7 Execution Algorithms You Should Know About….

So, you want to execute an order that would potentially not only impact the price and volume of the security, but also put you on the radar? How about you don’t execute the entire order at once, and instead use the Execution Algorithms discussed in this article, that are also commonly used by institutional traders and other trading firms?

Before we jump into the different types of Execution Algorithms, let’s revise a few head points of Algorithmic Trading first…

Introduction

Algorithmic Trading is the process of executing trades/transactions in the market automatically. In other words, instead of you looking for a trend reversal or a channel breakout to buy those 100 shares of Reliance, you let a computer program do it all for you.

The program would be coded to look for certain signals in the movement of the stock price, volume or even other correlated stocks, depending on your trading strategy, in order a send a buy/sell signal and execute your order. And, the best part is all of this is done in mere seconds.

Why Algorithmic Strategies Are Used

• Speed and Efficiency: Algorithms can process and react to market data much faster than human traders.
• Cost Reduction: Lower transaction costs due to reduced need for human intervention and optimized trade execution.
• Consistency: Algorithms follow predefined rules without emotional bias, leading to more consistent trading performance.
• Scalability: Ability to manage and execute large volumes of trades simultaneously.
• Market Liquidity: Increased liquidity as algorithms continuously buy and sell assets.
• Complex Strategies: Capability to implement complex trading strategies that are difficult for human traders to execute manually.

TYPES OF ALGORITHMS USED FOR ORDER EXECUTION:

1. Volume Weighted Average Price (VWAP)

VWAP is the average price of a security weighted by the total trading volume over a specific period. It is used to measure the performance of trade executions against the overall market.

How It Is Calculated:

VWAP is calculated by taking the total value of all trades in a security (price multiplied by the number of shares traded) and dividing it by the total number of shares traded over the same period.

The formula is:

How It Is Used:

The algorithm executes portions of the order throughout the trading period to match the VWAP.

It is suitable for large order that may influence the price of the security if executed at once and it is also used a technical tool/benchmark by institutional investors/traders.

Advantages:

• Provides a benchmark to evaluate execution quality.
• Reduces the likelihood of significantly moving the market.

Disadvantages:

• Not very effective in highly volatile markets.
• May result in missed opportunities if the market moves favorably away from the VWAP.

2. Time Weighted Average Price (TWAP)

TWAP is an execution strategy that is similar to VWAP, but this time, we use time as a weight instead of Volume. It spreads orders evenly over a specified time period, disregarding volume fluctuations. It aims to achieve an average price over that period.

How It Is Calculated:

TWAP is calculated by taking the sum of the prices at each time interval and dividing it by the number of intervals. This gives the average price over the specified time period.

The goal is to minimize market impact and execute the order in small and even chunks. TWAP is calculated using the following formula:

Where:

• N is the total number of time intervals.
• Pi is the price of the asset at the i-th time interval.

How It Is Used:

It is best suited for markets with a stable movement or where the volume fluctuations are limited.

Advantages:

• Simple and predictable execution.
• Reduces market impact by spreading trades over time.

Disadvantages:

• Ignores volume patterns, potentially missing periods of high liquidity.
• Not adaptive to changing market conditions.

3. Implementation Shortfall (IS)

Implementation Shortfall (also known as slippage) measures the difference between the decision price and the actual execution price (so, it includes, slippage, broker charges, commission etc.), incorporating both market impact and opportunity cost.

How It Is Calculated:

This algorithm, unlike VWAP and TWAP, focuses on minimizing the execution cost of the order instead of minimising market impact. The algorithm constantly adjusts its execution based on market conditions and the urgency of the order.

It is calculated using the following formula:

Implementation?Shortfall = (Execution?Price ? Decision?Price) × Quantity + Explicit?Costs

How It Is Used:

As you may have already guessed, it is best suited for executing urgent large orders at a minimal cost.

Advantages:

• Flexible and adaptive to market conditions.
• Balances speed and cost, aiming to achieve the best overall execution price.

Disadvantages:

• Complex and requires sophisticated modeling and real-time market analysis.
• May result in higher costs if not correctly tuned to market conditions.

4. Percentage of Volume (POV)

POV, or Participation Rate, executes orders as a specified percentage of the market volume, ensuring the order is a consistent part of market activity. In other words, it executes only the portion of the order that would blend in with the market volume at a time.

How It Is Calculated:

The way it works is, let’s say, you only want to occupy 5% of the market volume per trade, the algorithm will then allocate the corresponding portion of the order. Similar, to the IS model it constantly adapts to the fluctuating volume. The formula for calculating the Order Volume is:

Where:

• OV is Order Volume at a Time
• TMV is the Total Market Volume
• PR is Participation Rate (i.e. the total market volume the order will occupy)

How It Is Used:

This algorithm can be considered a combination of VWAP and IS, and hence, is best suited for executing large trades in small portions, without impacting market volume or prices.

Advantages:

• Adapts to market volume, ensuring participation without overwhelming the market.
• Reduces market impact and aligns with the overall market activity.

Disadvantages:

• Execution may be slow in low-volume markets.
• May not capture optimal prices if the market moves rapidly.

5. Iceberg Orders

Iceberg orders are among the most popular algorithms. These are large orders that are split into smaller visible portions to hide the true size of the order from the market.

How It Works:

These algos execute your order in very small chunks (tip of the iceberg), which keeps the majority of the order hidden. Once these small orders are executed one at a time, the next order is placed, and the process repeats itself until the entire order is executed.

How It Is Used:

Its works well at maintaining the anonymity of the trade by not impacting the market volume and only executing small portions at a time making for a good average price.

Advantages:

• Reduces the risk of market impact by hiding the order size.
• Allows for gradual execution, minimizing price slippage.

Disadvantages:

• May take longer to execute the full order.
• Opposing algorithms may detect iceberg orders and act against them.

6. Smart Order Routing (SOR)

These algorithms run orders through different exchanges and Electronic Communication Networks (ECNs) to choose the one best suited for the order execution.

How It Works:

The algorithm evaluates different trading venues, including exchanges and dark pools, and determines the optimal execution path. It, then, dynamically routes orders to achieve the best price and execution quality.

How It Is Used:

It is a great tool for comparing executions across multiple different markets. It is ideal for trading in fragmented markets with multiple liquidity sources.

Advantages:

• Optimizes execution quality by leveraging various liquidity sources.
• Reduces transaction costs and improves fill rates.

Disadvantages:

• Complex to implement and requires real-time market data integration.
• May result in higher latency if not properly optimized.

7. SMRT (Smart Market Routing Technology)

SMRT (Smart Market Routing Technology) is an even more sophisticated algorithm that combines features of SOR and other advanced strategies to optimize execution by considering multiple factors such as price, volume, and market conditions.

How It Works:

The algorithm continuously monitors market conditions and dynamically adjusts routing decisions to optimize execution. It can incorporate various execution strategies (like VWAP, TWAP, IS) and adapt based on real-time data.

How It Is Used:

SMRT is suitable for trade looking to optimise their trade execution over multiple dimensions. These algorithms are quite commonly used in HFT and institutional order executions.

Advantages:

• Highly adaptive and flexible, providing superior execution quality.
• Integrates multiple strategies to meet complex execution objectives.

Disadvantages:

• Requires advanced technology and significant computational power.
• Can be expensive to develop and maintain.

Conclusion

Each of these algorithmic strategies offers unique benefits and is suitable for different trading scenarios. The choice of algorithm depends on factors such as the size of the order, market conditions, and the trader's objectives. Sales traders often use a combination of these algorithms to optimize execution and achieve the best possible outcomes for their clients.