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Subject 1. The Basics of Algorithmic Trading

Algorithmic trading is automated trading by computers that are programmed to take certain actions in response to varying market data.

There are two types of algorithmic trading: execution algorithms and high-frequency algorithms.

Execution algorithms are used to minimize the market impact of large orders. For example:

  • The volume-weighted average price (VWBP) is used to ensure that the trader executing the order does so in-line with volume on the market. Such execution tries to reduce transaction costs by minimizing market impact costs.
  • The implementation shortfall is the difference between the decision price and the final execution price for a trade. It should be kept as low as possible for max liquidity.
  • The market participation algorithm sends partial orders according to defined participation ratio and volume traded in the market, until the trade order is fully filled.

High-frequency algorithms constantly monitor real-time market data, look for patterns to trade on and execute orders based on market conditions.

An event, such as a quote event, a trade event or a new event, describes a change in the state of the market. Certain events may generate short-term responses in a selected set of securities. High-frequency traders take advantage of such predictability to generate short-term profits.

A statistical arbitrage tries to exploit predictable temporary deviations from stable statistical relationships among securities. Examples are pairs trading, index arbitrage, basket trading, spread trading, mean reversion, and delta neutral strategies.

Other HFT algorithms include liquidity aggregation, smart order routing, real-time pricing of instruments, trading on news, and genetic tuning.

In the context of high-frequency trading, latency refers to the amount of time it takes for information to arrive at a trader's computer, a pattern to be identified, and trades to be placed and executed. Lower latency equals faster speed which is a key factor in HFT. Components in the low latency value chain include market data, algorithmic and high-frequency trading engine, order execution, physical connection and co-location.

Practice Question 1

Which question(s) do execution algorithms try to answer?

I. How to trade
II. When to trade
III. What to trade

Correct Answer: I

On the other hand, high-frequency algorithms try to determine "when to trade" and "what to trade" as well.

Practice Question 2

The ______ is a measure of the average price at which a stock is traded over the trading horizon.

A. volume-weighted average price
B. implementation shortfall
C. market participation ratio

Correct Answer: A

The volume-weighted average price is the ratio of the value traded to total volume traded over a particular time horizon (usually one day). A VWAP algorithm places orders over a time period based on the historic volume distribution, with the aim of meeting or beating the VWAP.

Practice Question 3

The difference between the March Kansas City wheat and the March Chicago wheat is referred to as ______.

A. intra-market spread
B. inter-exchange spread
C. inter-market spread

Correct Answer: B

Practice Question 4

In the HFT (high-frequency trading) world, when several firms are competing for the same opportunity, the one with the ______ wins.

A. lowest latency
B. highest capital volume
C. largest client groups

Correct Answer: A

Typically, the traders with the fastest execution speeds are more profitable than traders with slower execution speeds.

Practice Question 5

The delta neutral strategy involves creating a delta neutral position to profit from time decay or volatility, or to hedge an existing position and protect it against small price movements. It is an example of ______.

A. event arbitrage
B. statistical arbitrage
C. low-latency strategy

Correct Answer: B

The strategy can be used to earn a profit that is independent of the direction of price movement in the underlying asset.

Practice Question 6

In the high-frequency trading world, co-location means ______

A. A trader's data center is in the same location as its main trading office.
B. A trader's computers are in the same data center as an exchange's computer servers.
C. A trade's main trading office is in the same building as the exchange.

Correct Answer: B

In a largely digital world, sometimes physical proximity still matters.

Practice Question 7

Which execution algorithm dynamically adjusts the schedule of the trade to minimize the difference between the decision price and the final execution price?

A. volume-weighted average price
B. implementation shortfall
C. market participation ratio

Correct Answer: B

Implementation shortfall is the sum of execution costs and the opportunity cost incurred in case of adverse market movement between the time of the trading decision and order execution. This algorithm tries to minimize the trade-off between the market impact of immediately executing an order versus the risk of market drift if the order takes too long to execute.

Practice Question 8

A trading strategy identifies and defines a price range, and then implements algorithm that allows trades to be placed automatically when price of a stock breaks in and out of its defined range. This is likely to be ______ strategy.

A. mean reversion
B. delta neutral
C. spread trading

Correct Answer: A

In finance, mean reversion is the assumption that a stock's price will tend to move to the average price over time.

Practice Question 9

Which question(s) do high-frequency algorithms try to answer?

I. How to trade
II. When to trade
III. What to trade

A. II and III
B. I and II
C. I, II and III

Correct Answer: C

On the other hand, execution algorithms mainly focus on "how to trade".

Practice Question 10

Which algorithm trades in proportion to actual market activity?

A. Volume-weighted average price
B. Implementation shortfall
C. Market participation ratio

Correct Answer: C

The market participation algorithm executes an order as a percentage of volume trading in the market.

Practice Question 11

The spread trading strategy that involves the purchase of soybean futures and the sale of soybean oil and soybean meal futures is referred to as ______.

A. crack spread
B. spark spread
C. crush spread

Correct Answer: C

It is a trading strategy used in the soybean futures market. A soybean crush spread is often used by traders to manage risk by combining soybean, soybean oil and soybean meal futures positions, into a single position. The spread position is used to hedge the margin between soybean futures, and soybean oil and meal futures.

Practice Question 12

A pairs trading strategy matches a long position with a short position in a pair of highly correlated instruments such as two stocks. It is an example of ______.

A. event arbitrage
B. statistical arbitrage
C. low-latency strategy

Correct Answer: B

It is a market neutral trading strategy enabling traders to profit from virtually any market conditions: uptrend, downtrend, or sideways.

Study notes from a previous year's CFA exam:

a. define algorithmic trading;

b. distinguish between execution algorithms and high-frequency trading algorithms;

c. describe types of execution algorithms and high-frequency trading algorithms;