Execution Algorithms - Simple to Advanced
Execution Algos from TWAP to complex multi-exchange algorithms.
This article will be unique!
It’s a collaboration with KatanaQuant who will start with making the into to the article.
Intro
Lots of traders still struggle with the decision when to use Market Orders over Limit Orders or vice versa.
Some think Limit Orders are the only correct way to enter a trade while others try to simplify their execution by only using market orders.
Lets sort both of these type of traders into baskets and give each group a hero.
Hero No1: Ben
Ben is an FX intraday scalper. After observing dozens of his limit orders not getting filled he established that Market Orders are the only way to enter setups before price moved away too much, obliterating his potential gains.
He tried cancelling and reopening orders but couldn't really make it work and likes it when things are simpler.
Market Orders are the only way he can comfortably enter his setups while keeping his conviction.
Hero No2: Paul
Paul on the other hand is a Swing Trader and focuses mainly on stocks.
His investment horizon leads to setups with holding times of weeks or even months. He used market orders in the past but was fed up with paying the bid-ask spread. Nowadays he always uses limit orders to "reduce trading costs" as he calls it and even sometimes makes additional profits by doing so through fee rebates on certain exchanges.
The world is not all black and white
Even though both of our Heroes have reasoning behind their decisions, they are both right and both wrong in a sense.
It's true that using market orders increases trading costs and it's also true that you can miss out a lot of much needed returns in fast-paced setups to make them worthwhile.
Now you might be wondering, if both are right, which freaking order type is the correct one to use? You might categorize yourself into a somewhat similar basket to either Paul or Ben and just copy their approach.
After all they are representative Heroes so surely doing what they do is a good approach.
But you might still not feel comfortable enough to (literally) bet your money on it.
Luckily there's a method to this madness.
Limit Orders
Let's first have a look at what each order type does, starting with the Limit Order.
Limit orders allow traders to specify a price at which they're willing to buy or sell a security.
They provide liquidity to the markets in a sense that you're posting at what price you want to transact into the orderbook.
When another trader decides to execute a market order, he's just transacting at whatever price is posted in the books, filling your limit order.
So for each transaction there needs to be an active side (market order) and a passive side (limit orders).
Limit orders provide potential cost savings by enabling traders to potentially transact at a more favourable price than the prevailing market price.
However, they introduce execution risk, as there's no guarantee the order will be filled if the market price doesn't reach the specified limit and a risk of getting adversely selected.
Market orders
These orders are executed immediately at the best available market price posted in the books.
Market orders guarantee execution but come at a higher cost, as they may involve paying a premium to buy or receiving a discount to sell compared to limit orders.
As you can see they both have different characteristics and therefore are usually suitable for different scenarios.
Urgency
When deciding which order type to use the main factor to consider is primarily urgency.
If you don't know the difference between urgent and important yet, you should have a look at this: https://reclaim.ai/blog/eisenhower-matrix
The TL;DR of this article is, urgency means something needs to happen fast.
So we're talking about the need to execute your trades fast here.
How fast you need them to be executed is a function of multiple factors:
cost considerations
risk aversion
order flow distribution
What does each one of these mean?
Cost Considerations
Market orders incur explicit costs like brokerage fees and the bid-ask spread, reflecting the difference between the highest bid price and the lowest ask price. Limit orders, while offering potential savings on the spread, may involve exchange fees or rebates that influence their overall cost.
Fee Structures: The fees and rebates associated with market and limit orders at different exchanges directly influence the optimal allocation. Traders will naturally seek venues that offer the most favourable cost structures.
Risk Aversion
Limit orders carry the risk of not being filled, particularly within a specific time horizon. This risk increases in volatile markets or when the specified limit price is far from the prevailing market price. Market orders, in contrast, guarantee immediate execution, mitigating this risk.
There is also a risk of getting adversely selected if other people are aware of alphas in the market and predict the market to move against your limit order.
Order Flow Distribution
Order Size: The quantity of shares being traded plays a critical role. For smaller orders, limit orders might be sufficient to achieve full execution with minimal cost. Larger orders, however, may necessitate a mix of market and limit orders to manage execution risk.
Order Queues: The length of order queues at different exchanges impacts the likelihood of limit order execution. Longer queues translate to a higher probability of delay or non-execution, influencing the decision to use market orders for more immediate fills.
Order Flow Dynamics: The statistical properties of order flows at different exchanges, including their volume and volatility, affect the execution prospects of limit orders. Understanding these dynamics is crucial for determining the optimal order allocation.
3 Scenarios
Scenario 1: High Urgency, time sensitive information. Its imperative to acquire significant position before the move even if it means paying a premium because the potential gains outweigh their costs.
Scenario 2: Moderate Urgency
Scenario 3: Low Urgency, usually longer-term investment horizons
Table of Content
TWAP (Time Weighted Average Price)
VWAP (Volume Weighted Average Price)
Percent of Volume (PoV)
Iceberg Orders
Cont-Kukanov
Final Remarks