part 2:

Honing an algorithmic trading strategy

41 Chapter 4
Choosing the right algorithm for your trading strategy

51 Chapter 5
Anonymity and stealth

59 Chapter 6
Customising the broker’s algorithms

Honing an algorithmic trading strategy
Choosing the right algorithm
for your trading strategy
What are the options buy-side traders need to consider in selecting an
algorithm best suited to a particular investment style?
Tracy Black* and Owain Self**
Ia nvestors trading styles and
benchmarks can be different for
number of reasons. Index track-
ers and fund managers may have
specific price goals such as the
close price, whilst others may be
more constrained to the price at
which the investment decision
was made. Some investors may be
investing into 3-4 days volume of
a stock and others in smaller
more frequent trades. Reactions
to changes in prices and volumes
over the course of the implemen-
tation of their trade and, general-
ly, the degree of impact they are
willing to have in order to com-
plete, will differ from investment
case to investment case. Whether
or not an investor’s trading style
involves large slow money orders
or smaller high frequency trades,
there is a place for algorithms if
used appropriately. In this chapter
we will explore the attributes of
the more commonly available
■ ALGORITHMIC TRADING
■ Chapter 4
algorithms without going into the
complex mathematics behind
their construction.
Algorithmic choice 41
When deciding if you can utilise
an algorithm to execute a particu-
lar order a number of questions
need to be answered. Besides the
obvious question of ‘what is my
benchmark?’ other factors will
ultimately dictate whether algo-
rithmic trading is an option and,
if so, what type of algorithm and
which parameters to apply.
First, you need to assess
whether the stock is suitable. Blue
chip liquid names that trade a
large percentage of their volume
on the order book will be good **Owain Self ,
executive director –
candidates. Small/mid cap stocks Equities,
that trade a very small percentage UBS Investment Bank
on the order book are only suit- *Tracy Black,
able with correct parameterisa- executive director –
European Sales
tion. The reasons for this are obvi- Trading,
ous, a computer can only react to UBS Investment Bank
■ A BUY-SIDE HANDBOOK ■ THE TRADE 2005
 ■ Chapter 4
Honing an algorithmic trading strategy
■ “VWAP algorithms do not
generally take into account
absolute volume levels and will
still try to complete the order even
if this would cause additional
market impact.”
information that is electronically
fed to it, it cannot participate in
off market prints and it cannot
make phone calls to negotiate
block trades.
Secondly, you have to decide
42 what proportion of the order you
want to execute via an algorithm.
You might want to put your
entire order into an algorithm if
it suits your benchmark or you
may want to combine algorithms
with more of a traditional trading
service, such as Block Trading or
DMA.
Making the process even more
complex for the client is the fact
that not all algorithms are equal.
Brokers have different names for
algorithms that have similar trad-
ing styles and sometimes two
firms will offer an algorithm
under the same name, which will
execute very differently. This cre-
ates a minefield for the client.
Only through education from bro-
kers on what to expect of their
algorithms and through actually
■ ALGORITHMIC TRADING ■ A BUY-SIDE HANDBOOK
using them will a client be able to
know which algorithms at which
firms best suit their trading style.
Undetermined benchmarks
Algorithms can generally be split
into two types of benchmark, pre-
determined and undetermined.
First generation algorithms try to
obtain a yet undetermined bench-
mark, such as VWAP, where the
benchmark will be determined
over the life of the order. The more
recently developed
Implementation Shortfall algo-
rithms will be measured against a
benchmark predetermined at
order creation.
VWAP (Volume Weighted
Average Price) has been the most
commonly used algorithm histor-
ically. As things have evolved,
VWAP has gained its critics but it
still has its uses. Ultimately used
with the aim to minimise market
impact, VWAP is useful for exe-
cuting trades where you don’t
necessarily have a view on a stock
and want to obtain a fair price by
sampling market levels over a
specified period. Due to its sensi-
tivity to changes in volume distri-
bution, VWAP will participate
relative to liquidity. However,
VWAP algorithms do not gener-
ally take into account absolute
volume levels and will still try to
complete the order even if this
would cause additional market
■ THE TRADE 2005
 ■ Chapter 4

Honing an algorithmic trading strategy

impact. It is therefore important Figure 1: GlaxoSmithKline PLC

that traders apply price and vol-
ume caps on larger trades to 8.00 16.35
2004/07/12 2004/07/12
minimise such an impact, 2004/10/1 2004/10/1

te
although this potentially means 2005/07/29 2005/07/29

Da
the order will not complete. 2,800,000 2,800,000
The expectation of VWAP is

Volume
2,400,000 2,400,000
not just about mean perfor-
2,000,000 2,000,000
mance; we know that if you exe-
1,600,000 1,600,000
cuted an order each and everyday
1,200,000 1,200,000
of the year in the same stock, the
800,000 800,000
mean performance would be
400,000 400,000
acceptable, however this is an 0 0
unlikely scenario. Therefore, the 8.00 16.35
Time
risk-adjusted performance and
the standard deviation of the
returns become important. Due
to VWAP’s sensitivity to volume Figure 2: LogicaCMG PLC 43
distributions, the performance
risk is affected by its ability to 8.00 16.35
2004/07/12 2004/07/12
predict changes in these distribu- 2005/01/11 20,050,111
2005/01/11
tions. The majority of trading
te

2005/07/25 2005/07/25
Da

engines are based on historical 800,000 800,000

data. This can often mean that
Volume

you have to choose your stocks

carefully. Some will have a rela-
tively stable historical trading 400,000 400,000
pattern – e.g. GlaxoSmithKline
(Fig. 1) – and therefore a more
predictable outcome. Others,
0 0
however, can have a more volatile 8.00 16.35
Time
trading pattern historically – e.g.
LogicaCMG (Fig. 2). In these
cases, using an average historical
curve will not deliver acceptable patterns based upon both histori-
performance, as your standard cal and real-time data analysis.
deviation would be too large. It is This results in an improved stan-
important that the algorithm you dard deviation of returns even
are using can predict trading when trading less suitable stocks.

■ ALGORITHMIC TRADING ■ A BUY-SIDE HANDBOOK ■ THE TRADE 2005

 ■ Chapter 4
Honing an algorithmic trading strategy
■ “Neither VWAP nor TWAP have
any macro level price
sensitivity – the overall profile of
execution is not affected by
movements in the price of the
stock. Their aim is to get the order
executed by the end time,
irrespective of price.”
VWAP’s sensitivity to the vol-
ume distribution over the life of
the order may not always suit
44 your trading style. For example, if
you need to execute an order over
the remaining hour of the day. If
you use a VWAP algorithm to
trade, then based on the volume
distribution you could execute
25%-50% of your order in the
closing auction. This ties your
execution price to the closing
price and samples fewer market
prices during continuous trading.
If your aim is to minimise market
impact by sampling over a period
of time but you have a lower sen-
sitivity to changes in volume pro-
files, then TWAP (Time Weighted
Average Price) can be a useful
algorithm.
Early versions of a TWAP algo-
rithm simply split the order into
portions of equal quantity and
time. At the end of each portion, if
■ ALGORITHMIC TRADING ■ A BUY-SIDE HANDBOOK
stock had not been bought bid
side the algorithm would pay the
offer. Besides, the obvious foot-
print left behind by doing the
same trade in the same size
repeatedly, paying the offer only
because time dictates, will lead to
poor execution quality. Advanced
TWAP algorithms trade in a more
sophisticated manner, deciding the
prices they pay in the market on
the basis of how much they are
ahead/behind and whether it is
the right price, whilst still trying
to achieve an even average.
Important to note here is that
neither VWAP nor TWAP have
any macro level price sensitivity –
the overall profile of execution is
not affected by movements in the
price of the stock. Their aim is to
get the order executed by the end
time, irrespective of price. This
macro price sensitivity needs to be
added by way of price limits. The
inbuilt price sensitivity of these
algorithms will be at a micro level
– i.e. the part of the algorithm
that makes the decisions on the
individual executions of the order.
The price sensitivity here results
in the algorithm deciding how
much risk it can take in order to
take advantage of favourable
prices, the degree of sensitivity
can often be set by a risk aversion
or aggression level. This will dic-
tate to the algorithm how far it
can fall behind before needing to
■ THE TRADE 2005

Honing an algorithmic trading strategy
pay the offer and how far ahead it
can get when buying bid side.
Higher risk aversion generally
results in a tighter standard devia-
tion of returns at the expense of
lower mean performance. The
opposite is true with a lower risk
aversion level.
Inline/Percentage of Volume
algorithms also target an undeter-
mined benchmark. The aim is
purely to participate with market
volume at a rate specified by the
user. The Inline algorithm is sen-
sitive to absolute changes in vol-
ume levels. This results in it
actively participating when vol-
ume trades and scaling back if
volume does not permit. The level
of participation sets the aggres-
sion level of this strategy – i.e.
how much impact you are willing
to have in order to get the trade
completed more quickly. An
investor who wants to trade if liq-
uidity permits but does not want
to have significant impact will
choose a low level, e.g. 5%.
Someone who wants to execute
more quickly at the cost of added
impact will choose an aggressive
level, e.g. 33%. One major con-
cern for this style of execution is
that 33% has become the market
default, and the market impact of
such a high percentage is often
underestimated. For example,
when buying at a rate of 33% and
10,000 shares trade away from
■ ALGORITHMIC TRADING
■ Chapter 4
■ “Generally, Inline algorithms
do not have any macro price
sensitivity besides price limits.
The micro sensitivity is the same
as in VWAP/TWAP, deciding what
price to pay based on your risk
(amount ahead/behind).”
you, you wouldn’t need to buy
3,300 to catch up, you would need
to buy 5,000. This is because you
need to be 33% of the total vol-
ume of 15,000 once you have
traded. Participating at a rate of 45
33% means you have to trade
50% of volume that trades away
and this is amplified as the target
percentages get higher. For exam-
ple, take two buyers at a rate of
33%, combined they would need
to be 200% of any volume missed.
Due to this compounding
nature of Inline algorithms, stocks
are often seen spiralling out of
control, with algorithms partici-
pating at unfavourable levels.
Generally, Inline algorithms do
not have any macro price sensitiv-
ity besides price limits. The micro
sensitivity is the same as in
VWAP/TWAP, deciding what price
to pay based on your risk (amount
ahead/behind). Efficient Inline
algorithms will manage risk in
terms of liquidity and not simply
■ A BUY-SIDE HANDBOOK ■ THE TRADE 2005
 ■ Chapter 4
Honing an algorithmic trading strategy
■ “If you are executing a high
frequency of smaller orders,
the generation of which are often
triggered by the price of the stock,
Implementation Shortfall
algorithms are the most suitable.”
in terms of the actual percentage
it has traded. For example, it is
better to target 30% +/- a normal
trading size in the stock versus
being 30% +/-5%. The latter will
result in inconsistent risk
46 throughout the life of the order.
There will be little risk at the
beginning and therefore no
favourable prices, but high risk
towards the end of the order.
Predetermined benchmarks
Predetermined benchmarks have
been a more recent trend, using,
for example, the mid price at initi-
ation or the previous nights close.
The algorithms to use in these situ-
ations are Implementation
Shortfall and Arrival Price style
algorithms (unfortunately, these
names are sometimes used to
describe the same or different types
of algorithm). What we can do is
split these into two distinct trading
styles, ones with low macro price
sensitivity, which for the purpose
of this chapter we will call
■ ALGORITHMIC TRADING ■ A BUY-SIDE HANDBOOK
Implementation Shortfall, and
ones with high macro price sensi-
tivity, which we will call Arrival
Price.
Implementation Shortfall style
algorithms are designed to min-
imise the average shortfall over a
number of trades. This shortfall is
measured as the difference between
the execution price and the price at
initiation. To minimise this we
need to find the optimal level
between how much we move the
price (market impact) and how
long we work the order (risk). We
know that if we didn’t execute in
the market we wouldn’t have mar-
ket impact but we are exposed to
movements in the stock.
Conversely, if we bought the entire
amount immediately, we would no
longer be exposed to future move-
ments but could have extremely
large market impact.
In order to optimise the execu-
tion, the algorithm will determine
when and how much to trade by
taking into account a number of
factors, primarily the size of the
order, the stock’s liquidity, volatility
and the time remaining. Generally
this will involve being more active
in the market initially, as the stock
price will be at your benchmark
and becoming less active as a high-
er proportion of your order is
completed. This is not a new con-
cept; clients have been using this
trading style for many years.
■ THE TRADE 2005

Honing an algorithmic trading strategy
Typically a percentage of the order
was traded on risk to start, then
worked relatively aggressively in
the market. Once the majority had
been executed more passive execu-
tion would follow. This ultimately
is what the Implementation
Shortfall algorithms do, they
decide how aggressively to trade
based on how much risk they are
offsetting. If the stock had low
volatility then this reduces how far
it is expected to move so you can
afford to be less aggressive and
have less impact. However, with a
volatile stock you can afford more
impact to reduce the larger risk.
For the algorithm to optimise this
trade off it needs to know the full
extent of the order, otherwise it
miscalculates how much risk it is
actually offsetting.
One thing to note about this
type of algorithm is that it will not
necessarily be more aggressive
below the initiation level.
Supporting a stock at a certain
level in the market does not min-
imise market impact. Market
impact isn’t just judged as the
amount you move a stock against
you, it is also a measure of how
much you restrict the stock from
moving for you.
When using an Implementation
Shortfall algorithm, you need the
ability to set macro sensitivities,
such as volume and price caps, but
you also need to understand that
■ ALGORITHMIC TRADING
■ Chapter 4
■ “If a stock is trading on the
favourable side of your
benchmark they [Arrival Price
algorithms] become very
aggressive until the order is
complete. If the stock is moving
away from the benchmark they
become much more passive.”
these can sub-optimise the strategy.
A volume cap might mean you are
unable to be as aggressive at the
beginning of the order when the 47
stock is at the initiation level. A
crucial parameter is some kind of
risk aversion (aggression) setting.
Algorithms have been built with a
risk level in mind. However, your
appetite might be very different.
You may believe you have more
alpha and therefore are willing to
take more impact in order to get
the trade executed quickly and
reduce risk; in this case you should
choose a higher risk aversion level.
Arrival Price algorithms are the
other style of algorithm in this
space. These work similarly to that
of Implementation Shortfall, but
have inbuilt macro price sensitivity
to your benchmark (usually mid at
initiation or a set level such as pre-
vious close). If a stock is trading
on the favourable side of your
■ A BUY-SIDE HANDBOOK ■ THE TRADE 2005
 ■ Chapter 4
Honing an algorithmic trading strategy
Figure 3
Implementation
Probability density
Arrival
Price Shortfall
Price achieved
benchmark they become very
aggressive until the order is com-
48 plete. If the stock is moving away
from the benchmark they become
much more passive.
This results in a different distri-
bution of returns to that given by
the Implementation Shortfall algo-
rithm (Fig. 3). In Implementation
Shortfall we get a relatively sym-
metrical distribution of returns.
However, with Arrival Price we get
a skewed distribution. This is
because we often complete our
order before we get the chance to
participate at more favourable
prices and as we slow down when
the stock moves away we poten-
tially participate at very
unfavourable levels. This skewed
distribution of returns can be seen
in any algorithm with macro price
sensitivity. Inline algorithms that
vary their participation rate
■ ALGORITHMIC TRADING ■ A BUY-SIDE HANDBOOK
according to the price of the stock
will deliver similar results.
Order execution
The proportion of your order exe-
cuted via an algorithm is also
important. If you are executing a
high frequency of smaller orders,
the generation of which are often
triggered by the price of the stock,
Implementation Shortfall algo-
rithms are the most suitable. Given
the entirety of the order the algo-
rithm can work out how best to
optimise execution and minimise
the shortfall on average. However,
if you had a large order that was
also measured relative to the price
at which the investment decision
was made, a standard
Implementation Shortfall algo-
rithm may not be suitable; one rea-
son being optimal execution may
take several days. The algorithm
will need to know completion is
not required by the end of day one
and each day following, it would
need to know all the details of the
previous algorithms.
In this scenario we don’t neces-
sarily have to rule out algorithmic
execution, it just means more con-
trol will need to be taken. You can
still utilise a combination of algo-
rithms to achieve the desired
results. Many people will start
trading aggressively with a small
part of their order using an Arrival
Price or Inline algorithm. As and
■ THE TRADE 2005

Honing an algorithmic trading strategy
when they have completed the
majority of the order or the stock
has moved significantly, they will
start to use the more passive algo-
rithms such as VWAP/TWAP for
remaining portions of the order;
ultimately replicating the trading
pattern of the Implementation
Shortfall strategy.
The point to note here is that
an algorithm is not the be all and
end all for a particular order. For
example, if you had an order that
was benchmarked against VWAP
and you felt you could add value
to the execution, you may put half
of the order into an algorithm and
choose levels to execute the
remaining via other algorithms, a
block desk or DMA.
In summary, when assessing
which algorithm to use you have to
take into account which type best
suits your benchmark. Then you
need to decide on your sensitivity
to changes in price and volume
levels. Algorithms with low sensi-
tivity to price movements will give
you a more symmetrical distribu-
tion in returns for both rising and
falling markets, highly sensitive
ones will give you a skewed distrib-
ution. Sensitivity to volume
changes will ultimately result in
you trading with the crowd and
less independently. Additionally,
you need to decide on your
appetite for risk. Algorithms with
lower risk aversion will give you a
■ ALGORITHMIC TRADING
■ Chapter 4
■ “It is becoming more common
to see algorithms that are
sensitive to additional factors
such as momentum indicators,
mean reversion and relative
performance.”
better mean but at the expense of a
higher standard deviation, and a
higher risk aversion will tighten
deviation but at the expense of the
mean.
The depths to which sensitivi-
ties to external factors can be 49
introduced are endless. It is
becoming more common to see
algorithms that are sensitive to
additional factors such as momen-
tum indicators, mean reversion
and relative performance. In order
to gain access to the best possible
algorithms to suit their trading
styles, investors will need to retain
close relationships with sell-side
brokers who can deliver customis-
able algorithmic solutions as trad-
ing styles evolve. ■
© UBS 2005. All rights reserved.
■ A BUY-SIDE HANDBOOK ■ THE TRADE 2005

Honing an algorithmic trading strategy
Anonymity and
stealth
What assurances can the sell-side offer to safeguard the client’s alpha
capture and minimise information leakage?
Richard Balarkas*
Fareirst let’s be clear what we mean
by anonymity and stealth as they
two quite different things:
Anonymity – Refers to the
expectation that information
relating to the identity of the client,
information which the client must
of necessity give to the broker, is
not divulged in the trading process
or at any subsequent point post-
execution.
Stealth – Refers to the act of
moving, proceeding, or acting in
a covert way. In conflict and
game play this denotes achieving
ones objective without being
detected, uncovering what others
are attempting to conceal or
obscure, and otherwise avoiding
conflict.
Putting it another way, anonymity
is important in instances where
not the order, but the identity of
■ ALGORITHMIC TRADING
■ Chapter 5
who is behind the order, is itself
capable of moving the price.
Stealth is the act of completing
any order in a manner which 51
reveals as little as possible to the
wider market in the hope of min-
imising impact.
Are anonymity and stealth
important?
In 1997 the silver market was in
the doldrums. From July ’97 until
early ’98 its price rose 25% (at
one point it was up 50%). In
February ’98, Berkshire
Hathaway, the investment vehicle
of Warren Buffet, famous for
building large if not controlling
stakes in corporate stocks with
long term value and a strong
brand image, announced that it
had been buying silver. (Buffet
already had a 32-year investment
history during which time *Richard Balarkas,
global head of
Berkshire Hathaway had risen by AES™ Sales, CSFB
■ A BUY-SIDE HANDBOOK ■ THE TRADE 2005
 ■ Chapter 5
Honing an algorithmic trading strategy
■ “Anonymity isn’t restricted to
active managers. Passive
managers also need to take care
that repeated habitual portfolio
slices are not sending signals that
others can learn to anticipate.”
an average 33% each year.) With
regard to silver he had the same
information as everyone else,
essentially that demand was run-
ning ahead of supply and
appeared likely to continue for
52 the foreseeable future. Over a
seven-month period he bought
silver through a single broker
without taking any position in
futures or options. He amassed
what amounted to more than
25% of the world’s supply. Years
later commentators were still
debating whether he had actually
taken delivery of the silver, or still
owned it, or leased it out…
Buffet understands the value of
anonymity and stealth.
He needs to. Regarded by many
as the oracle of the investment
world, Buffet’s every move is
watched via scores of internet sites
selling Buffet-related books and
software, hosting chat room
threads, Buffet-dedicated sites, fan
clubs etc. There is a whole indus-
try out there trying to guess his
■ ALGORITHMIC TRADING ■ A BUY-SIDE HANDBOOK
next move in order to beat the
market to the punch. Any public
statement on his next hunch
would be a self-fulfilling prophecy
as the investment herd try to
anticipate his move. It is not sur-
prising that the last place to look
for his ideas is the Berkshire
Hathaway home page.
Buffet appreciates the value
that can be lost through informa-
tion leakage. So did we at CSFB
when we constructed our
Advanced Execution Services
(AES™) algorithmic trading
capability. Like many of the fea-
tures that are at the heart of our
algorithmic trading service, the
principles of protecting client
anonymity and stealth trading
were already embodied on our
trading floor and in our trading
practices, algorithms simply gave
us a new medium in which to
take anonymity and stealth to the
next level.
Valuing anonymity
From a user perspective, the
process of selecting whose algo-
rithms to use should be based pri-
marily on performance. Piles of
colourful marketing literature may
give some vague insight into how
different broker services are con-
structed and delivered, and the
similarities that are present in
high-level marketing descriptions
of tactic objectives may create the
■ THE TRADE 2005

Honing an algorithmic trading strategy
impression that all broker algo-
rithms are much the same thing
and achieve very similar results.
This is far from true. The con-
struction of trading algorithms
and their further refinement
through practical use is a highly
quantitative process.
Clients clearly believe
anonymity and stealth are
extremely important, and in
seeking to continuously improve
the performance of CSFB’s algo-
rithms it would be ideal to disag-
gregate the performance in order
to focus on those components
where the potential value-add is
the highest. However, the reten-
tion of alpha gained through
anonymity and stealth are hard
components for a broker to
measure.
The benefits of anonymity
will be readily understood by
buy-side traders, many of whom
are regularly handling orders
that are on average multiples of
ADV where revealing the size
alone would be sufficient to
move the price.
However, knowing who is
behind a trade has additional
informational value. The better a
money manager is perceived to be
at stock selection and timing, the
greater the informational compo-
nent of the trade, and the greater
the likelihood that if this infor-
mation leaks out the market will
■ ALGORITHMIC TRADING
■ Chapter 5
Anonymity
Early attempts at
anonymous trading
were not entirely
successful
move in anticipation. And the
benefit of trading with full
anonymity isn’t restricted to
active managers. Passive managers
also need to take care that repeat-
ed habitual portfolio slices are 53
not sending signals that others
can learn to anticipate.
Science of stealth
Whereas anonymity has been
enshrined in CSFB’s AES™ ser-
vice from the start, stealth tactics
can always be improved and is
the area our AES™ developers
find the most exciting. Many
beginners think that playing
poker online will prove to be
completely different than playing
offline and they are sometimes
■
“The retention of alpha gained
through anonymity and
stealth are hard components for a
broker to measure.”
■ A BUY-SIDE HANDBOOK ■ THE TRADE 2005
 ■ Chapter 5
Honing an algorithmic trading strategy
■ “Even if anonymity is assured,
an algorithm will not perform
well unless it uses stealth in order
to take advantage of other traders
and other less sophisticated
algorithms.”
correct, though usually for the
wrong reasons. There is a com-
mon but misguided notion that it
is much harder to ‘read’ your
opponents when you do not see
them sitting at the table. What
54 most fail to recognise is that the
majority of available information
when making a decision comes
from a variety of factors other
than ‘reading’ your opponents
faces. Most of the required infor-
mation comes from patterns,
position at the table and the
hands your opponents play.
It’s the same when you are
trading on a public limit order
book – you cannot see your oppo-
nents but if you can read their
signals they may, often unwitting-
ly, reveal their intentions. At the
same time you must be careful
that none of your actions are giv-
ing your game away. The winner
is the one who can coax traders
on the other side of the touch to
cross the spread and pay the pre-
mium. The winner is the one who
■ ALGORITHMIC TRADING ■ A BUY-SIDE HANDBOOK
can, when necessary, pay inside
the spread or even cross the
spread without being so aggres-
sive as to send out signals, keep-
ing trades ‘information-less’. The
winner is the one who can spot
reversion, whose participation is
overweight on the dips when buy-
ing and on the highs when selling.
So even if anonymity is
assured, an algorithm will not per-
form well unless it uses stealth in
order to take advantage of other
traders and other less sophisticat-
ed algorithms. The use of stealth is
also defensive, as there are plenty
of trading models out there
designed to make money from
reading signals generated by less
sophisticated traders and black
boxes. At the market micro-struc-
ture level stealth is important, and
CSFB’s AES™ incorporates
advanced probability and game
theory tactics in order to outwit
the opposition. ■
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Honing an algorithmic trading strategy

Game theory
Although game theory has been studied since the 1940s, it has only recently been
applied to the world of finance. Game theory champions garnered the 1994 Nobel
Prize in Economics, and, today, this theory is used to analyse everything from the
baseball strike to auctions. Increasingly, game theory is making its mark as a potent
tool for traders.
In simple terms, game theory is the study of conflict based on a formal approach
to decision-making that views decisions as choices made in a game. Whether
playing individually or in a group, each player in a conflict has more than one course
of action available to him, and the outcome of the ‘game’ depends on the interaction
of the strategies pursued by each party. Algorithms can take advantage of the fact
that game theory and probability often have the edge over human intuition. To
illustrate this, here are some problems where the answer does not appear to be
intuitive, and in one case is actually counter-intuitive (for answers and explanations,
see pages 56 and 57):

Problems 55
Example 1.
If you throw a die until the running total exceeds 12, what is the most likely final
total?

Example 2.
This is a demonstration of the power of faith in random decision-making over simple
logic and probability. It was inspired by the format of an old USA TV gameshow ‘Let’s
Make A Deal’, hosted by Monty Hall.
The conundrum is that you are on a game show and given the choice of three
doors: Behind one door is £1million, behind the others nothing. You are invited to
pick a door. The host, who knows what’s behind the doors, opens one of the two
remaining doors to reveal there is nothing behind it. He then invites you to pick again
between the two remaining doors. Is it to your advantage to switch your choice?

Example 3.
You are in a game of Russian roulette, but this time the gun (a six-shooter revolver)
has three bullets in sequence in three of the chambers. The barrel is spun only once.
The two players then take it in turn to pull the trigger. If they live, the gun is passed
to the other player who then pulls the trigger, etc. Would you rather be first or
second to shoot? Continues overleaf ➧

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Honing an algorithmic trading strategy

Game theory (continued)

Answers & explanations

Example 1.
Answer: 13
The way to get a final total of 13 is to build up some total between 7 and 12
inclusive, then make a single throw of the appropriate value.
The way to get a final total of 14 is to build up some total between 8 and 12
inclusive, then make a single throw of the appropriate value.
Thus if we take the list of sequences producing 14, then subtract 1 from the final
throw of each sequence, we will have part but not all of the list of sequences
producing 13. Moreover, corresponding sequences are equally likely to occur,
because they contain the same number of throws. Thus 13 is strictly more likely than
14. A similar argument shows that 14 is strictly more likely than 15, and so on. Hence
13 is the most likely total

56 Example 2.
Answer: You should change your choice.
The problem is called ‘counter-intuitive’, because the answer seems for many to defy
instinct and logic, even after it’s been explained several times. Most contestants on
Monty Hall’s show were apparently reluctant to change their original choice for fear
that it was right, or because intuitively they felt that probability could not be altered
by revealing one of the ‘losing’ doors.
The door you originally chose was a 1-in-3 chance – i.e., the likelihood of your
guessing the winning door was 1-in-3. The ‘other’ door is now a 1-in-2 chance, and
the likelihood of your guessing the ‘other’ door to be the winning door is 1-in-2. You
are 50% more likely to correctly guess a 1-in-2 chance than a 1-in-3 chance, so pick
the other door in preference to your original choice of door.
If you’re still in doubt, imagine there are 20 doors – one has the money, the
others nothing. You pick a door. Then 18 doors are opened revealing nothing, leaving
your choice and the one other door. Would you change your choice now? By
switching doors you’d improve your chances from 1-in-20, to 50:50 evens, or
(depending on how you look at it) arguably 19-in-20. Still sceptical? How about 100
doors? Pick a door. Open 98 revealing nothing, leaving two doors, one a winner and
the other a loser. Would you still prefer your original 99-to-1 shot compared to the
alternative that is at worst 50:50, and arguably a massive 99% chance?

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Honing an algorithmic trading strategy

Game theory
Answers & explanations

Example 3.
Answer: Player 2 is preferable.
All you need to consider are the six possible bullet configurations:

BBBEEE ➠ player 1 dies

EBBBEE ➠ player 2 dies
EEBBBE ➠ player 1 dies
EEEBBB ➠ player 2 dies
BEEEBB ➠ player 1 dies
BBEEEB ➠ player 1 dies

57

■ ALGORITHMIC TRADING ■ A BUY-SIDE HANDBOOK ■ THE TRADE 2005


Honing an algorithmic trading strategy
Customising the broker’s
algorithms
How much flexibility does the buy-side trader require to adjust and
fine-tune the broker’s algorithmic models?
Richard Balarkas*
A s conference organisers try to
squeeze more and more ‘algo’
events into an increasingly crowd-
ed space, the topics to be discussed
by their expert panels seem
increasingly innovative. So whilst
the majority of money managers
have yet to enjoy their first algo-
rithm experience, many conference
organisers are already filling their
bills with debates headlined –
‘Algorithms: does one size fit all?’ –
‘Algorithms: is customisation the
future?’ – and, ‘Algorithms: canned
or customised?’
What I want to do in this short
chapter is explain how customisa-
tion is not a future trend, but a fea-
ture that has been around since day
one. At the same time I want to
show how it is incorrect to cate-
gorise all broker-provided algo-
rithms as ‘canned’, as if they were
the trading equivalent of a fast
■ ALGORITHMIC TRADING
■ Chapter 6
food hamburger outlet. Not so – if
you want your algorithm on organ-
ic bread with the gherkin removed 59
from the pickle, your initials
spelled out in caviar on top with
strips of spring onion laying strict-
ly north to south (Tuesday and
Fridays only) – it would be our
pleasure.
It is important to recognise that
the term ‘algorithm’ has, unfortu-
nately, been stretched to include
not only the most complex mathe-
matical trading models but also
very mechanical and simplistic
trading techniques such as ‘ice-
berging’ (the simple drip feeding of
an order into the market in pre-
defined clip sizes). In some cases
even ‘stop loss’ orders have been
defined as algorithmic tactics.
There is nothing disreputable
about this – good results can be *Richard Balarkas,
global head of AES™
achieved using these tactics if you Sales, CSFB
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 ■ Chapter 6
Honing an algorithmic trading strategy
■ “The ability to tweak the
parameters means there is
significant scope for customising
each algorithm on an order by
order basis.”
pick the right spots, but it is
important to recognise that some
algorithms are more… well, ‘algo-
rithmic’ than others. For example,
those designed to anticipate vol-
ume curves, react dynamically to
complex signals, and trade with
60 stealth to minimise impact are far
more advanced than their more
mechanical stable mates and, as a
result, are offered by fewer brokers.
It is worthwhile making this dis-
tinction between the more complex
algorithms and simplistic mechani-
cal options. ‘Customising’ the latter
is not particularly challenging, and
it is understandable that users
might perceive such tactics as all
being the same regardless of the
provider.
Leading on from the above, if
the serious algorithms are such
complex beasts in which highly
qualified knowledge engineers at
the major brokerages have embod-
ied the firms trading skills, the first
issue worth exploring is why a
client might wish to customise an
algorithm at all. Algorithms are,
■ ALGORITHMIC TRADING ■ A BUY-SIDE HANDBOOK
after all, efficiency tools. Over and
above deciding which order is suit-
able for trading through which
strategy and at what point in time
to execute, many traders do not
necessarily want to have to consid-
er too many other factors – it may
be counter productive. As a result,
we aim to ensure that our algo-
rithms are optimised to deliver the
best performance without any
additional input from the end user.
For many traders this approach
works perfectly well.
Customising to order
Perhaps the first step towards cus-
tomisation happens when a trader
decides to adjust one of the para-
meters available with each tactic –
typically, start and end times,
price limit, aggression level, min
and max percentage volumes. The
ability to tweak the parameters
means there is significant scope
for customising each algorithm
on an order by order basis, even
to the extent that different tactics
can be forced to perform like oth-
ers, or combinations of others.
For example:
■ A trader who wanted to trade
‘volume in line 20%’ but didn’t
want the tactic to rigidly stick to
the 20% target irrespective of
price opportunities, might
instead use ‘price in line with a
15% min and 25% max’ – which
■ THE TRADE 2005

Honing an algorithmic trading strategy
would then aim to be on average
20% participation, but could
speed up or slow down within
the 15-25% range to respond to
pricing fluctuations.
The further step towards cus-
tomisation is when a trader finds
that his personal preference is
leading him to consistently use
the same tactic with the same
parameter adjustments for cer-
tain sectors or markets. In this
instance a request can be made to
adjust the default settings for that
client so that the revised parame-
ters are always used. The revised
tactic can be re-named if the
client also wishes to continue
using the default version.
Examples of this are:
■ A trader who always wants to
finish by 2pm GMT ahead of
US opening. All selected tactics
are defaulted to finish at that
time.
■ A trader in French mid-caps
who is less interested in poten-
tial impact and more interested
in grabbing available liquidity
might ask for the TEX strategy
to default to very aggressive
mode for these stocks.
■ A trader who trades VWAP in
the morning period but wants
the curve skewed to be more
aggressive/overweight at the
■ ALGORITHMIC TRADING
■ Chapter 6
start of the trading period and
less aggressive towards the end.
Beyond such requests, clients also
approach CSFB with ideas for
custom strategies, usually varia-
tions on the menu tactics we pro-
vide, examples of which it would
be inappropriate for us to reveal
as they offer real competitive
advantage to the client. These
ideas represent the desire of
traders to further automate their
own trading style; in effect when
they come to us with these
requests they have developed their
own strategy and are simply ask-
ing CSFB to put them into prac- 61
tice. For example:
■ When the stock gaps I like to…
■ Cross asset correlations – when
trading mining stocks I want
participation curves that
respond dynamically to com-
modity prices…
■ I have buy and sell baskets, I
want to maintain any natural
hedges as it progresses and keep
both sides dollar neutral…
■
“Customisation has been
around from the start. Indeed,
it is hard to see how the product
could have worked had it not.”
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Honing an algorithmic trading strategy

One other area of customised algorithms, the buy-side needs to

automation offered on AES™ is
our ‘Storyboard’ product.
Storyboard automatically sends
clients messages triggered by
price movements, news, volume
spikes etc. in the stocks they are
trading in AES. Here again, all the
trigger limits are configurable by
the client.
assess the merits or otherwise of
insourcing versus outsourcing.
Hopefully, this chapter gives those
who have yet to adopt algorithms a
better understanding of the current
scope of customisation and flexi-
bility that is already available. ■

FAQ
Customisation has been around

■
from the start. Indeed, it is hard to
see how the product could have “There is a view,
worked had it not. There is a view,
inaccurate in our opinion, that bro- inaccurate in our
62 ker algorithms are canned and opinion, that broker
therefore inflexible. Hopefully, the
examples that have been outlined algorithms are canned
prove otherwise. There are also and therefore
views expressed that all broker algo-
rithms deliver the same perfor- inflexible.”
mance, that they are ‘commoditised’.
We have not been presented with
evidence that shows this to be the
case, but it is understandable how
this viewpoint might add weight to
the argument that the only valuable
algorithm is a customised algo-
rithm. In our experience, even using
the ‘plain vanilla’ versions of our
algorithms, different clients achieve
different results – from good to
excellent!
As with all aspects of the buy-
side/sell-side relationship, be it
research, trading or the develop-
ment and use of trading

■ ALGORITHMIC TRADING ■ A BUY-SIDE HANDBOOK ■ THE TRADE 2005