08. Execution Algorithms to Optimize Trading Fees

Published at 1654249931.847155

The execution price of a stock is determined daily by the rules of supply and demand. At any given time, if an investor executes an order to buy or sell shares in too large of a volume compared to normal liquidity, it will immediately create an imbalance of supply and demand. The stock price in the short term will move in an unfavorable direction to the investor. Specifically, when placing a high-volume buy order, the market price will increase, resulting in a higher average execution price than expected; and vice versa when selling in a large volume.

The larger the volume compared to the stock liquidity, the larger the impact on the market price in the unfavorable direction. For example, an investor places buy orders for stock A and stock B, at 1 million shares. However, the daily liquidity of these two is different (table below):


While the volumes are the same, stock A has higher liquidity. So the buying order from stock A has less impact on the market price. The order to buy stock B is likely to have a big impact and increase its market price.

Why Large Volume Impacts the Market

When a high-volume buy and sell order enters the market, market participants are likely to believe that the market has key information that they are not aware of. They will then revise the price they are willing to buy or sell to reflect this unknown information.

To limit the market impact in an unfavorable direction, when trading in large volumes, investment funds and investors execute orders by dividing large orders into several smaller ones. They also execute orders at various times to minimize market impact. Commonly used execution algorithms include:

For retail investors, these strategies may be of limited value. However, for large investment funds and investors,  the application of execution algorithms is of great significance. It’s no less than the efforts to find value stocks or to manage portfolio risks.

POV Algorithm 

This algorithm executes orders at a predetermined percentage of market liquidity until reaching the target volume. As the trading volume in the market increases, the algorithm will trade more stocks and vice versa.

For example, investors like to buy 5 million FPT shares with the POV algorithm at a rate of 10%. For every 10,000 FPT shares traded on the market, the algorithm will buy 1,000 shares until reaching 5 million.

The advantage of this algorithm is that it keeps the volume of buy orders in the market depending on the current liquidity of the market (around 10% as in the example above). Thus it minimizes the impact on market prices.

The main disadvantage of this algorithm is that it’s possible investors will not complete the trade within a specified period of time, especially in unfavorable market liquidity. In the example above, the historical liquidity of FPT at the time of writing is 2.5 million shares a day. It would then take 20 days to buy all 5 million shares if the liquidity stays constant.

However, at unfavorable times, market liquidity can drop to half . It may take up to 40 days for the algorithm to complete. This leads to the risk that the fair market price has increased significantly from the expectation.

VWAP and TWAP algorithms can solve the problem above. They both calculate to divide the stock volume into small orders to trade and place these orders on a predetermined schedule. They ensure the algorithm is completed within a specified period of time, such as buying 5 million FPT shares completed in 20 days.

VWAP Algorithm 

This algorithm breaks down and puts orders into the market in different time frames. The volume is calculated based on historical data. The challenge is that the historical liquidity data may not always repeat itself in the future. There are time frames with high trading volume in the past but this may not happen again in the future.

TWAP Algorithm

This algorithm breaks down and puts orders into equal parts and places them into the market at regular time periods (normally spaced 5 minutes apart). It should be noted that investors should split orders small enough to ignore market liquidity impact. It’s because this algorithm does not include the liquidity factor in the calculation. Its goal is to complete the transaction within the specified time period.

In Vietnamese, investors can see this algorithm is widely used on blue chip stocks. They are traded with a volume of fewer than 1,000 shares every 2 seconds.