algos Developments in Algorithmic Trading

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overload
Matthew Samelson
Senior Analyst Aite Group

Algorithm
David Easthope
Senior Analyst Celent

Algorithms meteoric rise to essentiAl trAding tool brings greAter efficiency to trAding, encompAsses unchArted chAllenges.

The nascent trend of algorithm consults illuminates a new chapter in electronic trading: algorithm overload. The consultants are emerging as a resource to help traders determine which algorithms to employ to meet their trading objectives an increasingly difficult task due to the sheer volume of algorithms, many of them indistinguishable on the surface.

Algos
Developments in Algorithmic Trading

Matthew Samelson, a senior analyst with Boston-based consultancy Aite Group, says this next wave for algorithms is a highly valued service because these consultants with financial engineering or money-center financial backgrounds have in-depth knowledge on how to perform valid statistical analysis that helps determine which algorithms perform best under specified circumstances. Youve got a plethora of algorithms that to the naked eye all seem to work the same, Samelson says. And if youre a particular trader with particular benchmarks and youre trading particular types of securities, how can you really tell what the best algorithms are to help you leverage your workflow? Samelson anticipates that the analysis may become sophisticated enough to redirect flow on a daily or even real-time basis. Were at the forefront of a lot of this, he says. I imagine the margin of error will get smaller and the quality of results will get better.

In terms of providing algorithms to the developed U.S. capital markets, Easthope believes things are pretty tapped out. Whats next? he asks. Its difficult to point to any one particular issue. Theres a bit of exhaustion of opportunities. I dont want to say that there are no opportunities, but I think the obvious opportunities have been exploited.

algorIThm opporTunITIes
The opportunities Easthope does see: As an overall market, I think algorithms are very much here to stay, especially if you look globally because of the increasing use of algorithms across the European equity markets. He cites as impetus for European change the new regulatory landscape born of MiFID and the new concentration rules as well as the changing technology landscape with respect to smart order routers. I think that there will be a greater focus on trading equities and options simultaneously, he predicts. Theres a large global shift toward options. And certainly in these volatile markets, theres money to be made in options. Another area of potential development, though one that would not cause a huge shift in the market, he says, might be a gap in terms of high-frequency active traders looking to trade on a more sophisticated basis. There might be a focus more on smaller accounts, such as small hedge funds and smaller high-net-worth individuals who might like to see more algorithms made available to them, he says. Aites Samelson, on the other hand, predicts that new algorithms will continue to flood the market. Its also going to be increasingly hard to evaluate them, he says. The algorithms are going to become more advanced and more complicated, which means it becomes more important to really understand what they do for you and how well they do it. Among the advanced developments Samelson envisions are complex types of algorithms designed to handle the risk aspects of portfolios. On a particular portfolio of stocks being traded, the algorithm will not only control the execution of all the stocks as individual stocks, but it will look at the overall profile of the trade and control various risk elements and the integrity of the aggregate trade. Algorithms serve a very good and important purpose in terms of leveraging traders abilities and their effectiveness in the marketplace in terms of getting quality executions. Samelson says. The caveat is it doesnt help you if you dont understand the algorithmic arsenal at your disposal. Samelson advises traders to wade through the noise and the overload to find the set of algorithms that can add value to their particular style or type of trading or trading objective, however they choose to approach it. Its not an easy task, and it is not static, he says. Once youve found what you believe your optimal mix is or your optimal group of providers for algorithms, you need to constantly reevaluate to ensure that the right mix of algorithms are being used to the extent they can be used. n

IT spendIng
David Easthope, a senior analyst with Boston-based consultancy Celent, predicts continued heavy algorithm usage, but he anticipates a retrenching in algorithm development. We think these advanced analytics, algorithms, are going to be less significant going forward in terms of IT spending, he says, highlighting key findings from a new Celent report, Securities & Investments IT Spending Update: Navigating the New Volatility, November 2008. Certainly the last year or so theres been an emphasis on tapping into new venues, dark liquidity, sweep through different order books, find resident liquidity and match those orders, he observes. I think those have been quite important and definitely a significant development over the last few years. He notes, however, that natural cycles occur. When market conditions are good and there are new developments, theres a lot of spending on front-office tools, Easthope says. When markets retreat and theres the dreaded r word, recession, and layoffs hit, firms take a finer comb to their risk-manage functions, their operations, their compliance. They tend to focus on operational efficiency initiatives, rationalization of existing systems, etc. So I think were going to see a shift in that direction. In addition to shifting IT priorities, market conditions have changed the game, says Easthope, pointing to two algorithm innovators that have been hit by the global financial crisis: hedge funds and sellside firms. The hedge fund weakness is definitely going to put a damper on demand for algorithmic tools, he notes. These hedge funds, primarily the quantitatively-driven ones, are leaders in developing algorithms with their advanced strategies. The development of increasingly sophisticated strategies also has been driven by the sellside and its proprietary trading, which has been hit pretty dramatically, says Easthope. Their prop shops, Im sure many of them are sources of losses. If theyre not closed down or merged away, theyre rethinking how much risk theyre taking. And certainly providing algorithms to these clients could potentially suffer, he says.

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The Credit Suisse AES Vision Statement:

Smarter. Faster. Cheaper.*

*Since 2001, each year at Advanced Execution Services (AES), we have strived to make algorithmic trading a
bit smarter, a bit faster, and yes, a bit cheaper too. Try AES and see the results1 of this simple vision.
1

In 2008, AES again was voted Best Performing Algorithms in the Tabb Report, with 43% of head traders voting us #1 vs. only 23% for our nearest competitor. AES was also #1 in algorithmic penetration in all three regions (Americas, Europe, and Asia) in another leading industry survey.

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algos
Developments in Algorithmic Trading

As one of the worlds leading banks, Credit Suisse provides its clients with investment banking, private banking and asset management services worldwide. Credit Suisse offers advisory services, comprehensive solutions and innovative products to companies, institutional clients and high-net-worth private clients globally, as well as retail clients in Switzerland. Credit Suisse is active in over 50 countries and employs approximately 63,000 people. Credit Suisses parent company, Credit Suisse Group, is a leading global financial services company headquartered in Zurich. Credit Suisse Groups registered shares (CSGN) are listed in Switzerland and, in the form of American Depositary Shares (CS), in New York. Further information about Credit Suisse can be found at www.credit-suisse.com.

Advanced Execution Services Advanced Execution Services (AES) is Credit Suisses awardwinning suite of algorithmic trading strategies, tools, and analytics for global trading across equities, options, futures, and foreign exchange. With AESs tools, traders can work orders on multiple liquidity pools, increase productivity by automating trading and improve execution performance. AES helps more than two thousand institutions and hedge funds reduce market impact, improve performance versus benchmarks, and add consistency to their trading processes. The AES team is dedicated to a philosophy of constant improvement and innovation. The platform has been consistently ranked as the leader in global industry surveys.

Exe c uti v e s
Manny Santayana
Head of Advanced Execution Services (AES) Global Sales Credit Suisse Group 212.325.5300

upfront

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Algorithms Address Market Challenges

Equity market conditions over the past few months have been truly unprecedented. Record equity volumes and extreme volatility have suddenly become the norm. But electronic trading has risen to the challenge. In this new market environment, traders reliance on algorithms and other sophisticated tools is stronger than ever and is helping to drive demand for ever-more innovation from their providers. Jeff Brown, senior vice president of Electronic Brokerage Services for Fidelity Capital Markets Services, a unit of Fidelity Investments, discusses how developments in electronic trading are helping buyside and sellside traders consistently achieve best execution in this new paradigm.

How have the recent market events impacted trading? The trading conditions of the past several months highlight the importance and challenges of the recently implemented Regulation NMS. Traditional exchanges are now highly automated and high-frequency algorithmic trading firms have quickly penetrated the Listed marketplace. This, in turn, has contributed to a dramatic increase in liquidity. Market-wide domestic share volume averaged 12.3 billion shares in October, including an all-time high of 19.4 billion shares traded on October 101. These volumes would have been unthinkable in the pre-Reg NMS trading environment. While increased liquidity is good for traders and investors, it has its consequences. Elevated levels of order, execution, and quote traffic can put tremendous stress on the industrys trading systems. But despite the recent volatility, the markets underlying infrastructure has proven remarkably resilient.

markets stability, both by distributing increased volumes over a broader network of trading systems and by providing inherent redundancy to the market. While this diversification is beneficial to the industry as a whole, it comes at a significant cost for many market participants in the form of fragmentation. Historically, there have been only a handful of relevant venues and liquidity was heavily concentrated in the largest two or three. Today, equity trading is dispersed across approximately 50 trading venues, including some 40 non-displayed dark markets. Fragmentation presents a number of challenges for traders and technologists. The sheer number of venues and the connectivity effort involved in accessing all of them is daunting. Equally daunting is the challenge of researching and understanding the different matching logic and structural nuances of the various systems. Finally, after reconciling connectivity and rule set issues, firms must institute routing logic to help determine how to access these various markets. Developing algorithms that respond to real-time market conditions and can make decisions dynamically requires next-generation statistical techniques and logic.

Besides market volatility, what are some of the other challenges? Fragmentation continues to be a major issue for the industry. The growth in the number of trading venues has been critical to the

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algos
Developments in Algorithmic Trading

How do algorithms address these challenges? Algorithms have never been more critical to sourcing liquidity. At Fidelity, we are continually upgrading the algorithms that power our various execution products. For example, traditional quote-oriented routing techniques are inefficient in the existing trading landscape. They are particularly ill-suited to navigating the non-displayed markets, which by definition do not broadcast a quote. We have invested in next-generation heuristic algorithms that have been designed to navigate the modern marketplace. These new techniques are a significant improvement over rigid, quotebased routing methodologies that tend to lose their effectiveness as the percentage of off-exchange volume grows. Our new routing techniques are quote-neutral, and operate equally well in both displayed and non-displayed venues.

the market. The more volume we route, the more precise that picture becomes. This continuous feedback process allows our algorithms to adapt in real-time, improving the quality of our routing decisions.

How is Fidelity helping traders address the challenges? Clients continue to turn to Fidelity for the strength of our technology and our commitment to client service. Our high-speed, highperformance, and scalable architecture offers strong performance in todays highly automated marketplace where best execution is often measured in milliseconds. But technology is not enough. Our trading consultants work with traders to better understand their investment goals and execution objectives. Weve found that by carefully tailoring trading solutions to our clients needs, they are able to realize significant savings in both market impact and execution costs. Regardless of their trading strategy, were there to help our clients meet their investment objectives. n

Can you talk some more about what differentiates your algorithms? We believe that access to liquidity is critical to best execution, so we have devoted a lot of effort to extending the breadth and

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Jeff Brown
Senior Vice President of Electronic Brokerage Services for Fidelity Capital Markets Services (FCMS), a unit of Fidelity Investments

upfront
 urnewroutingtechniques O arequote-neutral,andoperate equallywellinbothdisplayed andnon-displayedvenues.

depth of our liquidity reach. We connect our clients to one of the industrys broadest networks of displayed and non-displayed liquidity, with access to more than 40 trading venues. By offering both visible and hidden markets in one network, we help our clients seek liquidity seamlessly in their search for best execution. The size of Fidelity and the diversity of our clients represent another major advantage, due to the volume of order flow that we handle. As we route to the marketplace, we develop an increasingly accurate picture of where liquidity resides in

Fidelity Capital Markets Services

200 Seaport Boulevard, Boston, MA 02210 www.fidelitycapitalmarkets.com 888.595.0589
The statements and opinions expressed in the article are solely those of the author and in no way represents the advice, opinions, or recommendations of Fidelity Investments, its affiliates, or employees. Fidelity does not guarantee that the information supplied is accurate, complete, or timely, nor does Fidelity make any warranties with regard to the results obtained from its use.
1Source:

Fidelity Capital Markets Services calculations as of October 2008

National Financial Services LLC is a Fidelity Investments company. Fidelity Capital Markets Services is a division of National Financial LLC, Member NYSE, SIPC 200 Seaport Blvd. Boston, MA 02210 510599.1.0

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Weathering Volatility With a Choice of ITG Algorithms

With unprecedented levels of uncertainty in todays markets, traders are looking for the most effective means of managing risk and volatility. The industry has seen increased use of algorithms over the past several years, and the sheer number available makes finding the best choice a difficult task. Selecting the right algorithm is especially important today because not all are built to handle such volatile conditions. More than ever, traders need algorithms that are fast, flexible, customizable and can be relied upon during extreme market swings.

As a pioneer in electronic and algorithmic trading, ITG offers a wide array of choices that span single-stock, list-based and dark trading algorithms. ITG AlgorithmsSM offer exclusive access to the unique, buyside-to-buyside liquidity of the POSIT crossing suite, as well as sophisticated anti-gaming logic to protect orders when accessing dark venues. Users also benefit through ITGs agency status and unparalleled commitment to transparency: We offer in-depth algorithm analysis and reports that detail trade performance and execution quality. These reports allow traders to adjust their strategies based on feedback from our transaction cost analysis.

high-touch trader, providing a fast, intelligent way to get in and out of names. This option has become a very popular one for traders who are looking for quick execution in a fast-moving market. ITGs Flexible Participation provides enhanced controls that allow a user to set up and implement a trading strategy. Traders with a view of the market can employ momentum or reversion strategies, controlling how much the algorithm should participate based on stock movement relative to a benchmark price or an index. The trader can also set an I Would price, meaning he is willing to get the entire order done at a specified level. Traders find this level of flexibility and control to be extremely valuable, especially during volatility, since they can set up the algorithm to trade based on set rules and not miss out on opportunities. This also allows the trader the time to concentrate on more difficult names and special trading situations.

Choosing an Algorithm for Volatile Markets Among the ITG Algorithms available, three offer particular benefits to clients during periods of increased volatility: Active, Flexible Participation and Dynamic Implementation Shortfall. ITGs Active algorithm is an arrival price algorithm that dynamically adjusts to changing market conditions. It opportunistically seeks liquidity in both dark and open market venues and employs a number of trading methods to gain price improvement. Active provides an Extreme Urgency feature that especially benefits the

Advanced Risk Control for the List Trader List traders face an ongoing struggle to reduce implementation shortfall, access dark liquidity pools and manage risk. When volatility is high, these challenges are compounded.

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algos
Developments in Algorithmic Trading

ITGs Dynamic Implementation Shortfall algorithm optimizes an entire list using the ITG Risk Model while executing in both the open market and in dark venues. It seeks to minimize implementation shortfall while controlling the cash imbalance and sector exposures of the list. Keeping the cash and sectors hedged is especially important given todays volatile markets. It is also critical that the algorithm adjust to changing conditions. Dynamic Implementation Shortfall responds to trading conditions such as spread, volume and pricing on every order. It also maximizes the block crossing in ITGs POSIT suite and other dark venues while maintaining cash- or ratio-neutrality on the list.

Under any market conditions but especially today ITG works closely with traders to constantly innovate our technology to meet new needs. With todays markets moving so quickly, we continually collaborate with our clients to keep them one step ahead. ITG is also recognized throughout the industry as a thought leader. We devote significant resources to research as an important part of our product development process. Our deep analytical insight results in unique products and capabilities beyond what other brokers can offer. For a list of recent research papers, visit www.itg.com, under News & Research. n

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upfront

Tony Huck
Managing Director ITG Inc.

 mongtheITGAlgorithms A available,threeofferparticular benefitstoclientsduring periodsofincreased volatility:Active,Flexible ParticipationandDynamic ImplementationShortfall.

Dynamic Implementation Shortfall is ideal for trading single- or multi-day transitions, portfolio rebalances or cash flow lists. It gives the trader the ultimate in control: users can set cash constraints, select trading urgency, control dark trading participation or modify parameters in real time.

About ITG
Investment Technology Group, Inc. (ITG), is a specialized brokerage firm that partners with clients globally to provide innovative solutions spanning the entire trading process. A pioneer in electronic trading, ITG has a unique approach that combines pre-trade, order management, trade execution, and post-trade tools to provide continuous improvements in trading and cost efficiency. The firm is headquartered in New York and maintains offices in North America, Europe and the Asia Pacific regions. For additional information, visit www.itg.com.

Committed to Collaboration & Research Today many economists agree that the world economy is heading into what could be a deep recession. An economic slowdown will spell more uncertainty and volatility for global markets. These times require traders to find new ways to succeed while mitigating their risks. Many of ITGs algorithms can be highly customized to meet the specific needs of our users and maximize control over trading.

2008 Investment Technology Group, Inc. All rights reserved. Not to be reproduced without permission. Products listed provided by ITG Inc., member FINRA, SIPC. 102908-43141

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Liquidnet Vanquishes Major Block-Trading Challenge

Fragmentation Neutralized Through New Market Structure, Advanced Technology The nemesis of institutional investors the 200-share average execution size is becoming irrelevant, courtesy of Liquidnet, Inc. The buyside crossing-system operator has created a global institutional marketplace that neutralizes fragmentation and liberates block orders from todays most vexing market constraints. Dubbed The Institutional Marketplace, this new Liquidnet venue is a wholesale environment complete with a super-sized dark liquidity pool and advanced, block order-focused strategies. Liquidnets more than 500 members institutional investors whose orders are regularly 50 to 100 percent of the average daily volume (ADV) in various stocks increasingly are turning to this resource, say Liquidnet executives, because it directs flow to institutional orders and allows blocks to remain intact. Jay Biancamano, Global Head of Marketplace at Liquidnet, and Mike Capelli, Global Head of Trading at Liquidnet, explain.

How is Liquidnet helping institutional traders address fragmentation challenges? Biancamano: We have created a venue that allows institutions to source liquidity in the marketplace in a way that gives control back to them. Institutions now have the power to decide how and when to enter the market in a way that gives them the advantage. Whats different about this approach? Capelli: Other industry solutions are electronic tools that enable institutional orders to be absorbed by the retail-size marketplace. These fail to address the core problem: the structure of the market. Liquidnet delivers sophisticated strategies that also address the structural issues of the marketplace. The market is upside down, forcing institutional orders to be split into retail-size orders. We have changed that dynamic by bringing liquidity directly to our members through our negotiated pool as well as via H2O. This combined liquidity represents approximately 10 billion shares daily in the United States. Bringing a huge amount of liquidity to a single venue is an extremely efficient solution to the problem of a fragmented retail structured marketplace. By addressing the structural problem of the marketplace, the symptoms a fragmented market with diminishing execution size will be reduced.

What results have you seen? Biancamano: This global institutional marketplace has addressed the structural problem of a broken marketplace. It brings liquidity to the institutional investor and keeps institutional orders intact. It increases the order execution size and reduces fragmentation. Capelli: Our 42-percent crossing rate (October 2008) has reduced impact and timing risk, two of the most expensive components of tradings transactional costs. By crossing a significant amount of the order flow against natural volume, we reduce the amount of impact that those shares would have incurred. Because the residual amount of trading in the marketplace is that much less, weve also reduced the timing risk of the order. Whats different from other liquidity pools? Biancamano: The key differentiator is that we have designed this to address institutions block liquidity. In other pools, traders start seeing drag at anywhere from 5 to 20 percent of the ADV whereas ours is built for order sizes significantly above that. Weve created an efficient marketplace unlike any other where both sides of the order the retail side and the institutional side benefit. The model also gives price improvement to retail-type orders since we interact with exchanges and ECNs.

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algos
Developments in Algorithmic Trading

We maintain a pure trading system by life guarding the pool to protect members from negative market selection. Our surveillance helps ensure that theres always a level playing field so that our members can feel safe and secure in the system. How do your algorithms come into play? Capelli: Traders gain access to this institutional marketplace through the Supernatural strategies or via our Trading Desk. Investment objectives, trading style and trading benchmark all dictate which Supernatural strategy traders choose. For example, our adaptive strategy is good for trading illiquid stocks. Our closing strategy is designed to reduce impact when trading into the bell while maintaining a small deviation from the closing price. And our newest strategy, the adaptive optimum strategy, incorporates the probability of a cross. How have you built upon Liquidnets strengths? Biancamano: Liquidnet has evolved from being strictly a block negotiation system to a system that allows our members to access

market. The market structure problem forces traders to split up institutional orders to protect themselves in all the different venues, hence leading to a fragmented market. Do you anticipate others will replicate this model? Biancamano: Liquidnet is the only one that can provide this type of institutional marketplace because we have an unmatched pool of global institutional liquidity. How has the global financial crisis impacted trading in the Liquidnet marketplace? Capelli: We have seen a tremendous increase in members using Supernatural strategies because they allow traders to control when they want to trade rather than having the market dictate when they can trade based on the availability of liquidity. Biancamano: All traders have their own trading style, especially in these times. No matter what their style, we can help members by giving them to access to a large pool of liquidity and by reducing risk associated with trading.

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upfront
 uradaptive O strategyis goodfortrading illiquidstocks.
Mike Capelli
Global Head of Trading Liquidnet

 lltradershave A theirowntrading style,especially inthesetimes.

Jay Biancamano
Global Head of Marketplace Liquidnet

unique liquidity. Our Supernatural strategies carry the Liquidnet hallmark: They allow institutions to trade anonymously and efficiently with zero market impact, leaving no footprint in the market. Capelli: In my opinion, Liquidnet still is the best venue for crossing blocks. But over the past eight years, weve also built an institutional marketplace and tools that reduce the overall execution costs while providing an extremely effective way to trade large order flow. Our Supernatural strategies have block trading built into their DNA, and they have access to a huge pool of natural liquidity. Why was it important to address the market structure? Capelli: Algorithmic trading, in the absence of liquidity, addresses the symptoms, not the problem; the problem being the inverted

What does the future hold for Liquidnet marketplace? Biancamano: Globalization is the key. Liquidnet marketplace and the Supernatural tools will make it seamless for somebody in Europe to trade Asian equities and somebody in the U.S. to trade European equities. Currently the Supernatural strategies are available in the United States. We anticipate going live in Europe and Canada next year, and the subsequent phase will encompass Asia. Capelli: Liquidnet will continue to innovate. To say exactly what that will be I dont know right now. But looking at the changing landscape, there definitely are going to be tremendous opportunities that will drive future Liquidnet products. n

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Algorithmic Trading and the Evolution of the Man-Machine Interface

For 200 years, equity market structure was largely unperturbed by progress, but the past few decades have been marked by revolutionary change in the way stocks are traded. Technology is now continually redefining the interface between equity traders and the market. At times, algorithm development has focused on the wrong objectives, depriving traders of the vital controls they require to capitalize on their own knowledge of how a stock trades, or to implement the nuanced intent of the portfolio manager. Also, theyve failed to automate parameter choices that must be made in real-time to track shifting order flow across dozens of liquidity pools. Much as a Ferrari provides responsive steering, braking, and acceleration, but automates the adjustment of fuel mixture and ignition timing, a properly designed trading system must provide meaningful controls that unleash the traders power to perform, while automatically optimizing the underlying engine.

The buy-side trader is a focal point for information and has first-hand access to the portfolio managers intent, sense of the urgency and expected alpha in the trade. Good traders use this informational advantage to outperform commodity algorithms by leveraging block market liquidity and exercising tactical control over the execution process. What are the right controls? Most tactical decisions represent a compromise between cost and risk. To lower risk, one can trade faster or use trading styles that track volume more closely. Decisions to lower risk typically lead to higher expected costs, and vice-versa, lowering costs require one to assume greater risk. The choice of trading speed and the selection of a strategic limit price require awareness of the investment objective and information environment of the stock, and therefore must remain with the trader. Highly responsive controls are absolutely critical here. Some controls are clearly less effective. The choice of a particular algorithm style can become counter-productive. For example, if the market develops an adverse trend, a passive algorithm will exacerbate the price move and get little done; using a dark aggregator over an extended period of time leaks information and causes excessive impact. Similarly, the choice of short-term limit prices requires real-time adjustment to remain optimal in changing market conditions. These tactical controls are good candidates for underthe-hood optimization. Too many vendor algorithms take away essential trader controls by automating the scheduling of a trade using VWAP or Implementation Shortfall strategies. This approach is optimal only if you believe the market is random.

Isnt the market random? Any single trading strategy leads to detectable footprints, opening the door to predatory trading strategies that directly drive increased impact costs this is not a random process. The market is an ecosystem of competing strategies, where the interaction between strategies creates structure in the data stream. The success or failure of a strategy depends on what others are doing every algorithm inevitably affects the behavior of others. Therefore, an intelligent execution strategy requires making tactical adjustments in response to what can be predicted from the observed order flows. These include not only the critical trading controls governing trading speed and urgency, but auxiliary adjustments to how much discretion to apply in seizing apparent opportunities, tactical limit prices, and the choice of an algorithmic trading style. A high-performance trading technology should adjust all these auxiliary settings on a real-time basis to deliver optimal performance given the traders instructions. How should an optimal algorithm strategy be chosen? Whether they are presented as style-specific or not, all broker algorithms end up demonstrating a distinct trading style. Some buy mostly on the bid; some execute at the midpoint or use hidden orders. Pipeline research systematically runs vendor algorithms through random, sector-balanced long-short baskets to measure every aspect of cost, order pricing and display characteristics. This analysis shows that algorithms cluster in seven distinct styles, which we characterize as Dark, Hidden, Opportunistic, Passive, Pegged, Participation and Stealth. The performance of each algorithm style varies dramatically with market conditions. In addition, any single algorithm eventually leaves specific footprints on the market, leading to information costs.

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algos
Developments in Algorithmic Trading

To understand how to use algorithms effectively, Pipeline partnered with the top performers in prediction technology: Doyne Farmer, co-founder of Prediction Company, and Chris Stephens, cofounder of ATi. ATi has invested 12 years of research in developing powerful quantitative methods to predict future performance in dynamic environments. Applying proprietary non-linear methods derived from Genetic Algorithms and Bayesian learning models, Stephens found that the short-term performance of algorithms was highly predictable. This led to the development of a prediction engine that uses over 50 predictive drivers and was benchmarked to predict anomalous algorithm performance 56% more accurately than linear regression. Why Algorithm Switching? The predictability of single-algorithm performance implies that there is room to improve results, beyond the optimization that is already built-in to every quality vendor algorithm. Predictive switching strategy can outperform the single optimal algorithm by 30% [Fig. 1].

Do short-term costs matter on a giant trade? Market impact is symptomatic of the information transfer caused by trading. Minute-by-minute, algorithmic actions cause small but permanent effects on prices. These incremental contributions aggregate to a larger impact that grows roughly as a square root of trade size. For large trades an achievable 30% reduction in impact cost dominates over commission costs and enables a buy side trader to double alpha capture (Fig. 2). n
Profit vs Trade Size [ AAPL ]
$2.50 $2.00 $1.50

$1.00 $0.50 $0.00 0

41bps / 1M 28bps / 1M 41bps+[c=$0.01] 28bps+[c=$0.02]

| | | |

10

-$0.50 -$1.00

FIGuRE 2 Net alpha capture is affected by the increased shortfall as a function of trade size. A 30% reduction in shortfall from predictive switching (blue) over the optimal single algorithm (red) doubles alpha capture.

Profit (millions)

Shares (millions)

Exe c uti v e s

upfront

Henri Waelbroeck, Ph.D.

Vice President, Director of Research henri@pipelinetrading.com 212.370.8313

Pipelinesblockexecutionsystem increasescontrol,savestimeand empowerstheinstitutionaltrader toachieveunmatchedexecution performanceonlargeorders. TheAlgorithmSwitchingEngine revolutionizesaccesstodarkand displayedliquidity,predictingon aminute-by-minutebasisthebest algorithmtoimplementthetraders instructions.

120

100

Lowering Pareto Front with Predictive Switching MOT - 500k Shares Single Algorithm Switching Engine Aggressive

80

60

40

Predic

Moderate tive Switc hing

Trickle

20

10

12

14

Risk

FIGuRE 1 The Pareto Front summarizes the compromise a trader must make between market impact and risk when choosing an aggression level. This example of a 500,000share MOT trade shows how predictive switching technology is measured to reduce impact at every speed level, creating an improved frontier.

Cost (bps)

Pipeline Trading Systems

60 East 42nd Street, Suite 624 New York, NY 10165 www.PipelineTrading.com

Algorithm Switching automates the control of parameter settings that require real-time adjustment based on changing market conditions, maintaining real-time optimality while the trader takes control of execution speed and strategic limits.

2008 Pipeline Trading Systems LLC. Pipeline Trading Systems LLC is a member of FINRA and SIPC. This article was prepared for general circulation and without regard to the individual financial circumstances and objectives of persons who receive or obtain access to it. The analyses discussed herein are derived from Pipeline and third party data and are not meant to guarantee future results.

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The Personalization of Electronic Trading

By Will Sterling, Global Head of uBS Direct Execution

What do you get when you cross a consultant with a sophisticated algorithmic trading engine? Better performance.
Variation and Automation As the evolution of the equities trading industry continues to accelerate and an increasing percent of order flow becomes electronic, the people involved in the process have less and less direct contact. Considered from the standpoint of speed, efficiency, and confidentiality, this distance can be a positive. The client can maintain greater control over what is being sent to the market, their ability to source liquidity is greatly improved, and a traders daily capacity is exponentially increased. But what impact does this distance have on the ability of traders to make use of their brokers collective experience? Can a fullyautomated trading process enable a trader to change strategies on the fly, apply the lessons learned in every trade, or optimally interpret dynamic market color? And when it comes to strategy selection in a fully electronic world is it possible for traders to be fully conversant in the behaviors and unique variations inherent in every algorithm and order type, from every broker or platform in their toolbox? In our quest for the speed, sophistication, and efficiency of electronic trading what might we be giving up? The Missing Link The full-service voice broker is able to bring to bear, in a non-linear way, the in-market experience, insight, and his or her own knowledge of a clients preferences and priorities. This cognitive ability enables us to draw inferences and read subtle nuances in a way that is unique to human beings. So while todays algorithms are more intelligent than ever before able to process massive amounts of data at the sub-millisecond level and make instantaneous routing and technical decisions no one could manually implement they cannot provide the sort of intuition or discernment that can make all the difference at the margins. Because as every trader knows, finding differences at the margins can make the difference between execution and best execution. Hybridization So what are we to do? In this highly complex environment, in a fragmented marketplace, we need the super low latency and multidimensional logic delivered by todays algorithms. How do we retain the best advantages of these new tools, yet still avail ourselves of the human interaction that adds so much value? At UBS, weve created a model that delivers both. The Direct Execution trading desk is staffed with experienced sales traders who know the markets, the full spectrum of behaviors, advantages, and capabilities of the UBS suite of advanced algorithms, and the goals of their clients. When a client sends an order using a UBS algorithm, it doesnt just go into a black box engine. The algorithms are backed by the support of regional in-market experts able to proactively or responsively deliver a service we call Execution Consulting. This doesnt mean that the electronic sales traders must touch the order the purpose is not to create manual intervention between the client and its destinations (unless that is required). But their proximity to the algorithmic development team and the trading infrastructure engineers means that this immediate proactive dialog creates a continuous feedback loop adding value both to the clients work flow and the evolution of UBSs trading tools and infrastructure. If a client wishes to get a deeper view into any execution or the current behavior of any strategy or venue, the electronic sales trader can quickly source, interpret, and deliver that information intraday. Whats more, clients who may be new users of an algorithm can benefit from the desks experience, immediately implement appropriate customizations, and adapt to the behavioral nuances demonstrated by every strategy. UBS Direct Execution maintains a rigorous wall of confidentiality on all client and order information traded electronically. The team has designed a set of internal controls over the confidentiality of client order and execution information, which include extensive technological barriers; as well as segregation of the desks, infrastructure engineers, support teams, and the relevant middle and back office functions. So clients will not have to worry that their interaction with UBS electronic sales traders will be exposed to the outside world, or other parts of the firm.

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Developments in Algorithmic Trading

A Breed Apart The goal of Execution Consulting is to assist traders in achieving best execution. So we first find out what best execution means to each client and work from there. Rather than looking at it as a review of historical results, we view it as an ongoing process one in which UBS helps clients to improve their trading overall. This process involves repeatable steps that wrap around the trading cycle. Step one is to understand our clients objectives. We work with traders to understand their overall program goals, not just explicit trade-by-trade directions. We then tailor our tools, customize or set up specific client-requested defaults in appropriate algorithms, and adapt our service model to their needs and coverage preferences. Step two is strategy selection. Given order X, what are the best strategies, venues, and tactical ways to trade? This is about finding the best way to access liquidity at the order level, of course, but must also map back to the clients objectives. The electronic sales traders actively observe market behaviors, news events, or any external factors that may impact the order

both in real time, as well as pre- and post-trade reports, our TCA not only explicitly relates what happened but also identifies lessons to be learned and areas for improvement. We apply this decision-loop to client trades, and also to our algorithm development cycle. So the result is that, over time, we constantly improve the way were trading and delivering execution for our clients. Its Alive In the fall of 2008, UBS Fusion began delivering Real-Time TCA. Real-Time TCA enables clients to have continuous real-time analytics for their orders. Post-trade analysis was previously sent to clients at the end of a trading day, week, or month to help evaluate an algorithmic trading strategys effectiveness. With the introduction of real-time execution and cost analysis, clients will have the opportunity to apply that information while there is still time to affect the orders outcome. UBS Fusions real-time analytics continuously update while the orders are live allowing clients to monitor how orders are performing across

Exe c uti v e s
Will Sterling
Global Head of UBS Direct Execution UBS Investment Bank
uBS Direct Execution +1.203.719.1750 +1.800.563.8018 de-sales@ubs.com

upfront

ngeniousalgorithms I combinedwiththe insightandexperience ofaseasonedglobal tradingdeskmakes foranewbreedof best-in-classservice.

and will recommend strategies or tactics accordingly. As inhouse experts on how UBS algorithms behave, they are in a good position to recommend the strategies most likely to be effective for the goals, symbols, and situation at hand. Step three is the actual order management process. While the order is live, UBS Direct Execution sales traders can assist their clients in monitoring and analyzing their orders performance. Where are fills coming from? Is there slippage against benchmarks and if so, why? Is this the optimal algorithm, given the situation? This level of proactive value-adding insight, combined with the firms advanced strategies and tools, is an attractive and differentiating hybrid, according to our global clients. The fourth and final step is Trade Cost Analysis (TCA), delivered by UBS Fusion the firms web-based analytics platform. Delivered

all venues, including the Exchanges, alternative markets and dark pools. This is full execution transparency, delivered sub-second. This dynamic analysis is fully integrated with electronic sales trader Execution Consulting, UBS Alerts, and an interesting new tool the firm has introduced called UBS Fusion IM. Fusion IM allows a trader to chat interactively via instant message with UBSs algorithmic trading engine, in order to get real-time responses to order status inquiries and chart requests. Taken together, these advanced tools offer clients the opportunity to reduce the noise in a highly frenetic market, shorten the distance between traders and their brokers, and enhances the clients ability to achieve best execution. Ingenious algorithms combined with the insight and experience of a seasoned global trading desk makes for a new breed of best-in-class service. n

This material has no regard to the specific investment objectives, financial situation or particular needs of any specific recipient and is published solely for information purposes. No representation or warranty, either express or implied is provided in relation to the accuracy, completeness or reliability of the information contained herein, nor is it intended to be a complete statement or summary of the developments referred to in this material. This material does not constitute an offer to sell or a solicitation to offer to buy or sell any securities or investment instruments, to effect any transactions or to conclude any legal act of any kind whatsoever. Nothing herein shall limit or restrict the particular terms of any specific offering. No offer of any interest in any product will be made in any jurisdiction in which the offer, solicitation or sale is not permitted, or to any person to whom it is unlawful to make such offer, solicitation or sale. Not all products and services are available to citizens or residents of all countries. Any opinions expressed in this material are subject to change without notice and may differ or be contrary to opinions expressed by other business areas or divisions of UBS AG or its affiliates (UBS) as a result of using different assumptions and criteria. UBS is under no obligation to update or keep current the information contained herein. Neither UBS AG nor any of its affiliates, directors, employees or agents accepts any liability for any loss or damage arising out of the use of all or any part of this material. UBS Securities LLC is a registered broker-dealer, a wholly owned subsidiary of UBS AG and a member of the New York Stock Exchange, other principal exchanges and SIPC. UBS 2008. All rights reserved.

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