Introduction to Trade Execution Algorithms
Trading execution algorithms are one of many ways advisors can leverage trading technology for their clients. Algorithmic trading relies on predictive analytics to recognize and take advantage of patterns that may be indiscernible to human traders.
Over the past twenty years, algo trading has taken over the market as the single most common trading strategy. More than 80% of US stock trades are algorithmic while the global market is predicted to grow to $18 billion by 2025.
A famous example of how even a basic algorithm can have a widespread effect is the case of giant ETF manager Good Harbor Financial. In 2014, Good Harbor had a habit of reshuffling its $11 billion main portfolio every month, causing shock waves in the market. When arbitrage traders finally recognized the company’s patterns, they began front running their trades to benefit their own clients.
With a good understanding of the most basic trade execution algorithms, you can add value to your clients and mitigate the risk of negative performance to their portfolios.
Advisors trading large blocks of ETFs or stocks without accounting for liquidity run the risk of significant negative performance for each executed trade. Execution algorithms can offer some protection against “slippage”, the negative effect on execution prices due to a lack of liquidity and other factors.
The basic idea is to systematically split a larger order into many smaller orders based on the available liquidity.
Most Common Trade Execution Algorithms
Three of the most commonly used trade execution algorithms are Time Weighted Average Price (TWAP), Volume Weighted Average Price (VWAP) and Percent of Value (PoV).
Time Weighted Average Price. This algorithmic strategy will break an order up into many equal parts and execute them during the trading day, normally at five-minute intervals. One potential issue with a TWAP order is that it doesn’t take into account that the volume traded is often greater at the beginning and end of the day.
Volume Weighted Average Price. A VWAP trade execution algorithm estimates the average volume traded for each five-minute interval and the order based on historical trading information. Its goal is to split the order into smaller pieces based on an average weighted volume. One challenge with VWAP is that the historical averages used may not correspond to the activity on that specific day.
Percent Of Value. POV addresses the VWAP issue of relying on historical averages by using actual volume during the trading day. It calculates the smaller blocks based on the percentage of participation in the market. The POV trade execution algorithm also avoids excessive impact on market pricing.
This brief overview covers some basics of algorithmic trading. There are many additional complexities to consider when building a trading strategy. Choosing the right software to drive momentum and manage trade execution can have a significant effect on your growth.
BlazePortfolio® offers powerful trade order management features that help you take full advantage of trade execution algorithms. From electronic trade executions to order blocking, stop and limit orders, and trading desk communication, Blaze software adds value to your clients’ portfolios. To learn more, contact us to set up your software demo.