Trading algorithm types — and the best time to use each one

Below is an excerpt from the research paper recently published in the Journal of Trading, by Jingle Liu and Kapil Phadnis. For the full paper, click here.

Traders today are very familiar with the advantages of leveraging algorithms for buy-side trades. The use of trading algorithms alone, however, does not necessarily guarantee better order execution performance. Rather, selecting the algorithm that is best for each specific trade is key.

To provide insights into the optimal selection and use of buy-side algorithms, Bloomberg Tradebook conducted a study of more than 270,000 buy-side orders that were executed over time and varied market conditions using more than 150,000 trading algorithms. This study was designed to compare actual trader behavior to results and look for opportunities to improve those results.

Algorithms were organized into four widely recognized types — Scheduled, Participation Rate, Dark and Implementation Shortfall. Performance of each type was analyzed against several factors, including average daily volume, order size, participation rate, duration and implicit trade costs. Based on millions of trades involving more than 4,500 tickers distributed across all market capitalizations and sectors, distinct patterns in trader usage of algorithms emerged. The findings on performance against arrival price, however, challenge some of those trader preferences.

Although 3 out of every 4 small orders (<1% of ADV), with low participation level are executed using Scheduled algorithms, Implementation Shortfall algorithms provide better average performance and smaller pricing risk.

When placing medium orders (1% to 10% of ADV), traders prefer Scheduled or Participation Rate algorithms with low or mid participation rate. Analysis of performance shows that Scheduled and Participation Rate algorithms are the worst performing type for medium orders, and Dark algorithms show the best performance regardless of participation rate.

For large orders (>10% of ADV), traders favor Scheduled algorithms. Because of the opportunistic nature and capability of getting blocks in dark pools, Implementation Shortfall algorithms and Dark algorithms provide consistently better results than scheduled algorithms.

Understanding these patterns and preferences in traders’ use of algorithms and the impact of algorithm choice on performance can be as valuable to traders as the algorithms themselves. This analysis reinforces the fact that selecting the most advantageous algorithm for a given order can significantly improve performance.

For the full paper, click here.