Cracking the Code of

Algorithmic Trading
By Jeremy Klein
The Frommer Group

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Lecture Outline
I. Introduction
II. Background
B k d
III. Basics of Execution Algorithms
IV. Advanced Execution Algorithms
V. Black
ac Boxes
o es vs.
s Fundamental
u da e ta Machines
ac es
VI. Conclusion
VII Q&A
VII.

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I. Introduction
 Algorithmic trading provides opportunities for
money managers to increase performance
 “Algo”, or computer driven, trading divides into
two categories:
 Execution models
 Investment based models

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II. Background
 How algo trading arose
 Expansion
p of electronic order routing
g to equity
q y and futures
exchanges
 Steady increase in program trading
 Because decomposing the basket to numerous single
stock executions was onerous, computer models were
written to offer the option of producing transactions that
accomplished the task with reasonable slippage
 Enabled the trader to be more productive by focusing on
other areas of the portfolio

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II. Background
 Complexity of algos deepened
 Execution algos:
g competition
p amonggqquant research desks at
most broker-dealers to determine who could supply clients with
the best prices
 Investment based algos: large,
large successful hedge funds
emerged as “black boxes” spawned high frequency trading

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III. Basics of Execution Algorithms
 Slicing
 Parameter: start and end time of
transaction
 Based on Volume Weighted Average
Price ((VWAP)) curves
 Operate on intraday basis
 Duration: a few minutes to a full
trading session
 Pre- or post-market algos do not
exist due to lack of liquidity and
consistency
 Optimal duration of trade determined
by projected market impact given the
time of day and intraday thesis for
stock performance
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III. Basics of Execution Algorithms
 Slicing
 Liquidity is thickest around Open and Close and
thinnest in middle of the day
 Time frame with heaviest execution: 9:30-10:30AM and
3:00-4:00PM
 Time Weighted Average Price (TWAP)
 Liquidity is not a concern
 Trade stock in equal amounts over a period of time
 Gaining
gppopularity
p y in futures and F/X markets

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III. Basics of Execution Algorithms
 Participatory
 Parameter: percentage of volume
 Ex: “Sell IBM at market and be 15% of
the volume”
 Calculate overall volume during
algorithm
l ith run titime
 Sell the amount of shares equivalent
to 15% of that volume
 Model that trades less than 10% of
stock’s volume = “passive” participation
 Model that trades greater than 20% of
stock’s
stock s volume = “active”
active participation
and has potential of pushing prices
around
 Order that calls for greater than 33%
should only be used in extreme cases

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IV. Advanced Execution Algorithms
 Need for prices that beat a
new standard for execution-
VWAP
 Examples of additional
parameters: strict price
limits, rules to buy only on
downtick or “zero plus tick”
(requirement for company
b b k via
buybacks i RRule
l 10b
10b-18)
18)

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IV. Advanced Execution Algorithms
 Pegging programs
 Force all orders to always remain at or within a fixed
price relative to current bid-ask quote
 Scaling
g models
 Allow for heavier than expected transactions vs. a
standard volume curve at a price at or better than the
VWAP ((or some fifixed
d price)
i ) while
hil lilightening
ht i up when
h
prices become less favorable

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IV. Advanced Execution Algorithms
 Other recent programs
 Coordinate level of activity to fluctuate with how stock performs against a
predefined or hand selected index
 Use stock-specific VWAP curves based on assumption that each stock
has common group of market players who return to the name daily and
thus transact in its own specific manner
 Keep portfolio of thousands of stocks sector, beta, and/or dollar neutral
throughout the trade (which often last days)

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IV. Advanced Execution Algorithms
 Pairs or spread trading
 Based on M&As
M&As, minority stake one company has in
another, or some fundamental correlation
 Calculate ratios for which buy/sell levels for the pair are
id ifi d
identified
 Provides speed in:
 Calculation of current ratio level
 Execution of multiple legs of trade
 Order generation and updates

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V. Black Boxes vs. Fundamental Machines
 Black boxes
 Seek “statistical arbitrage”
g
 Models will trade a variety of reversionary or momentum based
strategies
 Models will transact based on fundamentals
fundamentals, technicals
technicals, or both
 Expected value of every positions is very small so models can
easily execute thousands of trades per day
 Slippage low commission costs
Slippage, costs, and scalability are paramount for
success
 Not unusual for quant funds to be source of many trading errors,
which if identified early can offer others tremendous opportunity
opportunity,
since models are only as good as the humans who program them

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V. Black Boxes vs. Fundamental Machines
 Market making models
 Machines sit on bids and offers
offers,
calculating average historical
quotes for optimum placement to
realize
li th
the spread dbby simply
i l
offering liquidity
 Can be highly profitable since
ECNs typically pay firm for
supplying liquidity
 C b
Can be id
identified
tifi d when
h a currentt
bid or offer is “pennied”,
p
especiallyy in less liquid,
q , small
cap names
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V. Black Boxes vs. Fundamental Machines
 Index arbitrage
 Process of trading equity index futures and the
underlying perfectly weighted basket of stocks when
the two equivalent positions have minute price
discrepancies
 Only used by prop desks at a handful of broker-
dealers because access to cheap capital is a
requirement for being successful
 Not risk free since a fast market can cause
significant losses as algos get caught long futures
while not having the time to sell stocks fast enough
to flatten positions
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VI. Conclusion
 Along with advances in technology, the use of algorithmic
trading has expanded to be a dominant means to execute and
invest
 While it may be uncomfortable to embrace quantitative
modeling, one can be fully confident that the other side of a
countless number of his or her trades has been a machine
 Consequently, understanding how these models are designed
and implemented can be an important tool in any trader’s
trader s kit
whether he or she plans to utilize algorithms or not

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VII. Q&A
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