Algorithmic Trading Strategies

• Algorithmic trading uses computer programs to execute orders.

Motivation for Algorithmic Trading

• Reduce transaction costs and enhance execution quality.
• Increase trading speed and automate the trading process.
• Improves access to liquidity and facilitates arbitrage opportunities.

Types of Algorithmic Trading

• Execution algorithms include VWAP, TWAP, POV, IS, and Target Close.
• Market making algorithms involve quote submission, hedging, and inventory management.
• Statistical arbitrage strategies involve mean reversion and pairs trading.
• Smart order routing (SOR) directs orders to various venues like exchanges and dark pools.
• High-frequency trading (HFT) uses very short-term strategies where latency is critical.
• Direct market access (DMA) allows traders to directly access the exchange order book.

Limit Order Book (LOB)

• LOB is an electronic list of buy (bid) and sell (ask/offer) orders for a specific security.
• The orders are organized by price level.

Components of LOB

• A limit order is an order to buy or sell at a specific price or better.
• A market order is an order to buy or sell immediately at the best available price.
• Inside spread refers to the difference between the best bid and the best ask.
• Market depth refers to the number of shares available at each price level.

Order Types

• Market orders execute immediately at the best available price.
• Limit orders execute at a specific price or better.
• Buy stop orders are triggered when the price rises to a specific level.
• Sell stop orders are triggered when the price falls to a specific level.
• Stop-limit orders become limit orders when the stop price is reached.
• Hidden (iceberg) orders display only a portion of their size.
• Immediate-or-cancel (IOC) orders must be executed immediately, with any unfilled portion cancelled.
• Fill-or-kill (FOK) orders must be executed entirely immediately or cancelled.
• All-or-none (AON) orders must be executed entirely, but not necessarily immediately.

Key Considerations for Order Execution

• Adverse selection involves the risk of trading with someone with superior information.
• Implementation shortfall is the difference between the paper return and the actual return of a trading strategy.
• Slippage is the difference between the expected price and the actual price of a trade.
• Market impact is the effect of an order on the price of an asset.
• Latency is the time delay between sending an order and receiving confirmation.
• Tick size is the minimum price increment for a security.

Volume-Weighted Average Price (VWAP)

• Objective: Execute an order at the VWAP price.
• Method: Participate in the market in proportion to the historical volume.
• Formula: $\operatorname{VWAP}=\frac{\sum_{i=1}^{n} P_{i} \times V_{i}}{\sum_{i=1}^{n} V_{i}}$, where $P_i$ is the price of the $i$th trade, $V_i$ is the volume of the $i$th trade, and $n$ is the number of trades.

Time-Weighted Average Price (TWAP)

• Objective: Execute an order at the TWAP price.
• Method: Participate in the market in proportion to the time remaining in the trading day.
• Formula: $\mathrm{TWAP}=\frac{\sum_{i=1}^{n} P_{i}}{n}$, where $P_i$ is the price at time $i$ and $n$ is the number of time intervals.

Percentage of Volume (POV)

• Objective: Execute a fixed percentage of market volume.
• Method: Participate in the market at a fixed percentage of the total volume traded.
• POV algorithms are more aggressive than VWAP or TWAP algorithms.

Implementation Shortfall (IS)

• Objective: Minimize the difference between the paper price and the actual execution price.
• Method: Balances the trade-off between speed and market impact.
• Formula: $\text { Implementation Shortfall }=\left(P_{e}-P_{d}\right) \times N-C$, where $P_e$ is the average execution price, $P_d$ is the decision price, $N$ is the number of shares, and $C$ is commissions and fees.

Other Execution Algorithms

• Target Close: Execute a large order as close as possible to the closing price.
• Dark pools: Trading venues that do not display orders publicly.
• Smart order routing (SOR): Route orders to different venues to find the best price and liquidity.

Market Making Objective

• To profit from the spread between the bid and ask prices.

How Market Making Works

• Market makers post buy and sell quotes simultaneously.
• They provide liquidity to the market, manage inventory risk, and hedge exposure.

Key Considerations for Market Making

• Adverse selection involves the risk of trading with someone with superior information.
• Inventory risk is the risk of holding unwanted inventory.
• Order anticipation involves the risk of being front-run by other market participants.

Characteristics of High-Frequency Trading (HFT)

• Very short-term investment horizon and high portfolio turnover.
• Co-location, advanced technology, and sophisticated algorithms are used.

Strategies Used in HFT

• Market making provides liquidity and profits from the spread.
• Statistical arbitrage exploits short-term pricing discrepancies.
• Event-driven trading is based on news and other events.
• Index arbitrage exploits pricing differences between index futures and underlying stocks.
• Latency arbitrage exploits price differences between exchanges due to latency.
• Quote stuffing floods the market with quotes to gain an advantage.

Risks of HFT

• Technology risk involves system failures and errors in algorithms.
• Regulatory risk involves changes in regulations.
• Market risk involves unexpected market events.
• Adverse selection involves trading with someone with superior information.
• Reputational risk involves unethical behavior.

Regulations

• Regulation National Market System (Reg NMS) modernizes U.S. equity markets.
• The Order Protection Rule requires market centers to prevent trade-throughs.
• Dodd-Frank Act promotes financial stability by improving accountability and transparency.
• Markets in Financial Instruments Directive (MiFID II) increases transparency and investor protection in European financial markets.

Regulatory Objectives

• Prevent market manipulation and protect investors.
• Promote fair and efficient markets.
• Increase transparency and reduce systemic risk.