ALGORITHMIC TRADING AN OVERVIEW

ALGORITHMIC TRADING AN OVERVIEW

Algorithmic Trading What is it? Electronic trade execution piloted by a model Model tries to match a specific execution cost benchmark Usually breaks up a larger trade into a series of smaller trades to be executed over time

Algorithmic Trading How much is there today? Tower Group says 7% of all Buy Side flow Source: Market Structure and the Role of Exchanges, ECNs and ATSs Tower Group (2004)

Algorithmic Trading How much is there today?..while the Tabb Group reports that over half of all firms have access to algorithms. Source: Institutional Equity Trading in America: A Buy-Side Perspective The Tabb Group (2004)

Most Popular Algorithms The list of most popular algorithms is dominated by the key execution benchmarks: VWAP and Arrival Price VWAP (27%) Arrival Price (19%) Imp. Shortfall (13%) EOD / Beat Close (10%) Guerilla (8%) Liquidity (8%) % ADV (6%) Other (9%) Essentially the same algorithm (32%) Source: Institutional Equity Trading in America 2005 A Buy-Side Perspective. Tabb Group (2005)

Trading Cost How Big? 20bps Implementation Shortfall for Average Trade per Side* At 1 x Portfolio Turnover, 40bps Drag on Annual Portfolio Performance Assume 6% Annual Return 40bps / 6 % = 6.7% negative return contribution * Plexus BrokerEDGE Monitor (2004)

Implicit Trading Cost Attribution Market Impact Timing / Trend Cost Unexecuted orders/ Opportunity Cost Spread Cost Strategic / Scheduling Tactical / Implementation

Timing Cost is Critical, but Spread Costs Matter Too! Cost Attribution Example: Order to Buy 60,000 shares, filled via 3 Executions* 10:40am: Order arrives to Buy 60,000 shares 10:40am: Buying 20,000 shares @ 17.31 11:22am: Buying 20,000 shares @ 17.38 Execution Price B Ask 17.38 Spread Cost: 1.5c 11:48am: Buying 20,000 shares @ 17.39 Execution Price C Ask 17.39 17.38 Impact Cost: 1c Spread Cost: 2c Spread midpoint 17.365 Spread midpoint 17.36 Execution Price A Ask Spread midpoint 17.31 17.30 17.29 Impact Cost: 1c Spread Cost: 1c 1 Order Bid 17.28 3 Executions Execution A Execution B Bid 17.35 Timing Cost 7.5 cents Bid 17.34 Execution C Timing Cost 7 cents Total Cost: 2c Total Cost: 9c Total Cost: 10c Order Trading Cost is Sum Total of Executions A/B/C * Hypothetical Executions

Two Common Benchmarks Volume Weighted Average Price (VWAP) A weighted average price Trading volumes are the weights Intuitive & easy to use for traders > commonly used in the market VWAP does not measure Trend/Timing Cost! Arrival Price The portfolio decision price Difference between Arrival Price and execution price, plus forgone returns on unexecuted shares is called Implementation Shortfall There is little agreement in the market on what an appropriate implementation shortfall ought to be

Pros and Cons: VWAP vs Arrival Price VWAP Advantages Easy-to-use Direction-neutral Arrival Price Advantages Directly related to portfolio returns ( capturing alpha ) Can t be fooled VWAP Disadvantages Becoming VWAP Waiting out VWAP Stretching out the order Saying No to a block Arrival Price Disadvantages Harder to implement Law of large numbers Direction-bias

Becoming VWAP Threat Recent Data ITG Study Shows Empirical Evidence of Becoming VWAP VWAP and Arrival Price Cost vs %ADV Std Dev VWAP and Arrival Price Cost vs %ADV 4.5 50 80 140 Bps cost vs VWAP 4 3.5 3 2.5 2 1.5 1 0.5 0 45 40 35 30 25 20 15 10 5 0 Bps cost vs Arrival Price Cost vs VWAP Cost vs Arrival Price (diff. adjusted) StdDev of Bps cost vs VWAP 70 60 50 40 30 20 10 0 120 100 80 60 40 20 0 < 1% 1-5% 5-10% 10-25% 25-50% 50% > < 1% 1-5% 5-10% 10-25% 25-50% 50% > StrdDev of Bps cost vs Arrival Price StdDev Cost vs VWAP StdDev Cost vs Arrival Price (diff. adjusted) %ADV %ADV Data Source: ITG The Cost of Algorithmic Trading: A First Look at Comparative Performance (March 2005) Charts: Instinet

Instinet & Northfield Instinet already had a robust VWAP rule We wanted to develop an Arrival Price rule that would Factor in an effective measure of timing risk Work for portfolios & pairs, not just single stocks Factor in short-term stock correlations for portfolios & pairs So we turned to someone who Had expertise in risk management models Had a proven short-term risk model

The Instinet & Northfield Partnership Benefits & Synergies Be able to execute portfolios against Arrival Price React to real-time market data Optimize and re-balance real-time, during the execution process

TRADING TACTICS FOR ALGORITHMIC TRADING

Implementation FIX NEWPORT TM Execution Management System Instinet Order Handling Northfield Risk Model Feedback Loop Instinet Trading Engine Newport TM is patent-pending

NYSE Spread-cost Minimization Tactic: BlockPeg SM 1 Scenario: Buying 50,000 of NYSE-listed mid-cap, Limit 19c, Current Market 16c x 20c. BlockPeg Execution Style Aggressive Post at midspread 3 CBX Market: 16c x 20c Executed: 0 Left: 50,000 20c 18c 16c BlockPeg DOT 20c 16c Market?: 16c x 20c Executed: 10,000 Left: 40,000 CBX 20c Peer institution takes block @ 18c 16c BlockPeg DOT 20c 16c Post at bid Post at bid 2 Post at midspread 4 Not posting Hard limit @ 19c Market?: 17c x 21c Executed: 0 Left: 50,000 CBX 21c 19c 17c BlockPeg BlockPeg DOT Market?: 22c x 25c Executed: 0 Left: 40,000 CBX 25c 22c Hard limit exceeded 21c 17c DOT 25c 22c Post at bid Not posting DOT slice moves with the market 5 Market?: 15c x 19c Executed: 2,000 Left: 38,000 CBX DOT 6 Market?: 14c x 18c Executed: 1,000 Left: 37,000 CBX DOT Post at midspread 19c 17c 15c BlockPeg 19c 15c 2000 shares marketable @ 19c Post at bid Post at midspread 18c 16c 14c BlockPeg 18c Someone hits the bid: 1,000 shares @ 14c 14c Post at bid

Another Spread-Cost Minimization Tactic: Momentum detection & Mean reversion Rule Detects Intra-Day Volatility Noise - Pricing Buy Order Passively - Price 9:30 am Time 4:00 pm Passive Limit Price Rule Detects Adverse Momentum - Pricing Buy Order Aggressively - Price Floating Aggressive Limit Price 9:30 am Time 4:00 pm

Tracking Transaction Cost in Newport Cost vs Arrival Price I have realized (executed portion of the order) What the entire order s realized Cost vs Arrival would be if I executed all residuals now Arrival Price Cost vs Arrival Price of unexecuted residuals

Best Execution What else can you do? Use a great model Use great technology Trade through a broker who doesn t have a dog in the fight 100% Pure Agency 100% Anonymous Always trading for the customer No firm proprietary account

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