Algorithmic Trading: Market Microstructure

Course Overview

• Algorithmic trading and order execution involves both theoretical foundations and practical applications.
• Focus is placed on quantitative analysis, risk management, and regulatory compliance in electronic trading environments.

Learning Objectives

• Comprehend market microstructure and order book dynamics.
• Design, implement, and evaluate algorithmic trading strategies.
• Analyze and optimize order execution processes.
• Apply quantitative methods for assessing trading performance and risk.
• Navigate the regulatory framework governing algorithmic trading.

Course Outline

Introduction to Algorithmic Trading

• Electronic trading systems are reviewed.
• Market participants and their roles are described.
• The motivations behind algorithmic trading are outlined.

Market Microstructure

• Focuses on order book structure and dynamics.
• Explores market impact and price discovery.
• Discusses liquidity and volatility analysis.

Algorithmic Trading Strategies

• Covers trend-following strategies.
• Includes mean reversion strategies.
• Highlights statistical arbitrage strategies.
• Touches on machine learning in algorithmic trading.

Optimal Order Execution

• Includes Volume Weighted Average Price (VWAP) and Time Weighted Average Price (TWAP).
• Discusses Percentage of Volume (POV) strategies.
• Covers implementation shortfall.
• Explores smart order routing.

Risk Management

• Addresses market risk and credit risk.
• Discusses liquidity risk and operational risk.
• Covers risk monitoring and control.

Performance Evaluation

• Includes Transaction cost analysis (TCA).
• Discusses performance attribution.
• Covers benchmarking.

Regulatory and Legal Issues

• Examines market manipulation and insider trading.
• Covers Regulation NMS and MiFID II.
• Explores High-frequency trading regulations.

Assessment

• Assignments: 30%
• Midterm Exam: 30%
• Final Project: 40% (Design and implementation of an algorithmic trading strategy)

Prerequisites

• Basic knowledge of financial markets and instruments is needed.
• An Understanding of programming languages (e.g., Python, R, or MATLAB)
• Must have an understanding of statistical concepts

Required Readings

• "Algorithmic Trading: Winning Strategies and Their Rationale" by Ernest P. Chan
• "Trading and Exchanges: Market Microstructure for Practitioners" by Larry Harris
• "Quantitative Trading: How to Build Your Own Algorithmic Trading Business" by Ernest P. Chan

Economics Introduction

• Economics is about how society manages its scarce resources.

What Economics is About

• It explores how society manages its scarce resources.
• Scarcity: The limited nature of society's resources.
• Economics: The study of how society manages its scarce resources.

How People Make Decisions

People Face Trade-offs (Principle 1)

• "You can't have it all." Making decisions necessitates trading one goal for another.
• An example is a student choosing to attend a party the night before an exam.
• Parents decide how to spend family income.
• Society faces the trade-off between "guns" versus "butter."

The Cost of Something Is What You Give Up to Get It (Principle 2)

• Decisions require comparing costs and benefits of alternatives.
• Opportunity cost: What is given up to obtain something.
• Going to college for a year includes lost wages as an opportunity cost.
• Watching a movie includes the value of time that could have been spent studying.

Rational People Think at the Margin (Principle 3)

• Rational person: Someone who systematically and deliberately does their best to achieve their objectives.
• Marginal change: An incremental adjustment to a plan of action.
• Decision-making involves comparing marginal benefits and marginal costs.

People Respond to Incentives (Principle 4)

• Incentive: Something that induces a person to act, such as the prospect of a reward or punishment.
• Rational people respond to incentives.
• When the price of apples rises, people eat more pears and apple producers hire more labor and harvest more apples.
• Politicians respond to incentives.

How People Interact

Trade Can Make Everyone Better Off (Principle 5)

• The trade allows people to specialize in producing a good or service and exchange it for other goods.
• Countries also benefit from trade and specialization.
• Can get a better price abroad for goods they produce and buy cheaper goods from abroad than they could produce at home.

Markets Are Usually a Good Way to Organize Economic Activity (Principle 6)

• Market: A group of buyers and sellers.
• "Organizing economic activity" means determining what goods to produce, how to produce them, and how much of each to produce.
• Market economy: An economy that allocates resources through the decentralized decisions of firms and households.

The Invisible Hand

• Households and firms interacting in markets act as if guided by an "invisible hand" that leads to desirable market outcomes.

Governments Can Sometimes Improve Market Outcomes (Principle 7)

• An important role of the government enforcing property rights.
• Property rights: The ability of an individual to own and exercise control over scarce resources.
• People are less inclined to work, produce, invest, or purchase if there is a risk that their property will be stolen.
• Market failure: When a market fails to allocate resources efficiently.
• Externalities and market power causes market failure.
• Government can intervene in the market to promote efficiency and alter market outcomes to promote equity

How the Economy as a Whole Works

A Country's Standard of Living Depends on Its Ability to Produce Goods and Services (Principle 8)

• Standard of living measured in income or the value of the nation's production.
• Productivity: The quantity of goods and services produced from each unit of labor input.
• Productivity directly impacts standard of living.

Prices Rise When the Government Prints Too Much Money (Principle 9)

• Inflation: An increase in the general level of prices in the economy

Society Faces a Short-Run Trade-off between Inflation and Unemployment (Principle 10)

• Phillips Curve: Illustrates the trade-off between inflation and unemployment.
• More money results in higher spending, greater demand for goods and services and firms increase prices and hire more workers.
• It's a temporary trade off.

Explore algorithmic trading, electronic systems, and market dynamics. Includes designing and evaluating strategies. Learn about risk management and regulatory compliance in trading.