Valdi Algorithms e-Book

Algorithmic Trading for Busy People Volume 1: Fundamentals & Execution algorithms by Benjamin Becar
2011 SunGard. First published, April 2011. Second edition, June 2011. Trademark information: SunGard and the SunGard logo are trademarks or registered trademarks of SunGard Data Systems Inc. or its subsidiaries in the U.S. and other countries. All other trade names are trademarks or registered trademarks of their respective holders.

Table of contents

What does algorithmic trading really mean? Global usage of algorithms in 2011 Why do people use algorithms? What are the most popular algos? Providers and naming conventions Glossary and Resources

What does it really mean ?

Too many words

Automated

Blackbox

HFT

Flashcrash

Algorithmic Arbitrage
Low latency VWAP quantitative Percentage Volume Micro-Second Stat Arbitrage

Over the last five years or so, we have been inundated with documents and articles about algorithmic trading: often these have created confusion for many people working in the market: traders, technologists and regulators. Its not uncommon to hear I want to do algorithmic trading when the real objective is market making, High Frequency Trading, index arbitrage, or a dozen other things.

CEP regulation
PTA

Automated Trading Strategies

The main reason for confusion is that for some people, Algorithmic Trading is a specific trading strategy, while for others, its just a broad category involving any application of software to support trading. The term AUTOMATED TRADING is more correctly used for this broad category, to include all strategies that rely on computers, algorithms or automation of some kind.

Algorithmic Trading

High Frequency Trading The most common types of automated trading strategies are briefly described in the following slides:
Market Making Program Trading Index Arbitrage

Smart Order Routing

Decision-making Algorithms
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Automated Trading Strategies

Algorithmic Trading Automated execution of a block trade, in search of optimization. Also referred as execution algorithms, this trading strategy is usually applied to single instruments. Example: VWAP, Percentage Volume, Iceberg

High Frequency Trading (HFT) Framework aimed at profit by trading quickly, based on low-latency technology. A HFT strategy involves optimizing all aspects of the trade flow to be as fast as possible, including hardware, network, and distance from the trading engine to the exchange servers. Example: A HFT strategy could be to quote thousands of times per second the same instrument, hoping to be hit at a competitive price, and subsequently resell it higher. In a typical HFT strategy, less than 5% of the quotes sent to market result in actual trades.
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HFT controversy
There is controversy around HFT: some market participants, politicians and regulators view it as unfair.

The charts below indicate how a small number of High Frequency Trading firms dominate US equities trading.
High Frequency 1% High Frequency 56%

Traditional 99%

Traditional 44%

Percentage of US trading firms with a HF strategy

Percentage of US equity volume driven by HF strategies

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Source: TABB Group, Aug 2009

Automated Trading Strategies

Market Making A market maker is a company, or an individual, that quotes both bid and offer prices in a range of financial instruments or commodities held in inventory, with the objective of making a profit on the bid/offer spread.

What is a quant?
A quant, or quantitative analyst, is a mathematical and financial expert who analyses the market and defines trading algorithms to benefit from it.

Smart Order Routing (SOR) Looking for best/improved execution by making use of the price discrepancies that can occur between venues. As the number and specificities of venues expands in certain markets (60 venues in US equity markets, including dark pools, exchanges, systematic internalizers), smart routing strategies need to be more and more sophisticated. The associated algorithms are sometimes referred to as Liquidity Seeking Algorithms
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Automated Trading Strategies

Program Trading A program trader trades multiple instruments at the same time, in a basket. Some program traders focus on a single instrument type (e.g. equities-only baskets), while others trade derivatives of these instruments at the same time (options or futures). Cf. Index Arbitrage, described below.

Index Arbitrage Index arbitrage is a specific type of Program Trading, aimed at profiting from temporary discrepancies between the value of an index and the net asset value of the underlying components. Opportunities for index arbitrage tend to decrease over time in a given market, as the market becomes more competitive and the technology more sophisticated. On newer markets (like CFFEX at the present time, for example) there can be significant scope for index arbitrage.

Automated Trading Strategies

Decision-making Algorithms While all of the strategies described before take some sort of decision, decisionmaking algorithms describes a category of algorithms that encode a complete trading strategy, and then operate entirely automatically. In an ideal world, you could turn on the strategy in the morning, turn it off in the afternoon, and just cash in your profit. In reality, because most markets are complex and changeable, you have to monitor the algorithms progress, and modify it regularly. Decision-making algorithms rely on charts, statistics, historical and real-time data as the basis for each trading decision.

Because of the fierce competition in the automated world, those strategies evolve very quickly. More and more, you can see bridges between them, creating super algorithms: market makers add execution algorithms, index arbitrageurs use Smart Order Routers for improved efficiency, and so on. And these moves can influence how the markets behave for other participants, so vigilance is necessary!
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Automated Trading Strategies

Algorithmic Trading now accounts for a large share of the daily volume, as you can see in the below table. Following the 2010 flash crash (see glossary), a slight decline in algorithmic trading usage has been noticed in the US and in Europe. However if we compare to 2005 figures, we can see that this is just a minor trend in the overall growth pattern. If we look back to 2001, at Chicago Mercantile Exchange 90% of trades were handled manually! In just five years, meanwhile, Europe has multiplied its algorithmic trading usage by more than 30 times.

2005
US Europe 21% 1%

2009
61% 29%

2010
56% 38%

2011
54% 35%
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Source: TABB Group, Apr 2011

Usage in Asia

70%
60% 50% Algorithmic Trading % 40%

30%
20% 10% 0% Singapore Hong Kong Japan Australia India

Source: Celent, October 2010

* Note: 2011 & 2012 figures are estimations based on market analysis.

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Usage in Asia

In Asia, Hong Kong is clearly leading the pack. Estimated usage is expected to reach US levels within two years. Apart from Singapore, which will be following closely, and Japan, for which the chart seems to understate the reality, the other Asian markets are still well behind in terms of usage, leading to big opportunities for new entrants in this area. However, there are some hurdles, mostly regulatory, which continue to put a brake on the rate of adoption.

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Hurdles
All around the world, the economic crisis, followed by the flash crash in May 2010, created a skeptical approach towards algorithms at various levels. After some concerns raised by legislators and general public opinion, regulators worldwide have begun to move. In European and US markets, this is the #1 source of concern for 2011. In Asia, some of the hurdles include: Requirements for pre-approval of algorithms (India, Indonesia), Ensuring fair trading, i.e. providing the same price for orders received within the same time frame. (China) Exchanges resisting the rise of alternative trading venues: potential competitors transform into new entities such as the Chi-East joint venture between SGX and Chi-X. In other countries, alternative venues may have to wait a long time to have their approval (eg, Australia), or enjoy the facilities of the main exchange, like a central clearing (eg, Japan).
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Why use algorithms?

Most businesses can profit from algorithmic trading, with a variety of objectives:

Sell-side Improve performance of executions, provide additional services to clients Buy-side Route orders to the most effective sell-side, spread the risk, obtain better prices Market makers Improve strategies Hedge funds React immediately to trend changes, defining proprietary strategies quickly Most businesses Access multiple markets with the same or similar strategies

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Impact at the trading desk

Respondents to a recent survey* were asked to consider which factors affecting their trading desks were important.

Ease of use and trader productivity were seen as being almost equally important considerations. This reflects the role of algorithms in changing workflows in the trading environment.
Source: SunGard Business Intelligence, Mar 2011
*SunGard conducted a survey in 2011 with 150 buy-side firms. There were 500 individual responses: 45% of respondents are heads of trading desks.
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Impact on Execution
Survey respondents clearly consider that reduced market impact is a key benefit. This received 37% of all mentions, well ahead of Execution consistency (27%). Reducing latency was the area of least perceived importance , gaining only 17% of mentions. What Is clear from responses is that different firms are looking to achieve quite different things via algorithmic trading. Providers need to be sensitive to these differences, as they impact the views that different customers have of services.

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Source: SunGard Business Intelligence, Mar 2011

Other factors
Among other considerations in the use of algorithms, anonymity and access to internal crossing received the highest proportion of mentions. These scores are consistent with the importance of reduced market impact noted earlier. Customization received somewhat fewer mentions. Given the amount of resources devoted to creating custom solutions for clients, this may be regarded as disappointing.

Source: SunGard Business Intelligence, Mar 2011

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Client satisfaction

George and his demanding client George is the head of trading for a famous broker. Hes calling one of his software vendors: it seems something is wrong. George Jack George Jack George Jack George Hello Jack, I need to do algo trading! Well sure, what do you want to do with it? Improve your executions? No! I see - its to be more productive then? No, its not. Then what? I have this client, a very large insurance firm and they told me: George, if you dont have these simple algorithms within three months, Im going with another broker! Lets see what we can do!

Jack

With the buy-side becoming more and more educated in electronic trading techniques, this situation is now very common.
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What are the most popular algorithms?

Dozens of algorithms are created and advertised by brokers and software vendors. Their names can range from descriptive to technical, not forgetting strange names involving wildlife There are two major categories of popular algorithms:

Benchmark Seeking Liquidity Seeking

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The 2 majors Benchmark Seeking Algorithms

VWAP TWAP Percentage of Volume Implementation shortfall

Liquidity Seeking Algorithms

Dark only Aggressive inside a price (all venues)

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Execution Trading Algorithms

Execution Algorithms provide various benefits to dealers when they have to work their orders. Benchmark seeking algorithms, as described previously, are a kind of execution algorithm.

Hide your interest from the market Send your order at the right time Cover your position Be sure to be executed Follow a trend Meet key benchmarks

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Providers and Naming Conventions

Provider UBS Credit Suisse Deutsche Bank Barclays Liquidity Seeking Tap, Tap Now Pathfinder, Crossfinder Stealth Work & Pounce Hydra With Volume Ghost Percentage Volume Volume Inline Workit, Workit IW, Inline Hidden Hidden Guerrilla, Sniper, Reserve Dark only

BNP
Citi Nomura Others

Killer, Grab
Dagger Float & Pounce, Hide & Pounce Hunt, Snake, Eclipse

pvol, volscaler
Participate With Volume VOLINL

Dark Peg, Dark IOC

Dark Cross Dark

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Providers and Naming Conventions

Similar algorithms tend to be given the same names by different providers, but variations are not uncommon. For example: VWAP BWAP (Bloomberg) DWAP (Bloomberg), ALPHA (Barclays) IS Arrival Price Aqua/Arrid (JPMorgan) Tex (Credit Suisse) MOC At Close Tclose Target Close
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Implementation Shortfall

Market On Close

Glossary
Algorithmic Trading: Automated execution of a block trade, in search of optimization. Also referred as execution algorithms, this trading strategy is usually applied to single instruments. Arbitrage: Any trading strategy whose purpose is to profit from market discrepancy. > Index Arbitrage is when you trade the index against its underlying components. > Statistical Arbitrages goal is to identify correlated instruments, and buy/sell them at appropriate time for a profit. Decision Making Algorithms: Complex strategies, usually used by hedge funds and prop desk, to trade based on various information, including real-time and historical data. Index Arbitrage, Pairs Trading, MACD-based strategies are all decision making algorithms. ECN Electronic Clearing Network: See ATS. Execution Algorithms: Check Algorithmic Trading Flashcrash: Event that happened on 6th May 2010, in NYSE. In just a couple of minutes, the price of some stocks went crazy (from 0.01$ to 100,000$) before returning to normal. HFT - High Frequency Trading: Framework aimed at profit by trading quickly, based on low-latency technology. Latency: Usually defined as the time taken from the trading system to the exchange. Latency can be impacted by various factors including software performance, hardware, network, location, etc. MTF Multi-lateral Trading Facility: See ATS. PTA Post Trade Analysis: Analyze the performance of your order. PTS Proprietary Trading System: See ATS.
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ATS Alternative Trading System: A trading platform which is not considered as a stock exchange.
Automated Trading: Any automated order manipulation (order creation, modification, cancellation). Algorithmic Trading, High Frequency Trading, Pairs Trading, Basket trading are all various kinds of Automated Trading. CEP - Complex Event Processing: Dark Pool: Crossing venues where some or all information is hidden (bid/ask prices, volume, participants). Used by traders with large order to avoid showing their interest.

Resources
There are many online information resources relevant to algorithmic trading. Some useful starting points are given below. Automated Trader www.automatedtrader.com Advanced Trading www.advancedtrading.com To find out how SunGard can help you implement algorithmic trading solutions with Valdi Algorithms, please contact [email protected] Or visit www.sungard.com/globaltrading
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Valdi Algorithms
About the author About SunGard SunGard is one of the worlds leading software and technology services companies. Our four businesses serve 25,000 customers in over 70 countries.

Benjamin Becar heads product management for algorithmic trading solutions at SunGard.

With a strong background in mathematics, and knowledge of international markets, he drives product strategy.

SunGards global trading business provides multi-asset, front- to backoffice trading solutions for equities, fixed income, derivatives and commodities on exchanges worldwide. These solutions support full-lifecycle trading and trade processing activities including information services, market connectivity and order management that help improve trade efficiency and risk monitoring.
Learn more at sungard.com/globaltrading

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