Algos which trade according to a linear schedule or aim to get an average price over a time interval have been available in FX spot for at least 10 years. Every major FX broker has a version in what could be considered a commoditised product. However, these algos can be traded in a number of different ways, and so it is worth revisiting why they are so popular and features that can differentiate them.
Collectively, this class of algos are usually referred to as TWAP (Time Weighted Average Price) although other name variants exist. They are designed to target the average price over some time interval, and are still one of the most popular algos used by execution traders. There are three main reasons for their popularity:
The algos trading style is conceptually straightforward and easy to understand. This is beneficial for traders who are not active algo users, those who are new to algo trading, and traders who are required to explain execution methodology within their firm.
The algo is useful in working orders over a time interval. Not every trade needs to be executed at a point in time, so achieving an interval average price and working an order to reduce market impact and spread costs, is achievable and desirable.
From a cost analysis perspective, it is reasonably easy to measure how the algo has performed against its average price benchmark, and make comparisons across different executing brokers.
So how to determine one TWAP from another?
Firstly, look at standard performance measures provided by a broker or a third party. This should be based on a sample of similar trades in similar sizes and currency pairs. The TWAP benchmark is the average mid-price over the interval of the trade.
Secondly, when choosing from the menu of TWAPs available, functional considerations include:
- Will the algo execute solely at predetermined intervals by crossing a spread, or does it work passive orders to capture spread?
- Randomisation of frequency between orders sent to ECNs. Regular events have more obvious signals to
- microstructure sniffing algorithms to take advantage.
- If executing a less liquid currency pair, does the algo look at the market spread and is it opportunistic in capturing spread when it is narrow?
- Is the algo flexible in its scheduling based on market conditions? For example, in higher volatility markets capturing spread might become less important.
- Will the algo execute against internal liquidity and ECNs? Many brokers have different styles of passive execution into their liquidity pool including matching at mid.
- Does the algo employ any alpha in the strategy and what are the predictive statistics associated with the alpha?
A simple regular TWAP, which crosses the spread on every slice, can expect to have slippage of around half the spread to the benchmark with only a small variation from this. More advanced TWAP algos work orders both passively and aggressively against internal and ECN liquidity. They should perform better on average, although could have more variance in performance (due to having more flexibility in execution) especially in less liquid currency pairs.
If the goal is to reduce the risk of a sub-standard execution against the benchmark, a TWAP which closely follows the linear schedule against internal liquidity might be sufficient.
Alternatively, if the average performance is more important than the variability of performance, then an algo that has a bit more flexibility and advanced order working features is likely to be a better alternative.
Trading interval
The main parameter in defining a TWAP algo is the trading interval. Trading too quickly will have more impact and trading too slowly will incur more market risk. Pre-trade analytic tools provided by banks or independent vendors are useful tools to calculate a trade-off between market impact and market risk, and to choose the trading interval.
One technique used to reduce the likelihood of impact is to add a participation parameter to the algo instruction. Participation is the rate of trading relative to an estimate of volume from ECNs. Restricting a TWAP algo to a participation rate of say 15-20% would ensure market impact is kept under control. Although this might result in the algo taking longer to execute and potentially not complete by the desired end time. In less liquid currency pairs, where liquidity can be thin and variable, this parameter becomes more important.
Although the TWAP has been around for a long time, we have seen some of the features that can differentiate between implementations of this algo. Depending on the use-case, the style of TWAP chosen could be different. These decisions are where a trader can add additional value to the execution process.
