Chapter 12: Algorithmic Trading Strategies

Consider the situation where a trader wishes to buy or sell a large amount of a particular stock within a specific time frame. There could be various reasons for such a decision, such as liquidating a holding, or, re-balancing a portfolio. While the rationale for the trading decision is indeed important, in this chapter, we are not concerned with the actual reason. We will assume that the trader has arrived at the decision and consider the problem of how to implement the trade.

If the stock is very liquid (with respect to the size of the trade), then there is no problem. The entire buy or sell can be conducted as a single order. This, however, is rarely the case when the size of the trade is large. A large volume of trade usually moves the price in an adverse direction. In other words, if a large number of shares are to be purchased, this pushes up the price of the share, and conversely, if a large number of shares are to be sold, then this pushes down the price of the share. Consequently, for a buy order, the trader ends up paying more, while for a sell order, the trader ends up getting less. So, conducting the entire trade as a single order will have an adverse market impact, resulting in a sub-optimal return for the trader.