Glossary of Algorithmic Trading

Current “Core” Algorithmic Strategies

VWAP

Executes an order over a defined time interval with scheduling based on historic volume curves (usually with some, but limited, dynamic reaction). VWAP strategies are designed to trade to the end of a set period, so they have to manage the inventory of the order to ensure that there is always a suitable amount left to trade (based on historic trends). Once VWAP has defined its predicted volume curve, the need to manage inventory means that there is little room to manoeuvre when confronted with unexpected volume peaks and troughs.

Can work well for alpha neutral trades or where impact is a concern.

Be careful on expiry days, results, and other events that could cause unusual skew in volume and volatility.

TWAP

Executes an order evenly over a user defined time period. Like VWAP, this strategy manages the inventory of the order through to the end of the user defined period. Unlike VWAP, scheduling is done on an even basis during the chosen period, rather than trying to anticipate the volume curve of the period as VWAP does. So TWAP gives an even exposure to a chosen period, but runs higher risks of market impact as it makes no allowance for predicted volume curve as VWAP does.

Can work well as an alternative to VWAP over short periods, particularly into the close; can be used to work orders on a cash matched basis (e.g. futures vs. cash)

Be careful during periods of low liquidity where impact could be an issue.

Implementation Shortfall

Designed to address the balance between alpha capture and market impact. Scheduling uses some historic data, but is more reactive to order book volume than VWAP because there is no defined end time. This means inventory does not have to be managed over a defined period like VWAP, and so these strategies can speed up or slow down according to market conditions. This helps I.S. strategies find a balance between alpha capture and market impact. But because most rely in part on historic stats, they don’t tend to react immediately to unexpected volume spikes, which has advantages and disadvantages. In general, I.S. strategies need to be convinced that a trend has changed before they react.

Can work well in finding the balance between alpha capture and market impact – use of correct “aggression” level is key.

Be careful in sudden volume spikes, where Percentage of Volume strategies might be more responsive.

Percentage of Volume

Participates with order book volume at a rate defined by the user. Tends to trade more frequently and in smaller sizes than some of the other strategies, but can also cross the spread more often than other strategies as it reacts to volume. Generally used in “fast market” situations.

Can work well in volume spikes caused by unexpected events.

Be careful with wider spread names as this strategy tends to cross the spread more often than others. Glossary of Algorithmic Trading Part 1 Current “Core” Algorithmic Strategies.

 

Factors to Consider Before Trading in an Algorithm

(These should be reflected in statistical criteria checks designed to filter out potential unsuitable orders for algorithmic trading and handled according to user’s choice.)

• Market Cap
  • Often taken as a proxy for liquidity and tradability.
  • General rule of thumb is that the further down the market cap curve you go, the less suitable the stock is for algorithms
  • BUT there are many other factors to consider
• Estimated % of Interval Volume
  • % of Average Daily Volume gives you an idea of the relative size of the order, but it’s the actual % of Interval Volume which determines how much liquidity the order will demand and potential impact
  • Impact can be controlled by using a % of volume limit, but this can result in residuals and increased market risk (i.e. time to complete trade)
• Average Trade Frequency
  • A stock may trade 10 million shares a day, but if this is only in 3 prints, it will be difficult to trade
• Spread
  • Bid/ask spread is obviously an important component of execution costs, and can be an indication of difficulty for algorithms – spread can be an indicator for liquidity and tradability
  • Should be viewed in terms of absolute value and relative to historic and exchange averages
• Volatility
  • Higher volatility can make trade scheduling more difficult

MiFID

MiFID (Markets in Financial Instruments Directive)

EU Directive to establish and regulate the single market in investment services and activities in the EU. The Directive establishes the conditions under which an investment firm licensed in any EU member state can do business in any other member state without further licensing requirements. The Directive also establishes EUwide standards for the licensing, organisation and operation of investment firms, regulated markets and multilateral trading facilities; establishes regulations for the protection of investors and sets out a framework for cooperation and enforcement among investment services regulators. Upon its effectiveness on 1 November 2007, MiFID replaces the Investment Services Directive (ISD).

Concentration Rule

A provision in the ISD which permitted (but not mandated) individual member states to require orders originating from investors in that member state to be executed only on regulated markets.

A few member states have such a concentration rule which will be prohibited when MiFID becomes effective.

Systematic Internaliser

An investment firm which, on an organised, frequent and systematic basis, deals on own account by executing client orders outside a regulated market or MTF (Multilateral Trading Facility). Under MiFID, an investment firm which is a systematic internaliser in liquid shares below standard size as defined by the Directive, must comply with certain requirements, including making firm, continuous and publicly available quotes in those shares in order to conduct such business.

MTF

A multilateral system, operated by an investment firm or market operator, which brings together multiple third-party buying and selling interests in financial instruments - in the system and in accordance with non-discretionary rules - in a way that results in a contract.

Pre-Trade Transparency

Requirements under the Directive for regulated markets and MTFs to make public best bid/offer information for instruments traded on the market or MTF. Comparable requirements apply to Systematic Internalisers which deal in liquid shares below standard size.

Trade report/Post-Trade Disclosure

Requirements under the Directive for regulated markets and MTFs to make public price, volume and time data for transactions executed in respect of shares admitted to trading on a regulated market, as close to real-time basis as possible. Comparable requirements apply to investment firms which conclude transactions outside a regulated market or MTF in shares admitted to trading on a regulated market.

Transaction Report

Requirement for an investment firm to submit to its regulator a report regarding details of all executed transactions in financial instruments admitted to trading on a regulated market no later than the close of the business day following the transaction. Reports are required whether or not the transaction was carried out on a regulated market although under certain circumstances an investment firm may be able to discharge this obligation through a third party, a trade-matching or reporting system or by the regulated market or MTF where the transaction was executed.

Best Execution

The requirement under MiFID to take all reasonable steps to obtain the best possible result for the execution of client orders taking into account the best execution factors of the characteristics of the client (retail/professional), the client order, financial instrument that is the subject of the order and the characteristics of the execution venue or venues to which the order can be directed.

Client Categorisation

Classifying the investment firm's client into one of three MiFID categories: retail, professional or eligible counterparty.

Trade Data Monitor

An entity which an investment firm could use in order to discharge its trade reporting obligations. A TDM would check the trade publications in real time in order to monitor for potential inaccuracies and arrange for the information to be made publicly available in a way that facilitates its consolidation with similar data from other sources.

 

Liquidity

Alternative Trading System (ATS):

A platform, which does not operate as an exchange, that crosses business according to its own regulations. Examples include ECNs and Dark pools (see definitions below).

Crossing:

Internalised trading method where buyers and sellers are matched off order book at prices based on visible quotes on Regulated Markets, MTFs and/or ECNs.

Dark Pool:

Liquidity pool composed of nondisplayed resident and sweeping orders.

Electronic Communication Network (ECN):

A computerised system that facilitates trading of financial products outside of primary exchanges. Subscribers enter orders which are either matched against existing orders or posted onto the ECN’s order book.

Fragmentation:

Movement of order flow away from primary exchanges to multiple venues and/or ECNs.

Gaming:

The practice of using small orders to uncover large orders in the market for the purpose of transacting with those larger orders at a price which would suboptimal to the counterparty.

I Would If I Could:

An option within algorithmic strategies to define a quantity and price for which the algorithmic strategy seeks additional liquidity/blocks.

Latency:

The responsiveness or ‘turnaround time’ for an order on an execution venue. In a multiple venue environment, venues with higher latencies can slow down the smart-order routing process, with potential detrimental impact on execution quality.

Light Pool:

A liquidity pool with displayed and non-displayed resident orders and sweeping orders.

Minimum Crossing Size:

Minimum number of shares which are permitted to be executed in a Dark pool. This is a form of anti-gaming logic aimed at ensuring crossing occurs with ‘genuine’ orders.

Multilateral Trading Facility (MTF):

Similar to regulated exchanges in that they bring together multiple third parties looking to buy and sell securities. Platforms used by MTFs include electronic order books, block trades, periodic auctions, etc.

Regulated Market:

This is a system or exchange that meets the minimum standards for a regulated market as defined in MiFID.

Resident Order:

A limit order which sits in one execution venue. May be displayed or nondisplayed.

Systematic Internaliser (SI):

Term used by MiFiD to refer to an investment firm that is permitted “on an organised, frequent and systematic basis, to deal on own account by executing client orders outside a regulated market or MTF” according to defined criteria.

Sequential Scanning:

Sweeping order which scans venues in sequence with full slice or order size.

Simultaneous Scanning:

Sweeping order which scans multiple venues simultaneously by splitting order into smaller probing orders, and then reallocating unexecuted orders to venues where liquidity has been identified.

Smart-Order Routing:

An algorithm that scans multiple venues, slicing, working and distributing orders according to price and probability of execution.

Sweeping Order:

An order which if unexecuted on a venue passes through to be allocated to another venue.