DECODING

WALL ST

ALGORITHMS — the difference between you and

the people who actually make money on Wall Street

What Are Algorithms?

Algorithms are the math computers use to make decisions.

ALGORITHM

1 They process
huge data sets 2 Use advanced
math to find
patterns
3 Make predictions
based on
probability.

Algorithms are used in well-known products, like:

Google Search Amazon Book Recommendation

Financial Algorithms

Algorithms are also used in investing. Financial engineers create algorithms to

analyze and buy or sell stocks, and other financial instruments automatically. In

75%
the past 10 years, algorithmic trading has become a huge factor in trading.

of today’s global

VOLUME markets is driven

by algorithms.

75% volume is
25% volume is
executed by algorithms
executed by humans
(55% done by
high frequency shops)

Incredible Performance

Funds that use algorithmic strategies exclusively have performed exceptionally well
historically, beating benchmark indexes. Total returns for the past five years:

465%
371%
293%

-0.75%
Benchmark Industry Leader Industry Leader Industry Leader
S&P 500 Index Renaissance SAC Capital PDT Advisors
Medallion Fund

The Algorithm Advantage

Algorithms have changed the global investment game, putting individual investors
at a major disadvantage to investment banks and hedge funds.
Here are some of the reasons why:

Advantage 1: Process More, and Faster

Algorithms take advantage of computers’ ability to process data. They can compare price
and metrics of millions of financial instruments faster than individuals.

Advantage 2: Emotionless
Emotions can get in the way of sound investing, causing many to buy when prices are
going up and sell when they are going down. In contrast, algorithms buy when the
market prediction says buy.

1,000 WAIT!
BUY Shares SELL!
NO!!!!

Advantage 3: Execute Faster

Algorithms are operated on computers, which react faster than humans to market changes.
With low-latency fiber optic cables* connecting the world’s biggest markets, algorithms can
trade near the speed of light, which is significantly faster than your WiFi connection.

NEW YORK
LONDON There and back in
5,443 km
55.7 milliseconds

2x faster than
the average blink

*Banks and funds pay millions of dollars a year to access these networks, but they use algorithms to take advantage of the speed.

Advantage 4: Manage Risk

Algorithmic strategies can be developed to make calculated decisions balancing risk

and reward to maximize profits and minimize losses. Stop-Loss controls can be added to
automatically liquidate a position if an algorithm loses more than an defined percentage.
Risk algorithms are also used to manage correlated instruments in a portfolio,
limiting exposure to big losses.

Oil price
vs
Canadian Dollar

Positive correlation
Potential risk
Potential reward high

Types of Algorithms

Investment managers may use algorithms to analyze trades, and buy or sell manually
based on the algorithm’s suggestions, or may allow the algorithm to trade
automatically, intervening on occasion. Algorithms that are 100% automatic
are called black box because the decision-making process is hidden in code.

BLACK BOX

human intervention

DISCRETIONARY
TRADING 100% AUTOMATIC

An algorithmic investment system is made up of algorithms that

fulfill specific functions.

Alpha Model Risk Model Transaction Cost Model

Predicts future profitability Limits exposure to assets Verifies that potential profits
of instruments in portfolio with high risk and low reward are greater costs of trades

Portfolio Construction Model

Determines ideal portfolio holdings based on input of alpha,
risk and cost models, and makes trade orders.

Execution Model
Analyzes the trade orders and the liquidity of the market to
place orders in the most efficient way, for the best price

Source: Inside the Black Box

Algorithmic Strategies

Below are a few types of strategies that are commonly used in algorithmic trading.

TREND
FOLLOWING
These strategies follow
general trends in a set of data
by comparing historical and
current prices, profiting
whether prices go up or down
$
$
MEAN
REVERSION ARBITRAGE
The philosophy behind these These strategies depend on
strategies is that stocks have speed to catch price
an average price over time. imbalances between different
They use historical data to markets.
compute an average price.

NEWS HUMAN
READING SENTIMENT SCALPING
These strategies scan the These strategies scan social These strategies
news and invest based on networks and make trades act like market makers,
what is happening in the influenced by how anxious or and make small profits
world. News wires have been positive people feel. on differences in a
adapted for these algorithms. bid/ask spread.

HIGH FREQUENCY
TRADING
Operating at the millisecond
level, these strategies use
arbitrage or scalping
techniques at high volumes
and super fast speeds.
ICEBERGING STEALTH
This cost-reduction strategy The strategy of these
works to conceal large orders algorithms is to uncover the
by breaking them into smaller large iceberged orders
orders, executed over time. that have been cut into
smaller orders.

Criticism for Algorithms

Algoritmic trading, specifically high frequency strategies have come under criticism
in the past few years. According to a study by the British research group Foresight,

“While no systematic evidence that HFT reduced stability, the interactions

between algorithms may cause instability different from interactions between human.”

Algorithms have been blamed for:

LONG-TERM CAPITAL FLASH CRASH

MANAGEMENT
—1998—
The quant hedge fund was highly leveraged
in the fixed-income market that went bust
when Russia defaulted on their bonds. The
Federal Government organized a bailout to
a avoid global financial crisis.
—MAY 6 2010—
Waddell & Reed Financial Inc., a mutual
fund ran an execution algorithm that set
off a feedback loop among HFT, sparking
the largest intraday dip in the Dow’s
history–998.50 points.

BETTER ALTERNATIVE TRADING SYSTEM (BATS) IPO

—MARCH 2012—
At the IPO of the BATS electronic exchanges, a trading glitch drove the stock’s shares from
their opening price of $15.25 to 3.8 cents, forcing the company to halt trading and withdraw
their IPO. On the same day, Apple stocks dropped 9% on one share on BATS Global Exchange.

Made by Quants

Financial algorithms are written by quants, or quantitative analysts. Quants use

computer programming languages to design algorithms, drawing on advanced
math techniques, and scientific thinking and as well as knowledge of financial markets.

Algorithms are commonly written in:

C++ Java C#
While there are several degree programs, many top quant shops hire based on
skills in science and math, with no background in finance required. According to
QuantNet, the top five Masters programs in 2011 were:

INSTITUTION DEGREE
1 Carnegie Mellon University Computational Finance
2 Princeton University Master in Finance
3 Columbia University Financial Engineering
4 New York University Mathematics in Finance
5 Baruch College Financial Engineering
SOURCES:
Kevin Slavin: How Algorithms Shape Our World- Wikipedia Quantitative Analyst
Ted.com http://en.wikipedia.org/wiki/Quantitative_analyst#Algorithmi
http://www.ted.com/talks/lang/en/kevin_slavin_how_algorith c_trading_quantitative_analyst
ms_shape_our_world.html Inside the Black Box: The Simple Truth About Quantita-
Wikipedia Renaissance Technologies, SAC Capital tive Trading—Rishi K Narang
http://en.wikipedia.org/wiki/Renaissance_technologies Long-Term Capital Management—Investopedia
http://en.wikipedia.org/wiki/SAC_Capital_Advisors http://www.investopedia.com/terms/l/longtermcapital.asp#a
PDT xzz22KkYpb79
http://www.thetradenews.com/print.aspx?id=5402 How a Trading Algorithm Went Awry—WSJ.com, Tom
Is the Market Rigged? Lauricella, Kara Scannell and Jenny Strasburg
http://finance.yahoo.com/blogs/daily-ticker/market-rigged- http://online.wsj.com/article/SB10001424052748704029304
absolutely-says-streettalk-advisors-ceo-174425615.html 575526390131916792.html
Trading at the Speed of Light—Bloomberg Business- Dow Takes a Harrowing 1,010.14-Point Trip–WSJ.com,
week, Matthew Philips Tom Lauricella and Peter A. Mckay
http://www.businessweek.com/articles/2012-03-29/trading- http://online.wsj.com/article/SB10001424052748704370704
at-the-speed-of-light 575227754131412596.html
New York—London Fiber Optic BATS IPO Canceled in Share Crash—The Street,
http://www.hiberniaatlantic.com/services.html Antoine Gara
Algorithms Take Control of Wall Street—Wired, Felix http://www.thestreet.com/story/11468126/1/bats-global-
Salmon and John Stokes flash-crashes-on-ipo.html
http://www.wired.com/magazine/2010/12/ff_ai_flashtrading/ The Bats Affair: When Machines Humiliate Their
Blink Speed Masters—BLoomberg Businessweek, Brian Bremner
http://bionumbers.hms.harvard.edu/bionumber.aspx?s=y&i http://www.businessweek.com/articles/2012-03-23/the-
d=100706&ver=0 bats-affair-when-machines-humiliate-their-masters

Wikipedia Algorithmic Trading
http://en.wikipedia.org/wiki/Algorithmic_trading#cite_note-
54
Foresight Study
http://www.bis.gov.uk/foresight/our-work/projects/current-
projects/computer-trading/working-paper
Apple Flash Crash: Stock Halted After Trade Causes
9% Plunge—CNBC, John Melloy
http://www.cnbc.com/id/46835129/Apple_Flash_Crash_Sto
ck_Halted_After_Trade_Causes_9_Plunge
QuantNet
https://www.quantnet.com/pages/mfe-programs-rankings/

www.quantconnect.com