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A buy-side handbook

Algorithmic trading

Published by The TRADE


in association with:
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©The Trade Ltd. London 2005.


Although The Trade has made every effort to ensure the accuracy of
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No reproduction allowed without prior permission.
■ 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

Appendix
page 115
The TRADE guide to broker algorithms
Mark Muñoz, Mark Ponthier, director –
senior vice president, Engineering, Automated
Corporate Development, Trading Systems, page 130
Nexa Technologies 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?
■ Chapter 1

Market and mechanics

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- electronic trading mechanism, and 9


Itinues
ity of algorithmic trading con-
to grow. Market partici-
how its evolution and even deeper
acceptance within the marketplace
pants, especially those on the buy- will impact the direction of order
side, have willingly folded algo- flow in the future.
rithmic trading models into their Firms are significantly reallo-
everyday methodologies in efforts cating the way they route their
to effectively and anonymously orders to the market in response
find sources of liquidity for their to a number of interdependent
large orders, while simultaneously and unique forces, one of which is
minimising market impact. Over the increasingly difficult struggle
the past year, adoption of algo- to provide access to liquidity cen-
rithms has grown faster than any tres. Brokers and technology
other trading tool. This rapid providers are offering better and
acceptance is attributable primari- more integrated technologies to
ly to changes in market structure, both access and utilise low- and
cost, efficiency, and the need to no-touch trading technologies,
achieve best execution. The ques- making trading easier and more
tions begin to develop when efficient. This year, TABB Group
examining the market conditions has seen tremendous swings in
that are expected to support the the way buy-side traders route * Wendy Garcia,
analyst,
further growth of this particular their order flow. For example, TABB Group

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

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


■ Chapter 1

Market and mechanics

handful of brokers providing buy-side makes its needs known


algorithms, today there is a much and seeks to address them.
wider selection of broker-based Trading models also enable
algorithms on firms’ desks. traders to better align their exe-
Competition in this market will cution strategies against their
only become fiercer as more firms goals. As algorithms become
enter the market, additional more sophisticated and more
strategies are created, buy-side widely adopted, buy-side traders
adoption grows and high com- have an even more compelling
mission business becomes more reason for leveraging automated
challenging. trading strategies.
In order to compete more In satisfying perceived and
effectively, many sell-side firms actual buy-side needs for further
have developed targeted market- algorithmic trade development,
ing strategies that align their brokers need to look at the desires
models with specific customer clients have for increased customi-
segments. While those brokers sation, including the ability of
who were first off the line with algorithmic trade orders to react – 11
algorithmic trade models have appropriately – to changes in mar-
succeeded at landing more ket conditions and updates. In
clients, others more recently have addition, strategy security is a
focused on model customisation concern. If the perceived value of
as a way to gain buy-side favour algorithms is derived from
in an increasingly competitive anonymity, then any sign that
environment. Still other firms traders can ‘reverse-engineer’ these
have targeted size, focusing on algorithms would endanger the
either large or small firms, and entire field. A lesser concern is the
design their strategies according potential of a firm’s proprietary
to the particular needs of their desk to illegitimately access the
targeted firm size. electronic flow.

The needs of the sophisticated The increasing presence of the


buy-side trader: OMS:
As the buy-side continues to take Also changing and impacting the
a more directive approach to trading environment and order
order flow, the format and direc- flow is the relationship between
tion of order flows will continue clients, brokers and order man-
to shift in accordance to the agement system vendors. One
speed and fluidity with which the obstacle to the increased use of

■ ALGORITHMIC TRADING ■ 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
normalise the data or provide an
internal matching system in order
to make the trade process more
efficient.
The buy-side continues to look
algorithms into their processes, for additional ways to more effi-
including linking them to their ciently integrate algorithms into
their processes, including linking
transaction cost analysis tools them to their transaction cost
and their order management analysis tools and their order
management systems. The recent
systems.” acquisition of Macgregor by ITG
illustrates the value of a more
seamless integration of OMS and
algorithmic trade models is bro- advanced trading tools. As traders
kers’ use of tags as they continual- seek a more holistic trade man-
ly search for a competitive edge. agement system, TABB Group sees
12 Tags, which are how different this integration becoming a more
algorithms are electronically important driver of algorithms’
marked as they are sent through growth. However, there also is a
the electronic trade process, give danger in overloading the existing
brokers the ability to offer cus- technology to the point where its
tomisable algorithmic trades to proper functionality is hindered,
clients. However, although the creating inefficiencies that could
generic tag for, say, a VWAP or lead to a loss of the ease of imple-
Market-On-Close algorithmic mentation and integration that
trade strategy may be similar initially drew a buy-side trading
across brokers, it is not yet possi- desk to use a particular OMS to
ble to standardise the systems begin with.
with the availability of algorith- As usage increases, buy-side
mic customisation. Buy-side and firms are aiming to integrate algo-
sell-side traders are in favour of rithms more tightly into the trad-
standardising systems for consis- ing process by linking their OMS
tency in parameters such as directly to the algorithmic server.
aggressiveness and time con- The advantages of tight integra-
straints. In these instances the tion are twofold. If traders enter
tags differ from trade to trade orders through a separate web-
across brokers, and brokers are service or desktop application,
looking to the OMS providers to fills must be either manually

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


■ Chapter 1

Market and mechanics

entered into the OMS, or import- rithm links, double the number of
ed into Excel and then uploaded fundamental and mixed firms.
to the OMS. In addition, third- The automation of almost every
party applications may not offer process is a key component to the
all the variables of a direct con- quantitative business model.
nection. Large firms, defined as
those with over $50 billion in Algorithmic trade strategies
assets under management, are In a short time period, the buy-
twice as likely to have OMS algo- side has graduated from basic
rithm links as smaller firms, or users of algorithms to fickle
those with fewer than $10 billion clients, growing more selective of
in assets under management. the algorithms they deploy and
Tighter integration between even building strategies around
the buy-side and sell-side trading them. The buy-side now is ques-
platforms continues at breakneck tioning with more frequency
speed. As the number of relation- where and how algorithms can
ships decreases, the percentage of add value to the trade process. As
brokers connected to the invest- more options are made available, 13
ment manager’s order manage- such as increases in algorithmic
ment system is rising. Indeed, trade options and crossing net-
connecting to the OMS is a works, the buy-side trader is
requirement for doing business. maintaining growth in control
For all the benefits of electronic over its order flow. Indeed, it is
trading, the downside for brokers noteworthy that the buy-side is
is that the OMS/FIX infrastruc- actually using a method to choose
ture is the stepping-stone to alter- which algorithmic model to use
native execution vendors and has for particular trades at this point,
been an integral cause of the liq- given the use of trial and error a
uidity shift. TABB Group has year ago (see Exhibit 1 overleaf).
found that quantitative firms are TABB Group can cite several rea-
deeply engaged in optimising the sons for this progression. With
trading process, not surprising some measurable time under their
considering they traditionally belts in using algorithms, traders
have a broader knowledge base are now better equipped to use
about how the algorithmic trade historical information from pre-
systems function, thereby increas- and post-trade analysis with
ing their usage comfort level sig- enough confidence to develop
nificantly. Buy-side quant firms trade methodologies based on past
on average have five OMS algo- performance. It follows logically

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

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


■ Chapter 1

Market and mechanics

ing. Until the majority of market


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

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


■ Chapter 1

Market and mechanics

Exhibit 2: The advantages of algorithms

Anonymity 18%

Lower cost of trading 16%

Automate easy orders 14%

Decrease market impact 14%

Ease of use 9%

Best execution 9%

Control 7%

Solves fragmentation 7%
Response:
Hit benchmarks 7% 65%
16
Source: TABB Group study ‘Institutional Equity Trading 2005: A Buy-Side Perspective’

method, but the impact as the are not a means by which to


smaller trades hit the market is achieve alpha. Rather, they are
decreased. tools to help increase efficiency,
Another reason behind the remain anonymous and trade
increase in the use of broker algo- effectively in an environment
rithms is the idea that they where large blocks of shares are
increase the efficiency of trading unavailable.
by automating the execution of There also is the desire of the
less complicated orders and free- buy-side to achieve better align-
ing traders to concentrate on their ment between strategy and execu-
most difficult trades. In addition, tion, which it can achieve to some
the anonymity of algorithms degree as brokers increasingly
offers a significant advantage over make their algorithmic trades
the human element and solves the more customisable in order for
buy-sides’ biggest complaint clients to put specific limitations
about brokers, which is informa- or definitions in place for particu-
tion leakage. However, algorithms lar trades. Incredibly, algorithmic

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


■ Chapter 1

Market and mechanics

offerings are so critical to firms’ ability to satisfy regulatory com-


market positions that the quanti- pliance. Due to the methodologi-
tative engineers who are develop- cal documentation that occurs
ing algorithms are more highly during the algorithmic trading
cherished than many traders. process, this mechanism offers a
Many firms also believe that the regulatory solution through the
success of their low- and no- trail of information that is a
touch offerings is critical to their result of the transactions, unlike
business. manual trades that are carried
Among the distinct advantages out on the floor. Hence, it offers
offered by broker algorithms is the buy-side trader improved
the ability to maintain a lower monitoring capabilities over the
cost structure than a human- impact of their trades on the
based trading floor, as broker marketplace, as well as a superior
algorithms allow firms to retain view of the execution quality of
overall market share while elimi- their trades.
nating fixed costs. In addition, In its short history, broker algo-
commissions will decrease with rithm market share has been dom- 17
the increased use of algorithms inated by those with the quickest
since they offer a relatively low- time to market. The ‘first-mover’
cost means of efficient execution. advantage is valuable, but as the
Since broker algorithms are far algorithmic space becomes more
less expensive and risky than crowded, the game is changing.
developing and implementing Buy-side firms are now placing
proprietary ones, buy-side firms increased importance on how bro-
will continue to prefer that kers package additional trading
option. Hence, the increase in the tools into the most compelling
use of broker algorithms is rising electronic trading value proposi-
at a pace faster than that of pro- tion. The brokerages with the
prietary algorithms – or even keenest vision, the best tools, the
third party algorithmic providers most comprehensive support and
– despite the buy-side’s discom- the sharpest pencil will win. It will
fort with its reliance on brokers. no longer be the case that the first
In addition, it is easier for a bro- to market will get the spoils.
ker to shut down an inefficient Instead, the winning firms will be
algorithm than it is to fire a those that effectively help their
person. clients navigate the challenging
Another advantage to using markets, in the least complex man-
algorithmic strategies is their ner and at the lowest possible cost.

■ ALGORITHMIC TRADING ■ 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
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
and maintain their own systems, increased fragmentation, rather it
there will always be a place for is the increased use of electronic
trading strategies and technolo-
those brokers who stay on the gies to effectively hide and seek
leading edge of technology and liquidity within the marketplace,
traders will continue to adopt
provide the marketplace with more algorithmic trading models out of
advanced, customisable and competitive necessity. Order flow
will maintain its surge – not only
efficient algorithmic trade in equities, but across other asset
models.” classes as well, as we see algorith-
mic trading penetrate further
18 into the marketplace to incorpo-
The future rate foreign exchange, derivatives,
The buy-side will continue to and even fixed income, as players
grasp more control over its order in these markets look for anony-
flow as algorithms become more mous trading and search for hid-
enhanced and readily available, den liquidity – providing vendors
even if it means routing their with opportunities to shine as
orders through broker algorithms increased demands for more
in increasing numbers as they sophisticated technology are
look for ways to reduce costs. made by brokers and the buy-side
This will be the case especially as alike. The buy-side’s lack of trust
brokers increasingly make for the brokers will not subside,
attempts to supply the buy-side even as they decrease the number
with updated and additionally of brokers with whom they do
customisable models with which business and develop more inte-
to trade. grated relationships with the ones
The recent passage of Reg they do maintain.
NMS also will have its own However, until the buy-side
impact on the order flow as, with has the knowledge and the capital
the increasing electronic capabili- of the brokers in order to develop
ties of the marketplace, use of and maintain their own systems,
algorithmic and other electronic there will always be a place for

■ ALGORITHMIC TRADING ■ A BUY-SIDE HANDBOOK ■ 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


■ Chapter 2

Market and mechanics

Understanding how
algorithms work
Where does time slicing and smart order routing end and randomising
your orders through complex algorithms begin?

Dr Tom Middleton*

re we witnessing a revolution in Enhanced DMA strategies (see


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

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

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


■ Chapter 2

Market and mechanics

trades much less frequently with a adjustment; Participate will track


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

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

to the type of stock that it is As queuing time is generally long, it


attempting to trade. is important to get liquidity on the
order book as soon as possible to
High tick size/volatility, stand a chance of trading on the
high median spread/volatility right side of the spread. The large
This type of stock is well represent- amounts of stock on the best bid
ed by Ericsson. Although it is rea- and ask also mean that the effect of
sonably volatile, this is swamped adding more liquidity is unlikely to
on short timescales by its enor- significantly affect the supply/
mous tick size – approximately 36 demand imbalance, and so there is
26 bps as I write. Stocks whose behav- unlikely to be adverse price move-
iour is constrained by the tick size ment as a consequence of our
in this way characteristically have adding to the order book.
large amounts of liquidity at the
best bid and ask, relative to average Low tick size/volatility,
trade size or average daily volume. high median spread/volatility
Thus, the optimal spread capture These stocks are typically mid-capi-
strategy in this case is to be patient – talisation, less liquid stocks with
waiting on the order book, some- volatile spreads. Many providers do
times for hours, in order to stand a not recommend that this type of
chance of capturing spread. stock should be traded on the
Algorithmic trading adds huge value engines, owing to the difficulty of
for this class of stock, as a computer achieving high quality performance.
is able to constantly monitor liquidi- The counter-argument to this is that
ty on the order book, using the sup- these are also the stocks where infor-
ply/demand imbalance as an indica- mation leakage can be the most
tor of future price movement. If an damaging and so while trading them
adverse move is predicted on this electronically can be problematic at
basis, then the model should pay the least anonymity is maintained.
spread – otherwise patience is key. The correct strategy here is to
In terms of a slicing strategy, small is trade opportunistically and take
not beautiful for this type of stock. advantage of spread and liquidity

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


■ Chapter 2

Market and mechanics

opportunities within the blink of risk to which the trader is exposed


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

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■ Chapter 3

Market and mechanics

Build or buy?
What are the relative merits of broker-driven versus broker-neutral
algorithms? Understanding the trade off between cost and
performance

Allen Zaydlin*

ince the introduction of elec- market consensus on the precise


S tronic trading, the landscape of
trade execution, risk management
definition of each category, but for
the purpose of this chapter we will
and market access has undergone define them as alpha models and
significant and rapid changes. execution algorithms or simply
Being interdependent in nature, algorithms. 29
the advancements in one area force Algorithms – when used appro-
other areas to evolve. To that extent priately – can improve multiple
the automation of electronic trade facets of the investment cycle. They
execution can be seen as the ‘first give traders the ability to handle
violin’, because the increasing larger sets of securities. At the same
demand in execution speed, time traders are able to focus their
throughput and low latency on one attention on the instruments that
hand requires more efficient mar- are difficult to trade, for instance
ket access and risk management on illiquid stocks, while letting algo-
the other. rithms take care of more liquid
names. Algorithms benefit from
What are algorithms? the speed of computers and there-
Automation of trading processes fore can follow the market more
can be grouped into two general closely than traders. They also
categories – automation of trading eliminate the emotional aspect of
(what to trade) and automation of the trading process, resulting in
execution decisions (how to more consistent performance. In
trade). While the first one deals addition, algorithms help reduce
primarily with investment deci- information leakage. All of the
sions, the second one focuses on above can be summarised in a sin-
*Allen Zaydlin, CEO,
their implementations. There is no gle statement: InfoReach

■ ALGORITHMIC TRADING ■ 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
the dilemma is quite simple to
resolve and comes down to three
options:

1. Utilise algorithms provided by


algorithm for your trading desk a brokers.
more exacting task.” 2. Utilise ‘broker-neutral’ algo-
rithms provided by third-party
vendors.
“Algorithms are a more efficient 3. Develop proprietary algorithms.
way to trade in an environment
where cost, speed, consistency and The first thing you will need to do
the prevention of information in your quest to select an algorith-
leakage are crucial in attaining mic provider is to think clearly
alpha” and objectively. Simple analysis
and adequate understanding of the
Survival of the fittest goals that you need to reach, as
30 In recent years, execution algo- well as the means available can
rithms have become more preva- yield surprisingly unexpected
lent. Initially, algorithms were results. This will help you to avoid
offered by only a handful of bro- some common misconceptions
kers to the larger buy-side firms about algorithms’ functionality
that were willing to pay higher and performance, and will also
commissions. Since then, howev- assist in separating the marketing
er, algorithms have grown to hype from the algorithms. This
become a common service avail- will help you avoid the following
able from the majority of brokers, scenario:
as well as trading system vendors.
Furthermore, as algorithmic exe- Q: “Does your VWAP algorithm
cution becomes increasingly pop- guarantee to beat the VWAP?
ular, more third-party software No! The broker I am talking
vendors are building trading plat- to guarantees their algorithm
forms that serve as the foundation to beat VWAP every time.
for the rapid development of cus- A: “Great! Then you should be able
tom algorithms. The increase in to send any buy and sell orders
algorithmic offerings has made of the same symbol to this
the process of selecting the right VWAP algorithm simultaneous-
algorithm for your trading desk a ly and enjoy positive P&L every
more exacting task. Nevertheless, day.

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


■ Chapter 3

Market and mechanics

Q: How good is your VWAP?


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

■ ALGORITHMIC TRADING ■ 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
Custom-build

Pros
■ Customised functionality not
currently available from other
level of commoditisation that sources.
has occurred with certain ■ Quicker ability to modify.
■ Tighter control.
execution models and the
depreciation in their relative Cons
■ Bear unscalable expense of
value.” infrastructure, development and
enhancement effort.
■ Risk of failure achieving the exe-
Off-the-shelf cution performance objectives.

Pros Broker-driven vs. off-the-shelf


32 ■ Lower commission rate by tak- The emergence of various off-the-
ing advantage of DMA rates. shelf algorithms serves as an indi-
■ Tighter control over parameteri- cation of the level of commoditisa-
sation of the algorithms. tion that has occurred with certain
■ Reduced risk of information execution models and the deprecia-
leakage. tion in their relative value. Such
■ Ability to work with multiple off-the-shelf algorithms will have a
brokers simultaneously, while cost advantage in comparison to
keeping trading data consolidat- their broker-driven siblings. A sim-
ed within a single system. ple comparison of VWAP algo-
■ Broker neutrality. rithms provided by brokers and
■ Anonymity. off-the-shelf providers will serve as
a guideline on how to compare
Cons algorithms in general.
■ Require more infrastructure on Assuming that the ultimate goal
a client side to run. is selecting an algorithm with max-
■ Increased financial commitment imum efficiency – meaning the
regardless of usage. algorithm that combines best exe-
■ Tendency to lack more cution performance with lowest
sophisticated algorithms that cost – one can create a common
require a more elaborate scale that combines cost and per-
infrastructure. formance into a single unit of mea-

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


■ Chapter 3

Market and mechanics

sure. The cost basis is vital because


if two different algorithms perform
alike then cost becomes the main
differentiating factor. At the same
■ “Assuming that the ultimate
goal is selecting an algorithm
with maximum efficiency –
time we need to factor in perfor-
mance, because poor execution meaning the algorithm that
performance can quickly eliminate combines best execution
any advantage of a lower cost algo-
rithm. performance with lowest cost –
In determining the cost basis, it one can create a common scale
is useful to start with commission
rates. From what we observe in the that combines cost and
market today, it should not be performance into a single unit of
unreasonable to accept $0.0075 per
share as a common rate for broker- measure.”
provided algorithms. At the same
time, brokers’ DMA can offer a
very compelling commission rate, This hypothesis changes howev- 33
where $0.0015 is not unheard of. er, once the number of shares trad-
However, we also need to factor in ed via the algorithm increases to
the cost of the third-party vendor two million shares per month. Now
technology which delivers the bro- we are looking at $15,000 with bro-
ker-neutral algorithms that allow ker-driven versus $13,000 with
you to take advantage of low DMA broker-neutral algorithms. Thus,
rates in the first place. We will use the breaking-point lies somewhere
an average of $10,000 per month between one million and two mil-
for such technology and assume lion shares per month, or between
that it is a fixed cost that does not 50,000 and 100,000 shares per day.
increase with trading volumes. It does not really matter exactly
Taking the example of a firm trad- where the breaking-point lies, what
ing one million shares per month, is important is that in every partic-
we arrive at a commission cost of ular case it can be calculated.
$7,500 per month when using a Applying the same commissions’
broker-provided algorithm, com- rates for 20 million shares per
pared with $11,500 when using the month (one million per day) we
broker-neutral equivalent. Clearly, will get over $100,000 of savings
it does not add up – particularly if per month (over $1 million per
information leakage is not a major year) – a level of cost saving that
concern for the firm. most firms would regard as signifi-

■ ALGORITHMIC TRADING ■ 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
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.
for far less if it posts an inferior Using VWAP as the example once
performance. A quick analysis of more, and assuming that a broker-
driven algorithm slipped 0.03 of a
the numbers can help us basis point on 10 million shares
determine where the breaking- traded over a month, and using
$30 per share as an average stock
point is in terms of price, the value of slippage is
performance.” $90,000. As outlined in the Chart
1, the cost advantage of the off-the-
shelf algorithms was around
cant. While for the purpose of this $50,000 based on 10 million shares
exercise the numbers have been traded per month. To have this
34 rounded off, by using this advantage nullified due to the bet-
approach and calculating your own ter performance of a broker-driven
numbers you can easily find the VWAP model, the off-the-shelf
point at which the cost benefit of algorithm has to slip 0.047 of a
introducing broker-neutral algo- basis point or, in terms of the
rithms is going to start making math, under-perform by 156%.
sense to your business. (Go to That said, in ‘real-world’ trading, it
http://www.in4reach.com/ is well known that various VWAPs
compare.html to run a quick com- produce results only marginally
parison using your own numbers different from one another.
as input.) If this approach is calculated
The chart opposite provides a using different monthly trading
good indication of the projected volumes and average stock prices
differences in execution costs only, the core finding remains the
between the two venues relevant to same: that the performance ratio is
the number of shares traded. driven solely by the commission
For the sake of objectivity, we rates ratio. In order to be on par
also need to factor in the perfor- with a broker-neutral algorithm, a
mance of the algorithms we are broker-provided algorithm has to
comparing. This is key. The cost outperform it to a level that can
advantage of an off-the-shelf algo- compensate for the difference in
rithm over a broker-driven model their respective commission rates.

■ ALGORITHMIC TRADING ■ A BUY-SIDE HANDBOOK ■ 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
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
vendors, wrapped within a broker- some instances, it would be hard to
neutral model, can be taken as a justify such a high level of invest-
ment in infrastructure, since buy-
sign of increasing efficiency in the side demand for highly sophisticat-
market place.” ed algorithms varies depending on
the trading strategy being deployed
and the volumes involved.
Meanwhile, the ongoing operating
Reducing information leakage is costs remain constant. It is advis-
more a question of trust than an able, therefore, that before deciding
item that can be measured through to build proprietary execution
quantitative analysis. However, one algorithms, the cost and perfor-
36 clear advantage broker-neutral mance of existing offerings is fully
algorithm will have is that by understood.
spreading your trades in smaller Having considered the relative
sizes across multiple DMA pipes merits of execution algorithms –
you reduce the risk of information broker-driven, off-the-shelf and
leakage regardless of your level of proprietary – there appears to be a
trust. breaking-point, both in terms of
cost and performance, at which
Proprietary algorithms broker-neutral algorithms deliver
There are several reasons for build- clear advantages. The fact that
ing proprietary algorithms. First more broker-driven algorithms are
among these is control over the being made available from third-
functionality and performance of party vendors, wrapped within a
the algorithm, followed by lower broker-neutral model, can be taken
commission expense by making the as a sign of increasing efficiency in
algorithm broker-neutral. the market place. ■
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 ■ THE TRADE 2005