alg tr overview

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Algorithmic Trading: AnAlgorithmic Trading: An

Overview of Applications AndOverview of Applications And

Models.Models.

Ekaterina Kochieva

Gautam Mitra

Cormac Lucas


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Contents

Introduction

Stock exchange mechanism

Models for trade scheduling

Background

Basic models

References


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Introduction

Until recently, most of financial researchfocused on the investment decisions.

There was a missing part of investment cycle execution of investment decisions.

More over, many investment optimizationmodels assume zero execution cost. But in

reality it is not true. Ignoring this fact may lead to significant

mistake in estimating investment returns.


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Stock exchange mechanism


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Overview of stock exchanges

The main stock exchanges in the world include:

America American Stock Exchange

NASDAQ

New York Stock Exchange So Paulo Stock Exchange

Europe Euronext

Frankfurt Stock Exchange

London Stock Exchange Madrid Stock Exchange

Milan Stock Exchange

Zurich Stock Exchange

Stockholm Stock Exchange


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Overview of stock exchanges Australia/Asia/Africa

Australian Stock Exchange

Bombay Stock Exchange

Hong Kong Stock Exchange

Johannesburg Securities Exchange

Korea Stock Exchange

Shanghai Stock Exchange

Taiwan Stock Exchange

Tokyo Stock Exchange

Toronto Stock Exchange


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Listing requirements LSE main market has requirements for a minimum market

capitalization of 700,000, three years of audited financial statements,minimum public float of 25 % and sufficient working capital for at least

12 months from the date of listing

NASDAQ to be listed a company must have issued at least 1.25million shares of stock worth at least $70 million and must have earnedmore than $11 million over the last three years

NYSE a company must have issued at least a million shares of

stock worth $100 million and must have earned more than $10 millionover the last three years


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Participants

Broker an individual or firm which operates between a buyer and a sellerand usually charge a commission. For most products a licence is required.

Dealer an individual or firm which buys and sells for its own account.

Broker/dealer an individual or firm buying and selling for itself and

others. A registration is required. Principal a role of broker/dealer when buying or selling securities for its

own account.

Market maker a brokerage or bank that maintains a firm bid and askprice in a given security by standing ready, willing, and able to buy or sell atpublicly quoted prices (called making a market). These firms display bid and offer

prices for specific numbers of specific securities, and if these prices are met, theywill immediately buy for or sell from their own accounts.

Specialist a stock exchange member who makes a market for certainexchange-traded securities, maintaining an inventory of those securities andstanding ready to buy and sell shares as necessary to maintain an orderly marketfor those shares. Can be an individual, partnership, corporation or group of firms.


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Prototypical trading systems

Call (periodic) auction selling stocks by bid at intervalsthroughout the day. The orders are stored for execution at a singlemarket clearing price.

Continuous auction buyers enter competitive bids andsellers place competitive offers simultaneously. Continuous, since

orders are executed upon arrival.

Dealership market trading occur between principalsbuying and selling to their own accounts. Firm price quotations areavailable prior to order submission.

Auction markets are concentrated and order-driven

Dealership markets are fragmented and quote-driven


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Examples

NYSE opens with a periodic auction market and then

switches to a continuous auction. Same forTokyo Stock

Exchange.

NASDAQandInternational Stock Exchange

(London) are quote-driven systems (continuous dealershipmarket).


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Examples

Euronext Paris the market is segmented into a numberof different groups of stocks based on size and liquidity. Thetrading mechanisms vary depending on the segment.

Euronext 100, Next 150 ,CAC40 indices and stocks which have

more than 2,500 order book transactions per year continuousauction.

Other stocks call auction twice a day.


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Order types

Market order immediate execution at the best priceavailable when the order reaches the marketplace

Limit order to execute a transaction only at a specifiedprice (the limit) or better

Stop order

Good till cancelled

Fill-or-kill All or None

Day order


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Limit order book A register for limit buy orders and a registry for limit

sell orders.

Limit orders are queued for execution againstincoming market orders using price then time priority

rules.

Transparency: how much top orders can be viewed

More transparent order book allows to see what ishappening in the market and make more accurate

forecasts


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Limit order book

0

500

1000

1500

2000

49.5 49.6 49.7 49.8 49.9 50 50.1 50.2 50.3 50.4 50.5

Bid

Ask


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Cumulative Order Book

0

0.05

0.1

0.15

0.20.25

0.3

0.35

0.4

4,2

00

3,5

00

2,5

00

1,5

00

500

0 500

1,5

00

2,5

00

3,5

00

4,5

00

Size

Avg.

Price($

/Share)

Cum. Bid

Cum. Ask


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Example

Euronext Paris high transparency market:

Brokers observe the full limit book at all times

Other investors can observe the volume of

orders available at the five best prices


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Placing orders: How does it work?

Exchange

Electronic

Communications

Network

Market

MakerFirm Internalizes

Order

Internet

order

Phone

order


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Electronic Communication

Network ECN is a computer system that facilitates trading of financial

products outside of stock exchanges. The primary products that

are traded on ECNs are stocks and currencies.

In order to trade with an ECN, one must be a subscriber. ECN

subscribers can enter limit orders into the ECN, usually via a

custom computer terminal or a direct dial-up. The ECN will post

those orders on the system for other subscribers to view. The

ECN will then match contra-side orders for execution.

Generally, the buyer and seller are anonymous, with the trade

execution reports listing the ECN as the party.


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Principal bid

A transaction where a broker/dealer provide

an investor with guaranteed execution of the

trade list at the market prices at a specificpoint in time.

All timing risk is transferred to broker/dealers.

Investors are charged a premium for this.

Blind bid investor provides only trade list

statistics. Than broker/dealer defines the

price.


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The spread between Principal and

AgencyInvestor Cost

ImplicationsAgency Execution

Principal Bid

Transaction

Trading Costs

Comission Yes NoPrice Appreciation Yes No

Market Impact Yes No

Timing Risk Yes No

Opportunity Cost Yes No

Premium Fee No YesKnown Price No Yes

Guaranteed Completion No Yes

Trading Cost Forecast Distribution ofCost Single Value Estimate


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Models for tradeS

cheduling

1. Background


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Trading cost iceberg


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Potential execution strategies

Min cost in presence of risk

Balance trade off between cost and risk

Max probability of price improvement

*k

k

R)R(xs.t.

)(xMin

e

)R(x)(xMin kk

*

k L))(xProb(Max eN


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Constraints

Completion

Monotony (shrinking portfolio)

Participation rate

Cash balance

i

j

ij Xx !

1e ijij rr

Ee

ijij

ij

vx

x

maxmin DcashD j ee


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Market impact

Market impact is primarily caused by: Supply-demand imbalance (liquidity needs)

Information leakage

Market impact could be

Temporary occurs when the order is released but does

not alter markets long-term outlook caused by liquidity demandand immediacy requirements.

Permanent long-term change in price caused by anorder.


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Market impact bubble

Time

Price


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Temporary market impact

Time

Price


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P

ermanent market impact

Time

Price


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Long-lived Temporary MI

Time

Price


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Timing risk. Opportunity risk. Timing risk grows from the uncertainty

surrounding trading cost estimates. It

includes price volatility and instability involume profiles during a day.

Opportunity risk is of not being able to

implement investment decision in full. It is

caused by insufficient stock liquidity orunfavourable price movement.


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Models for tradeS

cheduling

2. Basic models


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Bertsimas and Lo Fixed blocks of shares s=[s1,,sn]

Fixed finite number of periods T

Set of price dynamics: Price = no-impact price + linear impact function

Find optimal sequence of trade to minimize expected

transaction cost

tttpp H! ~


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Further improvements Almgren and Chriss (2000) permanent and

temporary impact, efficient frontier of execution.

Almgren (2003) non-linear impact function.

Malamut (2002) instantaneous market impact: pre-

calculated aggregate impact value to each period.


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Further improvements

Kissel and Glantz(2003) ETF used to define besttrading strategies. Concept of a capital trade line (CTL) formixed trading strategies (agency versus principal bid).

Obizhaeva and Wang (2005) addingsupply/demand dynamics. Model includes discrete andcontinuous trading.

Engle and Ferstenberg (2006) integration ofportfolio decision and the execution decision. Hedging thetrading risk.


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References

Almgren, R. and N. Chriss, 2000, Optimal Execution of PortfolioTransactions. Journal of Risk 3, 5-39

Almgren, R., 2003, Optimal Execution with Nonlinear Impact

Functions and Trading-enhanced Risk.A

pplied MathematicalFinance 10, 1-18

Bertsimas, D. and A. W. Lo, 1998,Optimal Control of ExecutionCosts. J. Financial Markets 1, 1-50.

Malamut R., 2002, Multi-Period Optimization Techniques fortrade Scheduling, QWAFAFEW presentation

Obizhaeva, A. and J. Wang, 2005,Optimal Trading Strategyand Supply/Demand dynamics, NBER working paper

Engle, R., and R. Ferstenberg, 2006, Execution Risk, NBERworking paper


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References

Kissel, R. and M. Glantz, 2003, Optimal Trading Strategies.

Amacom

Bennouri, M., 2005, Auction versus Dealership Markets

Madhavan, A., 1992, trading Mechanisms in Securities Markets.The Journal of Finance, vol. XLVII, 2

Comerton-Forde,C. and A. Frino, 2004,The Impact of Limit

OrderAnonymity on Market Liquidity. SIRCA Working Paper


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Thank you!

alg tr overview

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