1. Algorithmic Trading: Learning to use the Technology Tool Dr Tom Middleton, Director Citigroup

2. Alternative Execution CITIGROUP ALGORITHMIC TRADING SERVICES FPL Electronic Trading Conference March 2006 Why use algorithms? What algorithms are available? Choosing the right strategy and parameters

3. Alternative Execution CITIGROUP ALGORITHMIC TRADING SERVICES FPL Electronic Trading Conference March 2006 Why use algorithms? If used properly, algorithms can improve performance, reduce execution volatility and increase productivity, by: Allowing small or liquid orders to be automated Trading opportunistically, where a human being would have to monitor the order book continuously Taking advantage of fleeting opportunities

4. Alternative Execution CITIGROUP ALGORITHMIC TRADING SERVICES FPL Electronic Trading Conference March 2006 What algorithms are available? Algorithms are typically designed to target popular trading benchmarks Commonly used strategies in Europe are Participate (47%), VWAP (42%), Market-on-close (7.5%), Implementation Shortfall (2.9%), and TWAP (0.3%) While there has been a shift away from VWAP in Europe in recent years, it still dominates in South Africa (73%)

5. Alternative Execution CITIGROUP ALGORITHMIC TRADING SERVICES FPL Electronic Trading Conference March 2006 What algorithms are available? VWAP, TWAP, Participate and MOC are fairly self explanatory – but how does an Implementation Shortfall (IS) algorithm work? The goal in IS is to balance opportunity cost and market impact systematically If we trade infinitely slowly we incur no market impact, but we don’t realize any alpha, but… …if we trade too quickly our market impact erodes any alpha that is there.

6. Alternative Execution CITIGROUP ALGORITHMIC TRADING SERVICES FPL Electronic Trading Conference March 2006 What algorithms are available? The BECS pre-trade model is used to manage the trade-off in Implementation Shortfall between market impact and opportunity cost The model defines a time-to-fill and an optimal profile shape for a given level of risk aversion Real trade data are used to re-calibrate the model to the changing market environment

7. Alternative Execution CITIGROUP ALGORITHMIC TRADING SERVICES FPL Electronic Trading Conference March 2006 What algorithms are available? Post-trade analysisBECS pre-trade model Optimal trading time and horizon

8. Alternative Execution CITIGROUP ALGORITHMIC TRADING SERVICES FPL Electronic Trading Conference March 2006 Choosing the right strategy and parameters One size doesn’t fit all: algorithms should be designed for the market and stock for which they will be used Key inputs into the model are bid-ask spread models, volume statistics and volatilities Many of our traders use a simple framework for classifying stocks into three classes

9. Alternative Execution CITIGROUP ALGORITHMIC TRADING SERVICES FPL Electronic Trading Conference March 2006 Choosing the right strategy and parameters TypeTick Size/VolatilityMedian spread/Volatility Example IHigh OML.L IILowHighOMLJ.J IIILow DTEGn.DE The trickiest to trade are Type II – and almost all South African stocks are in this category

10. Alternative Execution CITIGROUP ALGORITHMIC TRADING SERVICES FPL Electronic Trading Conference March 2006 The behaviour of type II stocks is characterized by: Algorithms must be designed to deal with – even capitalize on – these quirks Volatile spreads Erratic volume profiles and liquidity – especially in auctions and after the open Choosing the right strategy and parameters

11. Alternative Execution CITIGROUP ALGORITHMIC TRADING SERVICES FPL Electronic Trading Conference March 2006 Example: cumulative spread distributions for OMLJ.J (blue) and OML.L (red) Choosing the right strategy and parameters

12. Alternative Execution CITIGROUP ALGORITHMIC TRADING SERVICES FPL Electronic Trading Conference March 2006 Choosing the right strategy and parameters Any strategy can be used in the South African market, as long as the algorithms are designed with the market’s quirks in mind Algorithms are smart: but should always be used with price and volume constraints in the South African market except for the most liquid stocks Price limits are advised in most strategies, especially in participate Volume constraints should be used with all strategies where liquidity in the stocks being traded can be patchy

13. Alternative Execution CITIGROUP ALGORITHMIC TRADING SERVICES FPL Electronic Trading Conference March 2006 Conclusions Algorithms are suitable for the South African market, provided Quite complex then? It needn’t be. Your broker should be able to ‘can’ parameters and customize strategies for you. The model is designed appropriately for the quirks of the market Suitable parameters are chosen for the stock being traded