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*

* Plexus BrokerEDGEMonitor (2004)

At 1 x Portfolio Turnover, 40bps Drag on Annual Portfolio Performance

Assume 6% Annual Return

40bps / 6 % = 6.7% negative return contribution

Implicit Trading Cost Attribution

•Market Impact

•Timing / Trend Cost

•Unexecuted orders/Opportunity Cost

•Spread Cost

Strategic / Scheduling

Tactical / Implementation

Bid

Ask

Spread midpoint

Execution Price A

17.30

17.28

17.29

17.31

1 Order –3 Executions Execution A Execution B

10:40am:Order arrives to Buy 60,000

shares

10:40am: Buying 20,000 shares @ 17.31

Cost Attribution Example: Order to Buy 60,000 shares, filled via 3 Executions*

Timing Cost is Critical, but Spread Costs Matter Too!

Spread Cost: 1c

Bid

Ask

Execution Price B

17.35

17.365

17.38

Spread midpoint

Timing Cost 7.5 cents

11:22am: Buying 20,000 shares @ 17.38

Bid

Ask

Execution Price C

17.38

17.34

17.36

17.39

Spread midpoint

Timing Cost 7 cents

Execution C

11:48am: Buying 20,000 shares @ 17.39

Impact Cost: 1c

Spread Cost: 1.5c

Spread Cost: 2c

Impact Cost: 1c

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

VWAP Advantages• Easy-to-use• Direction-neutral

VWAP Disadvantages• “Becoming” VWAP• “Waiting out” VWAP• “Stretching out” the order• “Saying No” to a block

Pros and Cons: VWAP vs Arrival Price

Arrival Price Advantages• Directly related to portfolio

returns (“capturing alpha”)• Can’t be fooled

Arrival Price Disadvantages• Harder to implement• Law of large numbers• Direction-bias

“Becoming VWAP” Threat – Recent Data

VWAP and Arrival Price Cost vs %ADV

0

0.5

1

1.5

2

2.5

33.5

4

4.5

< 1%

1 -

5%

5 - 1

0%

10 -

25%

25 -

50%

50%

>

%ADV

Bps

cos

t vs

VW

AP

05101520253035404550

Bps

cos

t vs

Arr

ival

Pric

e

Cost vs VWAP

Cost vs Arrival Price(diff. adjusted)

Std Dev VWAP and Arrival Price Cost vs %ADV

0

10

20

30

40

50

60

70

80

< 1%

1 -

5%

5 - 1

0%

10 -

25%

25 -

50%

50%

>

%ADV

Std

Dev

of B

ps c

ost v

s V

WA

P

0

20

40

60

80

100

120

140

Str

dDev

of B

ps c

ost v

s A

rriv

al P

rice

StdDev Cost vs VWAP

StdDev Cost vs ArrivalPrice (diff. adjusted)

Data Source: ITG “The Cost of Algorithmic Trading: A First Look at Comparative Performance” (March 2005)

Charts: Instinet

ITG Study Shows Empirical Evidence of ‘Becoming VWAP’

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

Northfield Risk Model

Instinet Trading Engine

Feedback Loop

FIX NEWPORTTM Execution Management System

Instinet Order Handling

Newport TM is patent-pending

Scenario: Buying 50,000 of NYSE-listed mid-cap, Limit 19c, Current Market 16c x 20c. BlockPeg Execution Style “Aggressive”

1

BlockPegPost

at mid-spread

CBX DOT

Post at bid

Market: 16c x 20c Executed: 0 Left: 50,000

16c

20c

16c

20c

18c

21c

2

BlockPegPost

at mid-spread

CBX DOT

Post at bid

Market ?: 17c x 21c Executed: 0 Left: 50,000

17c

21c

17c

19c

CBX DOT

BlockPeg

Post at bid

Market ?: 16c x 20c Executed: 10,000 Left: 40,000

16c

20c

16c

20cPeer institution

takes block @ 18c

3

BlockPegNot

posting

Market ?: 22c x 25c Executed: 0 Left: 40,000

22c 22c

25c25c

CBX DOT

Not posting

Hard limit @ 19c

Hard limit exceeded

4

BlockPegPost

at mid-spread

CBX DOT

Post at bid

Market ?: 15c x 19c Executed: 2,000 Left: 38,000

15c

19c

15c

19c

17c

2000 shares marketable @

19c

5

BlockPegPost

at mid-spread

CBX DOT

Post at bid

Market ?: 14c x 18c Executed: 1,000 Left: 37,000

14c

18c

14c

18c

16cSomeone hits the bid: 1,000 shares @ 14c

6

DOT slice moves with the market

NYSE Spread-cost Minimization Tactic: BlockPegSM

Time9:30 am 4:00 pm

Rule Detects Intra-Day Volatility “Noise”- Pricing Buy Order Passively -

Price

Passive Limit Price

Time9:30 am 4:00 pm

Rule Detects Adverse Momentum- Pricing Buy Order Aggressively -

Price

Floating Aggressive Limit Price

Another Spread-Cost Minimization Tactic: Momentum detection & Mean reversion

Arrival Price

Cost vs Arrival Price of unexecuted

residuals

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

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

© 2005 Instinet, LLC. All rights reserved. INSTINET and the tagline “The Institutional Broker” are a registered mark in the United States and in other countries throughout the world. Instinet, LLC, member NASD/SIPC, branded as Instinet, The Institutional Broker, is a subsidiary of Instinet Group Incorporated which is part of the Reuters family of companies.

This presentation is provided for informational purposes only. It does not take into account the particular investment objectives, financial situation or needs of any individual or entity. Under no circumstances is it to be used or considered an offer to purchase or sell any security, or a solicitation or recommendation of the purchase, sale or offer to purchase or sell any security.

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