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# Algorithmic Trading and Order Execution ## What is Algorithmic Trading? Algorithmic trading is the execution of orders based on preprogrammed instructions. ### Algorithmic Trading Objectives * **Reduce transaction costs:** VWAP, TWAP, Percentage of Volume, Implementation Shortfall * **Impr...

# Algorithmic Trading and Order Execution ## What is Algorithmic Trading? Algorithmic trading is the execution of orders based on preprogrammed instructions. ### Algorithmic Trading Objectives * **Reduce transaction costs:** VWAP, TWAP, Percentage of Volume, Implementation Shortfall * **Improve execution speed:** More liquid markets, exploit short-lived opportunities * **Obtain anonymity:** Hide intentions * **Automate trading:** Routine tasks ## Order Types ### Market Order * Executed immediately at the best available price * May suffer from price impact * **Fill Probability:** High * **Market Impact:** Highest * **Use when:** Certainty of execution is priority ### Limit Order * Executed only at the specified limit price or better * Risk of non-execution * **Fill Probability:** Depends on the limit price * **Market Impact:** Lower than market order * **Use when:** Price is more important than certainty of execution ### Marketable Limit Order * A limit order with a limit price at or better than the best available price * Similar to a market order but with a price cap ### Other Order Types * **Stop Order:** Activated when a specified stop price is reached * **Stop-Limit Order:** A stop order that becomes a limit order when activated * **Hidden Order (Iceberg Order):** Only a portion of the order is displayed * **Immediate-or-Cancel (IOC) Order:** Any portion of the order that is not immediately executed is cancelled * **All-or-None (AON) Order:** The order is executed only if the entire quantity can be filled ## Electronic Communication Networks (ECNs) * Automated systems that match buy and sell orders * Provide transparency and reduce transaction costs * Examples: Nasdaq, NYSE Arca ## Dark Pools * Private exchanges or forums for trading securities * Offer anonymity but less transparency * Useful for large block orders * Concerns about potential for market manipulation ## Order Placement ### Routing * The process of directing an order to a specific exchange or market center * **Smart Order Routers (SORs):** Automatically route orders to the best available market ### Order Book * An electronic list of buy and sell orders for a specific security * Displays order size and price at different levels ## Execution ### Fill Rate * The percentage of an order that is successfully executed * Affected by order size, market liquidity, and order type ### Slippage * The difference between the expected price of a trade and the actual price at which it is executed * Caused by market impact and price volatility ## Performance Evaluation ### Benchmarks * **Volume-Weighted Average Price (VWAP):** The average price of a security weighted by its trading volume $$ \operatorname{V} W A P=\frac{\sum_{i=1}^{n} P_{i} \times Q_{i}}{\sum_{i=1}^{n} Q_{i}} $$ where $P_i$ is the price of the $i$th trade and $Q_i$ is the quantity of shares traded in the $i$th trade. * **Time-Weighted Average Price (TWAP):** The average price of a security over a specified period of time $$ T W A P=\frac{\sum_{i=1}^{n} P_{i}}{n} $$ where $P_i$ is the price at time $i$, and $n$ is the number of prices observed. * **Implementation Shortfall:** The difference between the actual portfolio return and the return of a paper portfolio that assumes no market impact $$ \text { Implementation Shortfall }=\left(P_{t}-P_{0}\right) Q-C+O C $$ where $P_t$ is the final portfolio value, $P_0$ is the initial portfolio value, $Q$ is the number of shares, $C$ is the commission paid, and $OC$ is the opportunity cost due to unfilled orders. ## Example ### High-Frequency Trading (HFT) * A type of algorithmic trading characterized by high speeds, high turnover rates, and short-term investment horizons * Often used for market making and arbitrage * Controversies regarding fairness and potential for market manipulation ### Statistical Arbitrage * A type of algorithmic trading that exploits statistical relationships between securities * Involves complex models and large amounts of data * Examples: pairs trading, index arbitrage