ALGORITHMIC TRADING AN OVERVIEW

Algorithmic Trading What is it?

Electronic trade execution piloted by a model Model tries to match a specific execution cost benchmark Usually breaks up a larger trade into a series of smaller trades to be executed over time

Algorithmic Trading How much is there today?

Tower Group says 7% of all Buy Side flow

Source: Market Structure and the Role of Exchanges, ECNs and ATSs Tower Group (2004)

Algorithmic Trading How much is there today?

..while the Tabb Group reports that over half of all firms have access to algorithms.

Source: Institutional Equity Trading in America: A Buy-Side Perspective The Tabb Group (2004)

Most Popular Algorithms

The list of most popular algorithms is dominated by the key execution benchmarks: VWAP and Arrival Price VWAP (27%) Arrival Price (19%) Imp. Shortfall (13%) EOD / Beat Close (10%) Guerilla (8%) Liquidity (8%) % ADV (6%) Other (9%)
Essentially the same algorithm (32%)

Source: Institutional Equity Trading in America 2005 A Buy-Side Perspective. Tabb Group (2005)

Trading Cost How Big?

20bps Implementation Shortfall for Average Trade per Side*

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

Assume 6% Annual Return

40bps / 6 % = 6.7% negative return contribution

* Plexus BrokerEDGE Monitor (2004)

Implicit Trading Cost Attribution

Market Impact Timing / Trend Cost Unexecuted orders/ Opportunity Cost Spread Cost Tactical / Implementation Strategic / Scheduling

Timing Cost is Critical, but Spread Costs Matter Too!

Cost Attribution Example: Order to Buy 60,000 shares, filled via 3 Executions*
10:40am: Order arrives to Buy 60,000 shares 10:40am: Buying 20,000 shares @ 17.31 11:22am: Buying 20,000 shares @ 17.38 11:48am: Buying 20,000 shares @ 17.39 Execution 17.39 Price C Ask
Spread Cost: 1.5c Spread midpoint Impact Cost: 1c Spread Cost: 2c

Execution Price B Ask 17.38

Spread midpoint

17.38

17.365 17.35
Timing Cost 7.5 cents

17.36

Bid Execution Price A Ask

Spread midpoint

Bid

17.34

Timing Cost 7 cents

17.31 17.30 17.29 17.28

Impact Cost: 1c Spread Cost: 1c Total Cost: 2c Total Cost: 9c Total Cost: 10c

1 Order 3 Executions

Bid

Execution A

Execution B

Execution C

Order Trading Cost is Sum Total of Executions A/B/C

* Hypothetical Executions

Two Common Benchmarks

Volume Weighted Average Price (VWAP)

A weighted average price Trading volumes are the weights Intuitive & easy to use for traders > commonly used in the market VWAP does not measure Trend/Timing Cost!

Arrival Price
The portfolio decision price Difference between Arrival Price and execution price, plus forgone returns on unexecuted shares is called Implementation Shortfall There is little agreement in the market on what an appropriate implementation shortfall ought to be

Pros and Cons: VWAP vs Arrival Price

VWAP Advantages Easy-to-use Direction-neutral

Arrival Price Advantages Directly related to portfolio returns (capturing alpha) Cant be fooled Arrival Price Disadvantages Harder to implement Law of large numbers Direction-bias

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

Becoming VWAP Threat Recent Data

ITG Study Shows Empirical Evidence of Becoming VWAP
VWAP and Arrival Price Cost vs %ADV
Std Dev VWAP and Arrival Price Cost vs %ADV

Bps cost vs VWAP

3.5 3 2.5 2 1.5 1 0.5 0

< 1% 1 - 5% 50% > 10 - 25% 25 - 50% 5 - 10%

StdDev of Bps cost vs VWAP

70 60 50 40 30 20 10 0
1 - 5% 10 - 25% 25 - 50% 5 - 10% 50% > < 1%

Bps cost vs Arrival Price

120 100 80 60 40 20 0

Cost vs VWAP Cost vs Arrival Price (diff. adjusted)

StrdDev of Bps cost vs Arrival Price

4.5

50 45 40 35 30 25 20 15 10 5 0

80

140

StdDev Cost vs VWAP StdDev Cost vs Arrival Price (diff. adjusted)

%ADV

%ADV

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

Instinet & Northfield

Instinet already had a robust VWAP rule We wanted to develop an Arrival Price rule that would
Factor in an effective measure of timing risk Work for portfolios & pairs, not just single stocks Factor in short-term stock correlations for portfolios & pairs

So we turned to someone who

Had expertise in risk management models Had a proven short-term risk model

The Instinet & Northfield Partnership

Benefits & Synergies

Be able to execute portfolios against Arrival Price React to real-time market data Optimize and re-balance real-time, during the execution process

TRADING TACTICS FOR ALGORITHMIC TRADING

Implementation
NEWPORTTM Execution Management System
Instinet Order Handling

FIX

Northfield Risk Model

Feedback Loop Instinet Trading Engine

Newport TM is patent-pending

NYSE Spread-cost Minimization Tactic: BlockPegSM

Scenario: Buying 50,000 of NYSE-listed mid-cap, Limit 19c, Current Market 16c x 20c. BlockPeg Execution Style Aggressive
1
Market: 16c x 20c Executed: 0 Left: 50,000

2
Market ?: 17c x 21c Executed: 0 Left: 50,000

CBX
20c

DOT
20c

CBX
21c

DOT
21c

Post at midspread

18c

BlockPeg
16c Post at

Post at midspread bid

19c

BlockPeg
17c Post at

17c

16c

bid

3
Market ?: 16c x 20c Executed: 10,000 Left: 40,000

4
Market ?: 22c x 25c Executed: 0 Left: 40,000

DOT slice moves with the market

CBX Peer institution takes block @ 18c

16c 20c

DOT
20c

CBX
25c

DOT
25c

BlockPeg
16c Post at bid

Not posting
Hard limit @ 19c 22c

BlockPeg
Not
Hard limit exceeded 22c posting

5
Market ?: 15c x 19c Executed: 2,000 Left: 38,000

6
Market ?: 14c x 18c Executed: 1,000 Left: 37,000

CBX
19c

DOT
19c

CBX 2000 shares marketable @ 19c bid

18c

DOT
18c

Post at midspread

17c

BlockPeg

Post at midspread

16c

BlockPeg

15c

15c Post at

14c

Someone hits the bid: 1,000 shares @ 14c 14c Post at bid

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

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

Price

Passive Limit Price

9:30 am

Time

4:00 pm

Rule Detects Adverse Momentum - Pricing Buy Order Aggressively -

Price

Floating Aggressive Limit Price

9:30 am

Time

4:00 pm

Tracking Transaction Cost in Newport

What the entire orders realized Cost vs Arrival would be if I executed all residuals now

Cost vs Arrival Price I have realized (executed portion of the order)

Arrival Price

Cost vs Arrival Price of unexecuted residuals

Best Execution What else can you do?

Use a great model Use great technology Trade through a broker who doesnt have a dog in the fight

100% Pure Agency 100% Anonymous Always trading for the customer No firm proprietary account

 2005 Instinet, LLC. All rights reserved. INSTINET and the tagline The Institutional Broker are a registered mark in the United States and in other countries throughout the world. Instinet, LLC, member NASD/SIPC, branded as Instinet, The Institutional Broker, is a subsidiary of Instinet Group Incorporated which is part of the Reuters family of companies. This presentation is provided for informational purposes only. It does not take into account the particular investment objectives, financial situation or needs of any individual or entity. Under no circumstances is it to be used or considered an offer to purchase or sell any security, or a solicitation or recommendation of the purchase, sale or offer to purchase or sell any security. Reproduction or redistribution of this information in any form in whole or in part is prohibited except with the written permission of Instinet.