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March 23, 2005

Five From the Popular Movement

By Peter Chapman

In these early days of the algorithm movement most brokers offer similar tools, or automated strategies. Here are five of the most common. Each algorithm attempts to match or beat a chosen price benchmark. The examples are taken from Merrill Lynch's descriptions of its own algorithmic strategies.

Volume Weighted Average Price (VWAP)

The most popular. The strategy attempts to fill orders at a share volume-weighted average price equal to, or better than, the share volume-weighted average price for all trades in the security for a given time period. That can be either a full day or less. With Merrill's VWAP, traders have control over start time, end time, maximum percentage of volume, limit price, and a benchmark risk factor.

Merrill example: Buy 100,000 shares of XYZ. Achieve VWAP from 2:30 to 3:30.

Merrill's model seeks to achieve VWAP between 2:30 and 3:30 by submitting slices of the order according to historical and real-time volume patterns in XYZ.

Time Weighted Average Price (TWAP)

The strategy attempts to fill orders at a time-weighted average price equal to or better than the time-weighted average price for all trades in the security for a given time period. That can be either a full day or less. With Merrill's product, traders can control the start time, end time, maximum percentage of volume, limit price, and a benchmark risk factor.

Merrill example: Buy 100,000 shares of XYZ. Achieve TWAP from 2:30 to 3:30. The model will slice the order into 10 lots of 10,000 shares, and trade each slice over five minutes.

Percentage-of-volume (POV)

Similar to TWAP. The strategy tries to trade order's shares in some fixed ratio to overall market volume. With Merrill's product, users control start time, target percentage of volume, limit price, and a benchmark risk factor.

Merrill example: Buy 100,000 shares of XYZ. Start at 9:45 and represent one-third of the volume. Merrill's model will begin trading at 9:45 and maintain 33 percent of the trading volume. The order will complete once a total of 300,000 shares of XYZ have been traded in the market.

Market-on-close (MOC)

The strategy attempts to match or beat the market's closing price. With Merrill's MOC, the model balances price impact against the objective of beating the closing price. Traders have control over maximum percentage of volume, limit price, and a benchmark risk factor.

Merrill example: Buy 100,000 shares of XYZ into the close with a low benchmark risk level. Merrill's model determines the appropriate start time based on volume and price forecasts into the bell. The low' level of aggressiveness translates into a lower participation rate in the closing auction. Into the close, it involves an earlier start time with less potential impact, but potentially greater opportunity cost versus the close.

Arrival Price

The newest and perhaps the most sophisticated. Not offered by all brokers. The strategy attempts to fill the order at the portfolio manager's decision price or the price at the time the order reaches the trader. Merrill's tool "balances price impact against delay costs to minimize implementation shortfall." The phrase "implementation shortfall" refers to the difference between a portfolio's actual return versus its return on paper. With Merrill's product, the user controls the start time, maximum percentage of volume, limit price, and a benchmark risk factor.

Merrill example: Buy 100,000 of XYZ starting at 9:45. Target a maximum participation rate of 10 percent of overall volume, but be aggressive. Merrill's model will minimize slippage from the current XYZ price while representing no more than 10 percent of the market volume over the life of the order. A high level of aggressiveness will tend to have a shorter duration, higher potential impact, but a lower opportunity cost than a less aggressive strategy.