Algorithmic Trading Concepts

Algorithmic Trading

• Employs computer programs for automated trade execution based on pre-defined rules.
• Consists of:
  • Strategy: trading idea or model.
  • Algorithm: Program implementing trading strategy.
  • Execution: Sending orders to the market.
  • Infrastructure: Necessary hardware/software

Order Book

• The order book is an Electronic listing of buy and sell orders for a specific security.
• Includes:
  • Bid: buyer's price.
  • Ask: seller's price.
  • Size: shares available at a price.
  • Market Depth: order volume at various prices.

Market Impact

• The definition of market impact is price movement due to large order execution.
• This is dependent on:
  • Order Size which has a direct correlation to impact.
  • Market Liquidity such that less liquid markets are more susceptible to impact.
  • Order type such that market orders have a higher price impact than limit orders.
  • Timing impacts efficiency since Peak hours reduce impact.

Order Types

• Market Order: Execution is immediate, at best price.
  • Pro: Execution guaranteed.
  • Con: Potentially unfavorable price.
• Limit Order: Execution only at a specific price or better.
  • Pro: Price certainty.
  • Con: Possible non-execution.
• Stop Order: Triggered when price hits the stop price.
  • Stop-Loss: Limits potential losses.
  • Stop-Buy: Enters position as price rises.
• Other types of orders:
  • Iceberg Order: Large order in smaller tranches. Execution is immediate.
  • Fill or Kill (FOK): Complete, immediate execution required; otherwise, cancelled.
  • Immediate or Cancel (IOC): Any portion not immediately executed gets cancelled

Execution Algorithms

• Volume-Weighted Average Price (VWAP): Executes orders at the average price by volume during a period.

  • Formula:

    $$ VWAP = \frac{\sum_{i=1}^{n} Price_i \times Volume_i}{\sum_{i=1}^{n} Volume_i} $$

• Time-Weighted Average Price (TWAP): Executes orders at the average price over time.

  • Formula:

    $$ TWAP = \frac{\sum_{i=1}^{n} Price_i}{n} $$

• Percentage of Volume (POV): Executes a set percentage of market volume.

  • Pro: takes advantage of market momentum.
  • Con: Order completion isn't feasible with low volumes.

• Implementation Shortfall: Works to minimize diff between execution price and the price at decision time.

  • Goal: Lessen order's market influence.

Optimal Execution

• To optimize execution, consider:
  • Market Conditions such as its volatility, liquidity, and trading volume.
  • Order Characteristics such as size, urgency, and direction.
  • Risk Aversion to determine tolerance for price fluctuation tolerance.
  • Transaction Costs like commissions, fees, and market impact.

Regulation

• Prohibits Market Manipulation like activities such as spoofing and layering.
  • Spoofing is order placement with no intention to execute orders.
  • Layering is using multiple orders at different prices for false market depth impression.
• Fair Access means fair opportunities shall be Provided to all market participants.
• Provide Transparency by sharing information about trading activity with the public.

Performance Evaluation

• Metrics use used to evaluate performance:
  • Execution Price verses benchmark prices.
  • Market Impact measured by price movement after execution.
  • Completion Rate to determine percentage of order successfully completed.
  • Cost Savings by subtracting estimated cost from actual.
• Performance is measured using:
  • Transaction Cost Analysis (TCA) to determine the costs of trading.