rating the stock. *Although the investment recommendations within the three-tiered.com/research/sec2711 or write to CIBC World Markets Inc. 11 .0% 0. hold ratings to securities rated Sector Performer. Toronto. CIBC World Markets' Stock Rating System Abbreviation Stock Ratings SO SP SU NR R O M U NA Sector Outperformer Sector Performer Sector Underperformer Not Rated Restricted Overweight Market Weight Underweight None Stock is expected to outperform the sector during the next 12-18 months. Banking Relationships Sector Outperformer (Buy) Sector Performer (Hold/Neutral) Sector Underperformer (Sell) Restricted Inv. relative stock rating system utilized by CIBC World Markets do not correlate to buy.2% Percent 0. Toronto.0% 0. 4th Floor. Brookfield Place. including potential conflicts of interest information. Attention: Research Disclosures Request.0% 0. 161 Bay Street. and sell ratings to securities rated Sector Underperformer without taking into consideration the analyst's sector weighting.com under 'Quick Links' or by writing to CIBC World Markets Inc. Sector is expected to equal the performance of the broader market averages.0% Percent 0. Sector rating is not applicable.0% 0.7% 9. please visit CIBC on the web at http://www.0% Ratings Distribution: High Frequency Trading Coverage Universe High Frequency Trading Sector includes the following tickers: (none). Important disclosures required by IIROC Rule 3400.S.0% Inv.5% 100. Attn: Research Disclosure Chart Request.5% 85. Brookfield Place. Banking Relationships Sector Outperformer (Buy) Sector Performer (Hold/Neutral) Sector Underperformer (Sell) Restricted Count 101 135 20 7 Count 0 0 0 0 Percent 83. ***Restricted due to a potential conflict of interest. Sector is expected to outperform the broader market averages.

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