CPT Algorithmic & Automated Trading 3 — Questions and Answers
Question 1: Which order routing strategy breaks a large order into smaller pieces executed over time to minimize market impact?
- VWAP algorithm
- Iceberg order
- Time-weighted average price (TWAP) algorithm (Correct answer)
- Market order
Correct answer: Time-weighted average price (TWAP) algorithm
A TWAP algorithm divides a large order into equal-sized slices executed at regular intervals throughout a defined time window to minimize market impact.
Question 2: What is 'latency arbitrage' in electronic trading?
- Exploiting price differences between geographically distant exchanges using faster data feeds (Correct answer)
- Profiting from delays in regulatory reporting requirements
- Arbitraging interest rate differentials across currencies
- Taking advantage of slow broker order routing systems
Correct answer: Exploiting price differences between geographically distant exchanges using faster data feeds
Latency arbitrage involves exploiting informational advantages gained by accessing faster market data feeds to trade ahead of slower market participants.
Question 3: In a pairs trading strategy, when the spread between two cointegrated assets widens significantly, the algorithm should:
- Buy both assets to capture momentum
- Sell the outperforming asset and buy the underperforming asset (Correct answer)
- Exit both positions immediately
- Buy the outperforming asset and sell the underperforming asset
Correct answer: Sell the outperforming asset and buy the underperforming asset
Pairs trading exploits mean reversion by selling the relatively overvalued asset and buying the relatively undervalued one, expecting the spread to narrow.
Question 4: What does 'alpha decay' mean for a trading algorithm?
- The algorithm's code becomes obsolete as programming languages evolve
- The gradual erosion of a strategy's edge as markets adapt or competitors replicate it (Correct answer)
- Radioactive decay modeled in volatility pricing formulas
- The daily theta decay applied to options positions held by the algorithm
Correct answer: The gradual erosion of a strategy's edge as markets adapt or competitors replicate it
Alpha decay describes the diminishing profitability of a trading strategy over time as market participants discover and arbitrage away the same opportunity.
Question 5: Which of the following best describes 'dark pool' trading?
- Illegal after-hours trading conducted off-exchange
- Private exchanges where large institutional orders are matched without public pre-trade transparency (Correct answer)
- Algorithmic strategies that only trade during low-volume periods
- High-frequency trading conducted in unlit fiber-optic cables
Correct answer: Private exchanges where large institutional orders are matched without public pre-trade transparency
Dark pools are private trading venues that allow large institutional orders to be matched without displaying quotes publicly, reducing market impact.
Question 6: A trading algorithm's 'Sharpe ratio' is calculated using:
- Total return divided by maximum drawdown
- Excess return over the risk-free rate divided by the standard deviation of returns (Correct answer)
- Average winning trade divided by average losing trade
- Total profit divided by total number of trades
Correct answer: Excess return over the risk-free rate divided by the standard deviation of returns
The Sharpe ratio measures risk-adjusted return by dividing the portfolio's excess return (above the risk-free rate) by its return volatility (standard deviation).
Question 7: What is the role of a 'market maker' algorithm?
- To aggregate liquidity across multiple venues and route orders optimally
- To simultaneously post buy and sell limit orders, profiting from the bid-ask spread (Correct answer)
- To execute large directional bets based on macroeconomic signals
- To replicate index returns through basket trading
Correct answer: To simultaneously post buy and sell limit orders, profiting from the bid-ask spread
Market-making algorithms continuously post bids and offers, earning the spread while managing inventory risk, thereby providing liquidity to the market.
CPT Algorithmic & Automated Trading 3
Which order routing strategy breaks a large order into smaller pieces executed over time to minimize market impact?