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Algorithmic Trading Methods
This page intentionally left blank
 Algorithmic Trading Methods
Applications using Advanced Statistics,
Optimization, and Machine Learning Techniques
Second Edition

Robert Kissell, Ph.D.

President
Kissell Research Group and Adjunct Faculty Member
Gabelli School of Business, Fordham University
Manhasset, NY, United States
Academic Press is an imprint of Elsevier
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Contents
Preface............................................................................................................................. xix
Acknowledgments........................................................................................................... xxi

CHAPTER 1 Introduction ................................................................................... 1

What is Electronic Trading? ......................................................................... 2
What is Algorithmic Trading? ...................................................................... 3
Trading Algorithm Classifications ................................................................ 3
Trading Algorithm Styles ............................................................................. 4
Investment Cycle .......................................................................................... 5
Investment Objective .................................................................................... 5
Information Content...................................................................................... 6
Investment Styles .......................................................................................... 7
Investment Strategies .................................................................................... 9
Research Data ............................................................................................. 15
Broker Trading Desks................................................................................. 16
Research Function....................................................................................... 17
Sales Function............................................................................................. 18
Implementation Types................................................................................. 19
Algorithmic Decision-Making Process ....................................................... 20
CHAPTER 2 Algorithmic Trading ....................................................................... 23
Advantages.................................................................................................. 25
Disadvantages ............................................................................................. 26
Growth in Algorithmic Trading.................................................................. 27
Market Participants ..................................................................................... 28
Classifications of Algorithms...................................................................... 31
Types of Algorithms ................................................................................... 31
Algorithmic Trading Trends ....................................................................... 35
Day of Week Effect .................................................................................... 37
Intraday Trading Profiles ............................................................................ 39
Trading Venue Classification...................................................................... 42
Displayed Market ................................................................................... 42
Dark Pool ............................................................................................... 42
Dark Pool Controversies ........................................................................ 43
Types of Orders .......................................................................................... 44
Revenue Pricing Models............................................................................. 45
Order Priority ......................................................................................... 46
Execution Options....................................................................................... 46

v
vi Contents

Algorithmic Trading Decisions................................................................... 47

Macro Level Strategies .......................................................................... 47
Micro Level Decisions ........................................................................... 48
Limit Order Models ............................................................................... 48
Smart Order Routers .............................................................................. 48
Algorithmic Analysis Tools........................................................................ 49
Pre-Trade Analysis................................................................................. 49
Intraday Analysis ................................................................................... 49
Post-Trade Analysis ............................................................................... 49
High Frequency Trading............................................................................. 50
Auto Market Making.............................................................................. 50
Quantitative Trading/Statistical Arbitrage.............................................. 52
Rebate/Liquidity Trading ....................................................................... 52
Direct Market Access.................................................................................. 54
CHAPTER 3 Transaction Costs .......................................................................... 57
What are Transaction Costs? ...................................................................... 57
What is Best Execution?............................................................................. 58
What is the Goal of Implementation?......................................................... 58
Unbundled Transaction Cost Components ................................................. 59
Commission............................................................................................ 59
Fees ........................................................................................................ 59
Taxes ...................................................................................................... 59
Rebates ................................................................................................... 60
Spreads ................................................................................................... 60
Delay Cost.............................................................................................. 60
Price Appreciation.................................................................................. 61
Market Impact ........................................................................................ 61
Timing Risk............................................................................................ 62
Opportunity Cost.................................................................................... 62
Transaction Cost Classification................................................................... 62
Transaction Cost Categorization................................................................. 65
Transaction Cost Analysis .......................................................................... 65
Measuring/Forecasting ........................................................................... 66
Cost vs. Profit and Loss ......................................................................... 67
Implementation Shortfall ............................................................................ 67
Complete Execution ............................................................................... 69
Opportunity Cost (Andre Perold)........................................................... 70
Expanded Implementation Shortfall (Wayne Wagner).......................... 71
 Contents vii

Implementation Shortfall Formulation........................................................ 74

Trading Cost/Arrival Cost...................................................................... 74
Evaluating Performance .............................................................................. 75
Trading Price Performance..................................................................... 75
Benchmark Price Performance............................................................... 75
VWAP Benchmark................................................................................. 76
Participation-Weighted Price Benchmark .............................................. 77
Relative Performance Measure .............................................................. 78
Pretrade Benchmark ............................................................................... 80
Index-Adjusted Performance Metric ...................................................... 80
Z-Score Evaluation Metric ..................................................................... 81
Market Cost-Adjusted Z-Score .............................................................. 83
Adaptation Tactic ................................................................................... 83
Comparing Algorithms ............................................................................... 84
Nonparametric Tests .............................................................................. 85
Paired Samples ....................................................................................... 86
Sign Test ................................................................................................ 86
Wilcoxon Signed Rank Test .................................................................. 87
Independent Samples .................................................................................. 89
ManneWhitney U Test.......................................................................... 89
Median Test ................................................................................................ 91
Distribution Analysis .................................................................................. 92
Chi-Square Goodness of Fit ....................................................................... 93
KolmogoroveSmirnov Goodness of Fit..................................................... 94
Experimental Design................................................................................... 95
Proper Statistical Tests ........................................................................... 95
Small Sample Size ................................................................................. 95
Data Ties ................................................................................................ 96
Proper Categorization............................................................................. 96
Balanced Data Sets................................................................................. 96
Final Note on Posttrade Analysis ............................................................... 97
CHAPTER 4 Market Impact Models ................................................................... 99
Introduction ................................................................................................. 99
Definition .................................................................................................... 99
Example 1: Temporary Market Impact................................................ 100
Example 2: Permanent Market Impact ................................................ 100
Graphical Illustrations of Market Impact............................................. 101
Illustration #1: Price Trajectory ........................................................... 101
Illustration #2: SupplyeDemand Equilibrium..................................... 102
viii Contents

Illustration #3: Temporary Impact Decay Function............................. 105

Example #3: Temporary Decay Formulation ...................................... 108
Illustration #4: Various Market Impact Price Trajectories .................. 108
Developing a Market Impact Model .................................................... 109
Essential Properties of a Market Impact Model .................................. 110
The Shape of the Market Impact Function .......................................... 112
Example: Convex Shape ...................................................................... 114
Example: Linear Shape ........................................................................ 114
Example: Concave Shape..................................................................... 114
Derivation of Models ................................................................................ 115
Almgren and Chriss Market Impact Model ......................................... 115
I-Star Market Impact Model ..................................................................... 120
Model Formulation ................................................................................... 120
I-Star: Instantaneous Impact Equation ................................................. 121
The Market Impact Equation ............................................................... 122
Derivation of the Model....................................................................... 122
Cost Allocation Method ....................................................................... 123
I* Formulation...................................................................................... 126
Comparison of Approaches.................................................................. 128
CHAPTER 5 Probability and Statistics .............................................................. 129
Introduction ............................................................................................... 129
Random Variables..................................................................................... 129
Probability Distributions ........................................................................... 130
Example: Discrete Probability Distribution Function.......................... 131
Example: Continuous Probability Distribution Function..................... 132
Descriptive Statistics ............................................................................ 135
Probability Distribution Functions............................................................ 136
Continuous Distribution Functions ........................................................... 137
Normal Distribution ............................................................................. 137
Standard Normal Distribution .............................................................. 138
Student’s t-Distribution ........................................................................ 139
Log-Normal Distribution...................................................................... 141
Uniform Distribution............................................................................ 142
Exponential Distribution ...................................................................... 143
Chi-Square Distribution ....................................................................... 145
Logistic Distribution ............................................................................ 146
Triangular Distribution......................................................................... 148
Discrete Distributions................................................................................ 149
Binomial Distribution........................................................................... 149
Poisson Distribution ............................................................................. 150
End Notes.................................................................................................. 150
 Contents ix

CHAPTER 6 Linear Regression Models ............................................................. 151

Introduction ............................................................................................... 151
Linear Regression Requirements ......................................................... 154
Regression Metrics............................................................................... 154
Linear Regression ..................................................................................... 156
True Linear Regression Model ............................................................ 156
Simple Linear Regression Model......................................................... 156
Solving the Simple Linear Regression Model ..................................... 157
Standard Error of the Regression Model ............................................. 159
R2 Goodness of Fit............................................................................... 159
T-test: Hypothesis Test......................................................................... 159
F-test: Hypothesis Test ........................................................................ 159
Example: Simple Linear Regression.................................................... 159
Multiple Linear Regression Model ...................................................... 161
Solving the Multiple Linear Regression Model................................... 162
Standard Error of the Regression Model ............................................. 164
R2 Goodness of Fit............................................................................... 164
T-test: Hypothesis Test......................................................................... 164
F-test: Hypothesis Test ........................................................................ 165
Example: Multiple Linear Regression ................................................. 165
Matrix Techniques .................................................................................... 167
Estimate Parameters ............................................................................. 167
Compute Standard Errors of b ............................................................. 168
R2 Statistic ............................................................................................ 169
F-Statistic ............................................................................................. 169
Log Regression Model.............................................................................. 169
Example: Log-Transformation ............................................................. 169
Example: Log-Linear Transformation.................................................. 171
Polynomial Regression Model.................................................................. 171
Fractional Regression Model .................................................................... 172
CHAPTER 7 Probability Models....................................................................... 175
Introduction ............................................................................................... 175
Developing a Probability Model............................................................... 175
Comparison of Linear Regression Model to Probability Model ......... 177
Power Function Model......................................................................... 177
Logit Model.......................................................................................... 178
Probit Model ........................................................................................ 179
Outcome Data....................................................................................... 180
Grouping Data...................................................................................... 182
x Contents

Solving Binary Output Models ............................................................ 182

Step 1: Specify Probability Function ................................................... 182
Step 2: Set Up a Likelihood Function Based on Actual Outcome
Results for all Observations. For Example, If We Have n
Observations, the Loss Function is Specified as Follows................... 183
Solving Probability Output Models .......................................................... 184
Examples ................................................................................................... 186
Example 7.1 Power Function............................................................... 186
Example 7.2 Logit Model .................................................................... 190
Comparison of Power Function to Logit Model ...................................... 191
Example 7.3 Logistic Regression ........................................................ 191
Conclusions............................................................................................... 195
CHAPTER 8 Nonlinear Regression Models......................................................... 197
Introduction ............................................................................................... 197
Regression Models.................................................................................... 198
Linear Regression Model ..................................................................... 198
Polynomial Regression Model ............................................................. 198
Fractional Regression Model ............................................................... 199
Log-linear Regression Model............................................................... 200
Logistic Regression Model .................................................................. 200
Nonlinear Model .................................................................................. 201
Nonlinear Formulation .............................................................................. 201
Solving Nonlinear Regression Model....................................................... 202
Estimating Parameters............................................................................... 202
Maximum Likelihood Estimation (MLE) ............................................ 202
Nonlinear Least Squares (Non-OLS)........................................................ 204
Step I: Define the Model...................................................................... 204
Step II: Define the Error Term............................................................. 204
Step III: Define a Loss FunctiondSum of Square Errors................... 205
Step IV: Minimize the Sum of Square Error ....................................... 205
Hypothesis Testing.................................................................................... 205
Evaluate Model Performance.................................................................... 206
Sampling Techniques................................................................................ 207
Random Sampling..................................................................................... 208
Sampling With Replacement .................................................................... 209
Sampling Without Replacement ............................................................... 210
Monte Carlo Simulation............................................................................ 210
Bootstrapping Techniques......................................................................... 211
Jackknife Sampling Techniques ............................................................... 212
Important Notes on Sampling in Nonlinear Regression Models......... 218
 Contents xi

CHAPTER 9 Machine Learning Techniques........................................................ 221

Introduction ............................................................................................... 221
Types of Machine Learning...................................................................... 224
Examples ................................................................................................... 225
Cluster Analysis ................................................................................... 225
Classification ............................................................................................. 228
Regression................................................................................................. 229
Neural Networks ....................................................................................... 231
CHAPTER 10 Estimating I-Star Market Impact Model Parameters .......................... 233
Introduction ............................................................................................... 233
I-Star Market Impact Model ..................................................................... 234
Scientific Method ...................................................................................... 235
Step 1: Ask a Question ........................................................................ 235
Step 2: Research the Problem .............................................................. 235
Step 3: Construct a Hypothesis............................................................ 235
Step 4: Test the Hypothesis ................................................................. 236
Step 6: Conclusions Communicate ...................................................... 236
Underlying Data Set............................................................................. 245
Data Definitions ................................................................................... 248
Imbalance/Order Size ........................................................................... 249
Average daily volume .......................................................................... 249
Actual market volume.......................................................................... 249
Stock volatility ..................................................................................... 249
POV Rate ............................................................................................. 249
Arrival Cost.......................................................................................... 250
Model Verification ............................................................................... 250
Model Verification #1: Graphical Illustration...................................... 251
Model Verification #2: Regression Analysis ....................................... 251
Model Verification #3: z-Score Analysis............................................. 251
Model Verification #4: Error Analysis ................................................ 252
Stock Universe ..................................................................................... 252
Analysis Period .................................................................................... 252
Time Period.......................................................................................... 252
Number of Data Points ........................................................................ 252
Imbalance ............................................................................................. 252
Side....................................................................................................... 253
Volume ................................................................................................. 253
Turnover ............................................................................................... 253
VWAP .................................................................................................. 253
xii Contents

First Price ............................................................................................. 254

Average Daily Volume ........................................................................ 254
Annualized Volatility ........................................................................... 254
Size ....................................................................................................... 254
POV Rate ............................................................................................. 255
Cost ...................................................................................................... 255
Estimating Model Parameters .............................................................. 255
Sensitivity Analysis.............................................................................. 257
Cost Curves .......................................................................................... 262
Statistical Analysis ............................................................................... 262
Stock-Specific Error Analysis .............................................................. 265
CHAPTER 11 Risk, Volatility, and Factor Models ................................................. 269
Introduction ............................................................................................... 269
Volatility Measures ................................................................................... 270
Log-Returns.......................................................................................... 270
Average Return .................................................................................... 270
Variance ............................................................................................... 270
Volatility............................................................................................... 271
Covariance............................................................................................ 271
Correlation............................................................................................ 271
Dispersion............................................................................................. 271
Value-at-Risk........................................................................................ 272
Implied Volatility ...................................................................................... 272
Beta ...................................................................................................... 273
Range.................................................................................................... 273
Forecasting Stock Volatility ..................................................................... 274
Volatility Models ................................................................................. 274
Determining Parameters via Maximum Likelihood Estimation .......... 277
Historical Data and Covariance ................................................................ 280
False Relationships............................................................................... 281
Degrees of Freedom ............................................................................. 283
Factor Models ........................................................................................... 288
Matrix Notation.................................................................................... 289
Factor Model in Matrix Notation......................................................... 290
Types of Factor Models ............................................................................ 292
Index Model ......................................................................................... 292
Macroeconomic Factor Models............................................................ 293
Statistical Factor Models...................................................................... 295
 Contents xiii

CHAPTER 12 Volume Forecasting Techniques ..................................................... 301

Introduction ............................................................................................... 301
Market Impact Model ............................................................................... 301
Average Daily Volume ............................................................................. 303
Methodology ........................................................................................ 303
Definitions ............................................................................................ 303
Monthly Volume Forecasting Model................................................... 304
Analysis................................................................................................ 304
Regression Results ............................................................................... 306
Observations Over the 19-Year Period: 2000e18 ................................... 306
Observations Over the Most Recent 3-Year Period: 2016e18 ................ 308
Volumes and Stock Price Correlation.................................................. 309
Forecasting Daily Volumes....................................................................... 309
Our Daily Volume Forecasting Analysis is as Follows....................... 310
Variable Notation ................................................................................. 311
ARMA Daily Forecasting Model......................................................... 311
Analysis Goal ....................................................................................... 311
Step 1. Determine Which is More Appropriate: ADV or MDV
and the Historical Look-Back Number of Days ................................. 312
Conclusion #1 ...................................................................................... 312
Step 2. Estimate the DayOfWeek(t) Parameter .................................... 314
Conclusion #2 ...................................................................................... 314
b
Step 3. Estimate the Autoregressive Parameter b................................ 315
Forecast Improvements ........................................................................ 316
Daily Volume Forecasting Model........................................................ 316
Conclusion #3 ...................................................................................... 316
Forecasting Intraday Volumes Profiles ................................................ 317
Forecasting Intraday Volume Profiles.................................................. 320
Predicting Remaining Daily Volume................................................... 321
CHAPTER 13 Algorithmic Decision-Making Framework ......................................... 323
Introduction ............................................................................................... 323
Equations................................................................................................... 324
Variables............................................................................................... 324
Important Equations ............................................................................. 325
Algorithmic Decision-Making Framework............................................... 325
Select Benchmark Price ....................................................................... 326
Comparison of Benchmark Prices ............................................................ 329
Specify Trading Goal ........................................................................... 330
Specify Adaptation Tactic.................................................................... 337
xiv Contents

Projected Cost ...................................................................................... 338

Comparison Across Adaptation Tactics ................................................... 345
Modified Adaptation Tactics..................................................................... 346
How Often Should we Reoptimization Our Tactic?............................ 347
CHAPTER 14 Portfolio Algorithms and Trade Schedule Optimization ...................... 349
Introduction ............................................................................................... 349
Trader’s Dilemma ..................................................................................... 351
Variables............................................................................................... 351
Transaction Cost Equations ...................................................................... 352
Market Impact ...................................................................................... 353
Price Appreciation................................................................................ 353
Timing Risk.......................................................................................... 354
One-Sided Optimization Problem ........................................................ 354
Optimization Formulation......................................................................... 354
Constraint Description.......................................................................... 355
Portfolio Optimization Techniques ........................................................... 358
Quadratic Programming Approach ...................................................... 358
Trade Schedule Exponential ................................................................ 360
Residual Schedule Exponential............................................................ 361
Trading Rate Parameter........................................................................ 362
Comparison of Optimization Techniques ............................................ 364
Portfolio Adaptation Tactics ..................................................................... 368
Description of AIM and PIM for Portfolio Trading ............................ 370
How Often Should we Reoptimize? .................................................... 371
Appendix .............................................................................................. 372
CHAPTER 15 Advanced Algorithmic Modeling Techniques ..................................... 375
Introduction ............................................................................................... 375
Trading Cost Equations ............................................................................ 375
Model Inputs ........................................................................................ 376
Trading Strategy................................................................................... 376
Percentage of Volume .......................................................................... 377
Trading Rate......................................................................................... 377
Trade Schedule..................................................................................... 378
Comparison of POV Rate to Trade Rate ............................................. 378
Trading Time ............................................................................................ 378
Trading Risk Components ........................................................................ 379
Trading Cost ModelsdReformulated.................................................. 380
Market Impact Expression ................................................................... 380
Timing Risk Equation .......................................................................... 382
 Contents xv

Derivation of the 1/3 Factor................................................................. 384

Timing Risk For a Basket of Stock ..................................................... 387
Comparison of Market Impact Estimates............................................. 388
Forecasting Covariance ........................................................................ 390
Efficient Trading Frontier .................................................................... 391
Single Stock Trade Cost Objective Function....................................... 393
Portfolio Trade Cost Objective Function ............................................. 394
Managing Portfolio Risk...................................................................... 395
Residual Risk Curve ............................................................................ 395
Minimum Trading Risk Quantity......................................................... 397
Maximum Trading Opportunity........................................................... 398
When to Use These Criteria? ............................................................... 400
Program-Block Decomposition............................................................ 400
CHAPTER 16 Decoding and Reverse Engineering Broker Models with Machine
Learning Techniques .................................................................... 405
Introduction ............................................................................................... 405
Pre-Trade of Pre-Trades............................................................................ 406
I-Star Model Approach ........................................................................ 407
Neural Network Model Approach ....................................................... 413
Portfolio Optimization .............................................................................. 416
What Should the Portfolio Manager Do? ............................................ 419
Deriving Portfolio Optimization Market Impact Models .................... 419
Example: Share Quantity Regression Model....................................... 420
Example: Trade Value Regression Model ........................................... 425
CHAPTER 17 Portfolio Construction with Transaction Cost Analysis ........................ 429
Introduction ............................................................................................... 429
Portfolio Optimization and Constraints .................................................... 430
Transaction Costs in Portfolio Optimization ............................................ 434
Portfolio Management Process ................................................................. 437
Example: Efficient Trading Frontier With and Without Short
Positions .............................................................................................. 437
Example: Maximizing Investor Utility ................................................ 438
Trading Decision Process ......................................................................... 439
What is the Appropriate Optimal Strategy to Use? ............................. 440
Unifying the Investment and Trading Theories........................................ 441
Which Execution Strategy Should the Trader Use? ............................ 443
Cost-Adjusted Frontier.............................................................................. 445
Determining the Appropriate Level of Risk Aversion ............................. 447
Best Execution Frontier ............................................................................ 448
xvi Contents

Portfolio Construction with Transaction Costs......................................... 449

Quest for Best Execution Frontier ....................................................... 451
Example .................................................................................................... 456
Important Findings ............................................................................... 464
Conclusion ................................................................................................ 466
CHAPTER 18 Quantitative Analysis with TCA ...................................................... 469
Introduction ............................................................................................... 469
Quantitative Overlays........................................................................... 469
Market Impact Factor Scores ............................................................... 469
Cost Curves .......................................................................................... 469
Alpha Capture ...................................................................................... 470
Investment Capacity............................................................................. 470
Portfolio Optimization.......................................................................... 470
Backtesting ........................................................................................... 470
Liquidation Cost................................................................................... 471
Sensitivity Analysis.............................................................................. 471
Are The Existing Models Useful Enough For Portfolio
Construction?....................................................................................... 472
Current State of Vendor Market Impact Models ................................. 473
Pretrade of Pretrades ................................................................................. 475
Applications ......................................................................................... 476
Example #1 .......................................................................................... 476
Example #2 .......................................................................................... 477
Example #3 .......................................................................................... 477
Example #4 .......................................................................................... 477
How Expensive is it to Trade? ................................................................. 478
Acquisition and Liquidation Costs....................................................... 481
Portfolio ManagementdScreening Techniques .................................. 484
Backtesting Strategies ............................................................................... 487
Market Impact Simulation ........................................................................ 490
Simulation Scenario ............................................................................. 491
Multi-Asset Class Investing ...................................................................... 495
Investing in Beta Exposure and Other Factors .................................... 495
Example #5 .......................................................................................... 495
Multi-Asset Trading Costs........................................................................ 498
Global Equity Markets ......................................................................... 500
Multi-Asset Classes.............................................................................. 501
Market Impact Factor Scores .................................................................... 508
Current State of Market Impact Factor Scores .................................... 510
 Contents xvii

Market Impact Factor Score Analysis ...................................................... 510

Alpha Capture Program ............................................................................ 512
Example #6 .......................................................................................... 513
Example #7 .......................................................................................... 514
Alpha Capture Curves.......................................................................... 516
CHAPTER 19 Machine Learning and Trade Schedule Optimization.......................... 519
Introduction ............................................................................................... 519
Multiperiod Trade Schedule Optimization Problem................................. 520
Setting up the Problem......................................................................... 520
Trader’s Dilemma Objective Function................................................. 521
Nonlinear Optimization Convergence ...................................................... 523
Newton’s Method................................................................................. 525
Example #1 .......................................................................................... 526
Example #2 .......................................................................................... 527
Machine Learning ..................................................................................... 528
Neural Networks .................................................................................. 530
Neural Network Errors......................................................................... 531
Machine Learning Training Experiment................................................... 531
Step I: Generating Simulated Trade Baskets ....................................... 532
Step II: Compile Stock and Basket Data Statistics.............................. 532
Step III: Solve the Multiperiod Trade Schedule Optimization
Problem ............................................................................................... 534
Step IV: Train the NNET..................................................................... 535
Step V. Calculate the Initial Parameter Values for the NNET ............ 536
Principal Component Analysis............................................................. 536
Stepwise Regression Analysis.............................................................. 536
Neural Network Structure .................................................................... 539
Neural Network Error .......................................................................... 539
Performance Results ................................................................................. 540
Conclusions............................................................................................... 542
CHAPTER 20 TCA Analysis Using MATLAB, Excel, and Python ................................ 543
Introduction ............................................................................................... 543
Transaction Cost Analysis Functions ....................................................... 545
Transaction Cost Model............................................................................ 547
MATLAB Functions................................................................................. 549
Excel and Python Functions ..................................................................... 549
TCA Report Examples.............................................................................. 550
Conclusion ................................................................................................ 558
xviii Contents

CHAPTER 21 Transaction Cost Analysis (TCA) Library ........................................... 559

Introduction ............................................................................................... 559
TCA Library......................................................................................... 560
Transaction Cost Analysis Using the TCA Library ................................. 561
List of TCA Functions ......................................................................... 565

Bibliography.................................................................................................................... 569
Index ............................................................................................................................... 577
Preface
Any intelligent fool can make things bigger and more complex. It takes a touch of
genius — and a lot of courage to move in the opposite direction.
Albert Einstein

“Algorithmic Trading Methods: Applications using Advanced Statistics, Optimization, and

Machine Learning Techniques,” Second Edition is a sequel to “The Science of Algorithmic
Trading & Portfolio Management.” This book greatly expands the concepts, foundations,
methodology, and models from the first edition, and it provides new insight into Algorithmic
Trading and Transaction Cost Analysis (TCA) using advanced mathematical techniques,
statistics, optimization, machine learning, neural networks, and predictive analytics.

Algorithmic Trading Methods provides traders, portfolio managers, analysts, students,

practitioners, and financial executives with an overview of the electronic trading environment,
and insight into how algorithms can be utilized to improve execution quality, fund
performance, and portfolio construction.

We provide a discussion of the current state of the market and advanced modeling techniques
for trading algorithms, stock selection and portfolio construction.

This reference book will provide readers with:

Insight into the new electronic trading environment.

Overview of transaction cost analysis (TCA) and discussion of proper metrics for cost mea-
surement and performance evaluation.

Description of the different types of trading algorithms: VWAP/TWAP, Arrival Price,
Implementation Shortfall, Liquidity Seeking, Dark Pols, Dynamic Pricing, Opportunistic,
and Portfolio Trading Algorithms.

Proven market impact modeling and forecasting techniques.

Trading costs across various asset classes: equities, futures, fixed income, foreign exchange,
and commodities.

Advanced forecasting techniques to estimate daily liquidity, monthly volumes, and ADV.

An algorithmic decision-making framework to ensure consistency between investment and
trading objectives.

An understanding of how machine learning techniques can be applied to algorithmic trading
and portfolio management.

A best execution process to ensure funds are positioned to achieve their maximum level of
performance.

A TCA library that allows investors to perform transaction cost analysis and develop algo-
rithmic trading models on their own desktop.

xix
xx Preface

A methodology to decode broker models and develop customized market impact models
based on the investment objective of the fund.
Readers will subsequently be prepared to:

Develop real-time trading algorithms customized to specific institutional needs.

Design systems to manage algorithmic risk and dark pool uncertainty.

Evaluate market impact models and assess performance across algorithms, traders, and brokers.

Implement electronic trading systems.

Incorporate transaction cost directly into the stock selection process and portfolio optimizers.
For the first time, portfolio managers are not forgotten and will be provided with proven
techniques to better construct portfolios through:

Stock Selection

Portfolio Optimization

Asset Allocation

MI Factor Scores

Multi-Asset Investing

Factor Exposure Investing
The book is categorized in three parts. Part I focuses on the current electronic market
environment where we discuss trading algorithms, market microstructure research, and
transaction cost analysis. Part II focuses on the necessary mathematical models that are used
to construct, calibrate, and test market impact models, as well as to develop single stock and
portfolio trading algorithms. The section further discusses volatility and factor models, as
well as advanced algorithmic forecasting techniques. This includes probability and statistics,
linear regression, probability models, non-linear regression, optimization, machine learning
and neural networks. Part III focuses on portfolio management techniques and TCA, and
shows how market impact can be incorporated into the investment decisions stock selection
and portfolio construction to improve portfolio performance. We introduce readers to an
advanced portfolio optimization process that incorporates market impact and transaction
costs directly into the portfolio optimization. We provide insight in how MI Factor Scores
can be used to improve stock selection, as well as a technique that can be used by portfolio
managers to decipher broker dealer black box models.

The book concludes with an overview of the KRG TCA library. This chapter providers readers
with insight into how the models and methodologies presented in the book can be packaged and
utilized within numerous software packages and programming languages. These include:
MATLAB, Excel Add-Ins, Python, Java, C/Cþþ, .NET, and standalone applications as
.EXE and .COM application files.

And like the Albert Einstein quote above asks, Algorithmic Trading Methods dares to be
different and exhibits the courage to move in new direction. This book presents the
simplicity behind the algorithmic trading curtain, and shows that the algorithmic trading
landscape is not nearly as complex as Einstein’s intelligent industry fools would have us
believe. This book is a must read for all financial investors and students.
Acknowledgments
There have been numerous people over the years who have made significant contributions
to the field and to the material introduced and presented throughout the text. Without their
insights, comments, suggestions, and criticisms, the final version of this book and these
models would not have been possible.
Roberto Malamut, Ph.D., from Cornell University, was instrumental in the develop-
ment of the numerous methodologies, frameworks, and models introduced in this book.
His keen mathematical insight and financial market knowledge helped advance many of
the theories presented throughout the text. He provided the foundation for multiperiod
trade schedule optimization and is by far one of the leading experts in algorithmic trading,
finance, statistics, and optimization. Roberto is a coauthor of the CFA Level III reading
“Trade Strategy and Execution,” CFA Institute 2019, and he and I have coauthored more
leading-edge algorithmic trading papers in peer-reviewed journals than either one of us can
probably remember.
Morton Glantz, my coauthor from Optimal Trading Strategies, provided invaluable
guidance and direction, and helped turn many of our original ideas into formulations that
have since been put into practice by traders and portfolio managers, and have now become
mainstream in the industry.
The All-Universe Algorithmic Trading Team: Roberto Malamut (Captain), Andrew
Xia, Hernan Otero, Deepak Nautiyal, Don Sun, Kevin Li, Peter Tannenbaum, Connie Li,
Nina Zhang, Grace Chung, Jungsun (Sunny) Bae, Arun Rajasekhar, Mustaq Ali, Mike
Blake, Alexis Kirke, Agustin Leon, and Pierre Miasnikof. Thank you for all your con-
tributions and ideas, which have now become ingrained into the algorithmic trading
landscape. Your contribution to algorithmic trading is second to none and has shaped the
industry.
Wayne Wagner provided valuable direction and support over the years. His early
research has since evolved into its own science and discipline known as transaction cost
analysis (TCA). His early vision and research have helped pave the way for making our
financial markets more efficient and investor portfolios more profitable. Robert Almgren
and Neil Chriss provided the groundbreaking work on the efficient trading frontier, and
introduced the appropriate mathematical trading concepts to the trading side of the in-
dustry. Their seminal paper on optimal liquidation strategies is the reason that trading
desks have embraced mathematical models and algorithmic trading.
Victoria Averbukh Kulikov, Director of Cornell Financial Engineering Manhattan,
allowed me to lecture at Cornell on algorithmic trading (Fall 2009 & Fall 2010) and test
many of my theories and ideas in a class setting. I have a great deal of gratitude to her and
to all the students for correcting my many mistakes before they could become part of this
book. They provided more answers to me than I am sure I provided to them during the
semester. Steve Raymar and Yan An from Fordham University for encouraging me to
continue teaching algorithmic trading and to push and encourage students.
Connie Li, Quantitative Analyst and Algorithmic Trading Expert, M.S. in Financial
Engineering from Cornell University, provided invaluable comments and suggestions

xxi
xxii Acknowledgments

throughout the writing of the book. And most importantly, Connie corrected the errors in
my math, the grammar in my writing, and helped simplify the many concepts discussed
throughout the book. Connie Li is also a coauthor of the CFA Level III reading “Trade
Strategy and Execution,” CFA Institute 2019.
Nina Zhang, M.S. in Quantitative Finance and Statistics from Fordham University,
provided insight and suggestions that led to the development of the TCA functions and
TCA Libraries for MATLAB and Excel. Nina is a coauthor of the paper “Transaction Cost
Analysis with Excel and MATLAB” (JOT, Winter 2017).
Grace Chung, M.S. in Mathematical Finance from Rutgers University, provided insight
and suggestions to help incorporate TCA into the portfolio optimization process. Grace is a
coauthor of the paper “An Application of Transaction Cost in the Portfolio Optimization
Process” (JOT, Spring 2016).
Jungsun “Sunny” Bae, M.S. in Information Systems from Baruch College, is a leading
researcher and practitioner in machine learning and natural language processing. Sunny
was instrumental in helping to develop machine learning applications for their use in
multiperiod trade schedule optimization. She is coauthor of the paper “Machine Learning
for Algorithmic Trading and Trade Schedule Optimization” (JOT Fall 2018).
Scott Bentley, Ph.D., was my publisher for Algorithmic Trading Methods, Second
Edition. He provided invaluable guidance, suggestions, comments, and encouragement
throughout both projects. He is a major reason for the success of both books.
Scott Wilson, Ph.D., provided invaluable insight and direction for modeling trading
costs across the various asset classes, and was influential in helping to structure the
concepts behind the factor exposure allocation scheme.
John Carillo, Jon Anderson, Sebastian Ceria, Curt Engler, Marc Gresack, Kingsley
Jones, Scott Wilson, Eldar Nigmatullin, Bojan Petrovich, Mike Rodgers, Deborah Bere-
bichez, Jim Poserina, Tom Kane, Dan Keegan, and Diana Muzan for providing valuable
insight, suggestions, and comments during some of the early drafts of this manuscript. This
has ultimately led to a better text. The team at Institutional Investor (now IPR), Brian
Bruce, Allison Adams, Debra Trask, and Melinda Estelle, for ongoing support and the
encouragement to push forward and publish with new ideas and concepts.
A special thanks to Richard Rudden, Stephen Marron, John Little, Cheryl Beach, Russ
Feingold, Kevin Harper, William Hederman, John Wile, and Kyle Rudden from my first
job out of college at R.J. Rudden Associates (now part of Black and Veatch) for teaching
the true benefits of thinking outside the box, and showing that many times a nontraditional
approach could often prove to be the most insightful.
Additionally, Trista Rose, Hans Lie, Richard Duan, Alisher Khussainov, Thomas
Yang, Joesph Gahtan, Fabienne Wilmes, Erik Sulzbach, Charlie Behette, Min Moon,
Kapil Dhingra, Harry Rana, Michael Lee, John Mackie, Nigel Lucas, Steve Paridis,
Thomas Reif, Steve Malin, Marco Dion, Michael Coyle, Anna-Marie Monette, Mal Selver,
Ryan Crane, Matt Laird, Charlotte Reid, Ignor Kantor, Aleksandra Radakovic, Deng
Zhang, Shu Lin, Ken Weston, Andrew Freyre-Sanders, Mike Schultz, Lisa Sarris, Joe
Gresia, Mike Keigher, Thomas Rucinski, Alan Rubenfeld, John Palazzo, Jens Soerensen,
 Acknowledgments xxiii

Adam Denny, Diane Neligan, Rahul Grover, Rana Chammaa, Stefan Balderach, Chris
Sinclaire, James Rubinstein, Frank Bigelow, Rob Chechilo, Carl DeFelice, Kurt Burger,
Brian McGinn, Dan Wilson, Kieran Kilkenny, Kendal Beer, Edna Addo, Israel Moljo,
Peter Krase, Emil Terazi, Emerson Wu, Trevor McDonough, Simon (I still do not know
his last name), Jim Heaney, Emilee Deutchman, Seth Weingram, and Jared Anderson.
My previous algorithmic trading students who provided tremendous insight into
algorithmic trading models through numerous questions:
Fall 2009 (Cornell): Sharath Alampur, Qi An, Charles Bocchino, Sai Men Chua,
Antoine Comeau, Ashish Dole, Michael Doros, Ali Hassani, Steven Hung, Di Li, Sandy
Mtandwa, Babaseyi Olaleye, Arjun Rao, Pranav Sawjiany, Sharat Shekar, Henry Zhang,
Xiaoliang Zhu.
Fall 2010 (Cornell): Alisher Khussainov, Shubham Chopra, Jeff Yang, Woojoon Choi,
Ruke Ufomata, Connie Li, Poojitha Rao, Zhijiang Yang, Seung Bae Lee, Ke Zhang, Ming
Sheng.
Fall 2015 (Fordham): Lu An, Chad Brown, Tyler Carter, Isabel Du Zhou, Tianzuo
Feng, Ying Gao, Zhen Huang, Xichen Jin, Aditya Khaparde, Hanchao Li, Shuang Lin, Yi
Liu, Xiaomin Lu, Jinghan Ma, Jinshu Ma, Fupeng Peng, Boyang Qin, Zilun Shen, Fen-
gyang Shi, Alton Tang, Jiahui Wang, Xiaoyi Wang, Jieqiu Xie, Jiaqi Yang, Anya Zaitsev,
Ning Zhang, Yufei Zhang, Yi Zheng, Ruoyang Zhu, Yuhong Zhu, Yunzheng Zhu.
Spring 2016 (Fordham): Amit Agarwal, Yash Bhargava, Richard Brewster, Yizhuoran
Cao, Liangao Chen, Nan Chen, Zhaoyi Ding, Ruiqun Fan, Rui Ge, Tianyuan He, Yue Jia,
Anqi Li, Yang Li, Hsin-Han Lin, Dongming Liu, Kuan-Yin Liu, Bingwan Liu, Yunpeng
Luo, Shihui Qian, Yisheng Qian, Wenlu Qiao, Shao Qiu, Vadim Serebrinskiy, Nitin
Sharma, Yuxin Shi, Hongyi Shu, Ethan Soskel, Shuyi Sui, Zhifang Sun, Ming Wang, Wen
Xiong, Chen Xueqing, Kaicheng Yang, Siqi Yi, Shuwei Zhan, Huidong Zhang, Diyuan
Zhang, Xianrao Zhu, Ying Zhu.
Summer 2016 (Fordham): Eric Adams, Mohammad Alhuneidi, Sergei Banashko,
Zheng Duan, Alexander Flaster, Yuting Guo, Junchi Han, Christian Hellmann, Yushan
Hou, Yangxiu Huang, Ziyun Huang, Hanchen Jin, Xi Jing, Yuxiao Luo, Edward
Mccarthy, Ryan McNally, Francesk Nilaj, Xiaokang Sun, Yinxue Sun, Guoliang Wang,
Melanie Williams, Zihao Yan, Yitong Zheng.
Fall 2017 (Fordham): Maha Almansouri, Seongjun Bae, Jinshuo Bai, Subhasis Bhadra,
Shiwen Chen, Taihao Chen, Yutong Chen, Yichen Fan, James Ferraioli, Patrick Fuery,
Ziqing Gao, Bingxin Gu, Yang Hong, Tingting Huang, Keyihong Ji, Owen Joyce, Jiayuan
Liu, Xun Liu, Xin Lu, Rui Ma, Mengyang Miao, Xueting Pan, Xiao Tan, Yaokan Tang,
Mengting Tian, Hongyuan Wang, Ning Wang, Yimei Wang, Jiajin Wu, Hansen Xing,
Zheng Zheng, Yuan Zhou.
Spring 2017 (Fordham): Jianda Bi, Sean Burke, Beilun Chen, Yilun Chen, Tamar
Chikovani, Niclas Dombrowski, Chong Feng, Fangfei Gao, Masoud Ghayoumi, Man
Avinash Gill, Jiangxue Han, Yuze Ji, Shuxin Li, Lianhao Lin, Chang Liu, Xinyi Liu, Yi
Luo, Tianjie Ma, Nicholas Mata, John Mitchell, Mathieu Nicolas, Boyuan Su, Haoyue
Sun, Yifan Tang, Tuo Wang, Weixuan Wang, Minqi Wang, Qijin Wu, Junhao Wu, Yifan
xxiv Acknowledgments

Wu, Wei Wu, Xin Xiong, Mao Yang, Kai Yang, Kirill Zakharov, Tongqing Zhang,
Haojian Zheng, Jiri Beles, Brian Block, Chaitanya Motla, Rongxin Wang, Ye Zhang.
Fall 2018 (Fordham): Jennifer Dunn, Nadir Bajwa, Riley Coyne, Robert Genneken III,
Connor Griffin, Liesel Judas, Lubaba Khan, Steve Kotoros, Ryan Mertz, James O’Hara,
Lokesh Sivasriaumphai, Roberto Stevens.
Spring 2019 (Fordham): Charles Blackington, Rong Deng, Lei Feng, Luoyi Fu,
Tianlun Gao, Yutong Guo, Tong Han, Yuxuan He, Danny Hemchand, Alana Higa, Boyu
Hu, Lan Huang, Brandon Jaskulek, Zhiyan Jiang, Athanasios Katsiouris, Rachel Keough,
Tanya Krishnakumar, Anqi Li, Chenxi Li, Yiteng Li, Kuiren Liao, Xin Liu, Xuwen Lyu,
Yaakov Musheyev, Ziwen Pan, Luman Sun, Chengxin Wang, Jingzhi Wang, Yutong
Xing, Yuxin Xu, Yazhuo Xue, Deyi Yu, Xiang Ning Zang, Yixiao Zhang, Zhizhe Zhao,
Lujun Zhen, Zepeng Zhong, Ruiyang Zou, Yingting Zou.
In addition to all those who have made significant contribution to the field of algo-
rithmic trading, unfortunately, there are also those who have impeded the progress of
algorithmic trading and quantitative finance. These individuals have been mostly moti-
vated by greed and their never-ending quest for self-promotion. The nice thing is that
many are no longer in the financial industry, but there are still a few too many who remain.
A list of those individuals is available upon request.

Best regards,
Robert Kissell, Ph.D.
 Chapter
1
Introduction
To say that electronic algorithmic trading has disrupted the financial envi-
ronment is truly an understatement. Algorithmic trading has transformed
the financial marketsdfrom the antiquated days of manual labor, human
interaction, pushing, yelling, shoving, paper confirmations, and the occa-
sional fist-fightdinto a system with electronic audit trails and trading facil-
itated using computers, complex mathematical formulas, machine learning,
and artificial intelligence.
Nowadays, the trading floors of these antiquated exchanges more resemble
a university library than they do a global center of trade and commerce.
Many of the glamourous trading floors of years ago, such as the floor of
the New York Stock Exchange, have been relegated to just another stop
on a historical walking tour of downtown New York City.
Trading floors are no longer an active center of trading commerce. Trading
floors are relatively quiet and are no longer littered with filled will paper or-
ders and confirmations. Today, all trading occurs electronically in data cen-
ters with computers rather than people matching orders.
In 2019, electronic trading comprised approximately 99.9% of all equity
volume and algorithmic trading comprised approximately 92% of all equity
volume.1 The remaining 8% of the orders that are not executed via an algo-
rithm are still transacted electronically. But in these situations, brokers still
route orders via a computer trading system to different exchanges, venues,
and/or dark pool to be transacted in accordance with specified pricing rules
define by these brokers.
Fig. 1.1 illustrates the evolution of electronic and algorithmic trading over
the period 2000e19. Electronic trading in the early years was dominated
by firms such as Instinet, Island, and ITG/Posit, and occurred mostly in
NASDAQ/OTC stocks. Electronic trading grew from 15% in 2000 to
99.9% in 2019. The only trading that does not occur electronically today

1
Source: Kissell Research Group, www.KissellResearch.com.
Algorithmic Trading Methods, Second Edition. https://doi.org/10.1016/B978-0-12-815630-8.00001-6
Copyright © 2021 Elsevier Inc. All rights reserved. 1
2 CHAPTER 1 Introduction

Electronic and Algorithmic Trading

120.0%

100.0%

80.0%

60.0%

40.0%

20.0%

0.0%

Electronic Trading Algorithmic Trading

n FIGURE 1.1 Electronic and Algorithmic Trading. Source: Kissell Research Group.

(<0.1%) occurs through special situation sales and transactions. Otherwise,

all trading in US markets occurs electronically.
Over the same period, algorithmic trading exploded grew from 1% of total
market volume in 2000 to 93% in 2019. The biggest increase in algorithmic
trading occurred first in August 2007 due to the quant meltdown and then
again in 2008e09 due to the financial crisis. It was during these periods of
high volatility, trading difficulty, and rapid price changes that institutions
realized the benefits of algorithmic trading. During these times, investors
were faced with rapidly adverse price movement and decreased transactable
liquidity. Time delay encountered in when disseminating orders to brokers
for immediate execution were often met with information leakage, less
favorable transaction prices, and lower profits margins. To avoid these hos-
tile trading conditions, investors turned to the more advanced trading sys-
tems and the usage of algorithms so that they could better control their
orders, keep their trading intentions hidden, and achieve more favorable
transaction prices.
The old-fashioned trading system environment we once know where we call
our broker, market-maker, or specialist over the phone are long gone.
Welcome to the new financial environment.

WHAT IS ELECTRONIC TRADING?

Electronic Trading is the process of transacting orders over a computer sys-
tem or network rather than via a phone call or fax sent to your broker where
you need to state your order, trading intentions, and any special instruction.
Electronic trading could be as simple as entering a buy order into a retail
trading system using a computer terminal, or more recently, via a mobile
app. Electronic trading could also be more advanced and complex such
 Trading Algorithm Classifications 3

as situations where investors route orders to different trading venues for

execution at specified prices, within price spreads, or for execution at
different times of the day. In all these cases, electronic trading encompasses
any order that generates via a computer connection.
Electronic trading should not be anything new. In fact, much of our daily lives
have become mobile and we are connected to the internet almost twenty-four
seven. Think of all the purchases we make on the internet including every-
thing from movie, sports, theater, and entertainment tickets; clothing, travel,
hotel, and airfare, automobile, and at times even home purchases.

WHAT IS ALGORITHMIC TRADING?

Algorithmic trading in its simplest form is the computerized execution of a
financial instrument following a prespecified set of trading rules and instruc-
tions. Investors, instead of sending an order to a broker for execution or
routing an order to an exchange, simply enter the order into the algorithm
for execution. Algorithms then slice larger orders into smaller pieces for
execution over the day, and at various trading venues, to achieve the best
market prices and reduce overall trading costs.
The primary goal of algorithmic trading is to ensure that the implementation
of the investment decision is be consistent with the investment objective of
the fund and to manage the overall transaction costs of the order and
achieve the favorable prices.

TRADING ALGORITHM CLASSIFICATIONS

Trading algorithms are classified into three categories: execution algo-
rithms, profit seeking algorithms, and high frequency trading algorithms.
n Execution Algorithms: An execution algorithm is tasked to transact the
investment decision made by the investor or portfolio manager. The man-
ager determines what to buy or sell based on their investment style and
fund investment objective, and then enters the order into the algorithm.
The algorithm will then execute the order and implement the decision
following a set of rules specified by the portfolio manager.
n Profit Seeking Algorithms: A profit seeking algorithm is an algorithm
that will both determine what to buy and/or sell in the market and will
execute those decisions without interaction by the portfolio manager.
For example, these algorithms will use real-time price information and
market data such as prices, volume, volatility, and price spreads to deter-
mine what to buy or sell, and will then implement a trade when the con-
ditions are favorable to the investor. Profit seeking algorithms seek to
4 CHAPTER 1 Introduction

earn a profit based on a quantitative model, market mispricing, or a stat-

arb strategy based on pairs, index funds, or ETFs.
n High Frequency Trading: High frequency trading (HFT) is a type of
profit-seeking algorithm that seeks to earn a short-term trading profit.
The holding period for an HFT trader will often only last for a few seconds
or less and HFT trading will tend not hold any overnight position as it ex-
poses the fund to much increment risk. HFT algorithms are characterized by
very high turnover rates and they seek to profit by exploiting market mis-
pricing and liquidity conditions across different exchange, venues, and
dark pools. HFT algorithms are also notorious for trying to uncover the
buying and/or selling intentions of long-term investor through processing
market data, prices, and quotes, and then using this information to their
advantage to achieve a profit. All HFT algorithms are profit seeking algo-
rithms, but not all profit seeking algorithms are HFT.

TRADING ALGORITHM STYLES

There are many different types of trading algorithms in the market, each
with a unique name that often does not adequately describe how the algo-
rithm will transact in the marketplace. To help managers differentiate algo-
rithms, they are often classified as aggressive, working order, or passive.
Managers need to determine the algorithm that will transact in a manner
consistent with the investment object of the fund. These are:
n Aggressive: Algorithms that will trade aggressively in the market
with the goal of transacting shares at a specified price or better. These
algorithms have often been described as liquidity seeking algorithms
and/or liquidity sweeping algorithms. These algorithms will likely trade
aggressively in the market and take liquidity across multiple venues
when there is volume at the specified price or better. They tend to trade
with more market order than limit orders.
n Working Order: Algorithms that trade in the market following prescribed
rules based on the needs of investors. These algorithms will often seek to
balance the tradeoff between trading cost and market risk, as well as seek
to maximize the specified investment objectives. These algorithms will
trade with an appropriate balance and mix of limit and market orders.
n Passive: Algorithms that trade in a very passive manner and using mostly
limit orders. These algorithms will also seek to trade greater quantities of
shares in dark pools to minimize information leakage and to ensure that
the execution of the order does not provide the market with signals per-
taining to the trading intentions of the fund.
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