Algorithmic Trading & DMAAn introduction to direct access trading strategies.

By Barry Johnson

Algorithmic Trading & DMA

Contents

Preface

Part I An overview of trading and markets

1 Overview1.1 Introduction1.2 Fundamentals1.3 Core execution methods1.4 Institutional trading types1.5 Electronic trading1.6 Algorithmic trading

Types of trading algorithmsThe evolution of trading algorithms

1.7 Direct Access TradingDirect Market AccessSponsored accessCrossingDirect Liquidity AccessDirect Strategy Access

1.8 Comparing execution methodsEfficiencyUsabilityPerformance / CostOther reasons

1.9 How much are these execution methods used?1.10 Fears and myths

Safety of algorithmic tradingPerformance of algorithmic tradingUsefulness of algorithmic trading

1.11 Summary

2 Market microstructure2.1 Introduction2.2 Fundamentals

Market functionParticipantsLiquidity

2.3 Market structure and designTypes of marketsOrder typesTrading Protocols

XIII

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vi Contents

Transparency 36After-hours and off-market trading 37Other important market design features 38

2.4 Trading mechanism research 39Price formation 39Price discovery / trade execution 40Reporting, clearing and settlement 46

2.5 Transaction cost measurement and analysis 47Cost measurement 48Analysing the components of transaction costs 49

2.6 Summary v . _ . 51

3 World markets 533.1 Introduction 533.2 Asset classes 54

Equity 54Fixed income 54Foreign exchange 55Money markets 55Derivatives 56Other asset classes 57

3.3 Market structure 58Inter-dealer markets 59Dealer-to-client markets \ 62Alternative markets s 63

3.4 Global market trends 66Electronic trading 67Transparency 69Accessibility 69Centralisation versus fragmentation 70

3.5 Global market comparison 74Overall size 74Average daily turnover 75Adoption of electronic and algorithmic trading 77

3.6 Summary 78

Part II Algorithmic trading and DMA strategies 81

4 Orders 834.1 Introduction 834.2 Market orders 844.3 Limit orders 854.4 Optional order instructions 88

Duration instructions 88Auction/Crossing session instructions 89Fill instructions 89Preferencing and directed instructions 92Routing instructions 92Linking Instructions 95Miscellaneous instructions 95

Algorithmic Trading & DMA vii

4.5 Other order types 96Hybrid order types 96Conditional order types 98Hidden order types 100Discretional order types 103Routed order types 106Crossing order types 108Order-contingent order types 109

4.6 Summary 112

5 Algorithm overview 1155.1 Introduction 1155.2 Categorising algorithms 1165.3 Common features of algorithms 118

Algorithm parameters 1185.4 Impact-driven algorithms 119

Time Weighted Average Price (TWAP) 120Volume Weighted Average Price (VWAP) 123Percent of Volume (POV) 127Minimal impact 130

5.5 Cost-driven algorithms 132Implementation Shortfall (IS) 133Adaptive Shortfall (AS) 138Market Close (MC) \ 141

5.6 Opportunistic algorithms 143Price inline (PI) 144Liquidity-driven 146Pair trading 150

5.7 Other trading algorithms 154Multi-leg 155Volatility-driven 157Gamma Weighted Average Price (GWAP) 159

5.8 Summary 160

6 Transaction costs 1616.1 Introduction 1616.2 The investment process 1626.3 Pre-trade analysis 165

Price data 165Liquidity data 166Risk data 166Transaction cost estimates 167

6.4 Post-trade analysis 167Performance analysis 167Post-trade transaction costs 172

6.5 Breaking down transaction costs 173Investment-related costs 175Trading-related costs 176Summary 184

6.6 Transaction costs across world markets 184

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6.7 Summary 186

77.17.27.3

7.4

7.57.67.77.8

Part

88.18.2

8.3

8.4

8.5

8.68.7

99.19.2

9.3

Optimal trading strategiesIntroductionAssessing the difficulty of ordersSelecting the optimal trading strategy

The efficient trading frontierChoosing the benchmarkDetermining the level of risk aversionChoosing a trading goal v

Determining the optimal trading tforizonChoosing between trading algorithms

Mapping algorithms to the efficient trading frontierFactors affecting algorithm choiceOther requirements for trading algorithms

To cross or not to cross?Market conditions during the 2007-09 financial crisisA decision tree for strategy selectionSummary

III Implementing trading strategies

Order placementIntroductionPrice formation

ValuationModels of price formation

Price discovery/Order matchingContinuous matchingCall-based matching

Order placement decisionsSignalling riskVenue choiceOrder choiceOrder aggressivenessMarket factors affecting order placement decisions

Dealing with hidden liquiditySpotting hidden liquidityEstimating the probability of hidden liquidity

Estimating execution probabilitySummary

Execution tacticsIntroductionDesigning execution tactics

Impact-driven tacticsPrice/Risk-driven tacticsOpportunistic/Liquidity-driven tactics

Alaorithm selection

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Algorithmic Trading & DMA ix

Factors affecting the choice of execution tactics 2719.4 Summary 275

10 Enhancing trading strategies 27710.1 Introduction 27710.2 Forecasting market conditions 278

Predicting asset prices 278Predicting trading volume 281Predicting liquidity 287Predicting volatility <. - 288

10.3 Estimating transaction costs 292Market impact 293Timing risk 299

10.4 Handling special events 300Predictable events 300Unpredictable events 306

10.5 Summary 309

11 Infrastructure requirements 31111.1 Introduction 31111.2 Order management 312

Order entry 313Order routing 316

11.3 Algorithmic trading 322Infrastructure requirements for algorithmic trading 323Designing an environment for algorithmic trading 326Implementing trading rules 329Testing 332

11.4 Other requirements 334Clearing and settlement 335Regulations compliance 335

11.5 Summary 337

Part IV Advanced trading strategies 339

12 Portfolios 34112.1 Introduction 34112.2 Portfolio risk 342

Portfolio volatility 342Diversification , 345Decomposing portfolio risk 346Portfolio risk measures 349

12.3 Transaction cost analysis for portfolios 351Market impact 351Timing Risk 352

12.4 Optimal portfolio trading 352Additional goals for portfolio trading 354Hedging 354Minimising the overall portfolio risk 359

Contents

12.5

12.6

Portfolio trading with algorithmsPortfolio trading with standard trading algorithmsTailoring algorithms for portfolio trading

SummaryAddendum A: Covariance

13 Multi-asset trading13.113.213.3

13.4

13.5

13.6

13.7

13.8

IntroductionMulti-asset trading strategiesUtility strategies ^

FX cash tradesCovering short sales

Structured strategiesPrincipal protected notes

Hedging strategiesHedging market riskHedging interest rate riskHedging derivative risk factors (the "Greeks")

Arbitrage strategiesMultiple listing/depositary receipt arbitrageBasis tradingIndex arbitrageETF Index ArbitrageOption arbitrageFutures and options arbitrageDividend arbitrage

Adapting algorithms for multi-asset tradingFactors to consider for multi-asset trading algorithmsMinimising riskTrading algorithm choice

Summary

14 News14.114.2

14.3

14.4

14.5

IntroductionTypes of news

Macroeconomic newsCorporate news

The changing face of newsDigitisation of newsDigitisation of corporate reports/researchChanging sources of news

Computerised news handling techniquesNews filteringNews associationNews analysisNews interpretationNews mining

Market reactions to newsReactions to macroeconomic newsReactions to coroorate news/announcements

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Algorithmic Trading & DMA xi

Other factors which affect the impact of news 42714.6 Incorporating news into trading strategies 432

Precautions for automated news handling 432Potential news-based indicators 433News-based algorithms 436

14.7 Summary 437

15 Data mining and artificial intelligence 43915.1 Introduction 43915.2 Data mining , 440

Data mining techniques ' 440Finding patterns/associations 442

15.3 Artificial Intelligence 448Types of artificial intelligence 449Predicting data and trends 455

15.4 Incorporating in trading strategies 461Applying short-term forecast models 461Generating trading strategies/rules/parameters 464Back-testing 465

15.5 The future 46815.6 Summary 469

Epilogue 471

Appendices 473A Equity markets 474B Fixed income markets 495C Foreign exchange markets 504D Money markets 509E Derivatives markets 515F Other markets 534

Abbreviations & Acronyms 543

References 545

Index 569