No news is good news for algos
Less media coverage and dwindling attendance at algorithmic trade shows suggests that equity algorithms are no longer hot news, writes Allen Zaydlin, CEO of Inforeach. However, the spotlight is merely starting to shift elsewhere, with the use of algorithms now being explored by traders in the derivatives and FX markets.
Algorithms have proved a valuable tool for equity traders, helping them address many of the challenges they face in today’s rapidly evolving market-place. Fragmentation of liquidity across exchanges, ECNs and dark pools, as well as crossing services in all their various forms, can be a cause of grief for traders’ intent on trading significant size and still hoping to achieve best price. Akin to smart order routers and dark liquidity aggregators, liquidity-seeking algorithms that have been engineered to probe all the relevant, yet disparate sources of fractured liquidity have been a vital tool in the trader’s toolkit.
Lack of uniformity in order types and order behaviour across various liquidity pools is yet another obstacle to efficient trading. Algorithms efficiently hide this inconsistency and pro-vide a ‘synthetic’ uniform interaction with different execution venues. Achieving the execution goal, be it VWAP, arrival or close price, participation in line with volume at a certain rate, or simply staying balanced while executing a number of orders, is extremely challenging when a trader has to deal with hundreds or thousands of symbols simultaneously. Moreover, the onset of high volumes of market data demands the automation of decision-making processes and response times which are beyond a trader’s physical capabilities. Confronted with these new market real-ties, for equity traders, entering the trading arena without being armed with algorithms can quickly put them at a disadvantage to their peers and negatively impact trading performance.
The new frontier
Buy-side traders are now pondering the extent to which execution algorithms, created for the equities market, can supplement trading in the derivatives and FX markets. Can execution algorithms deliver the same benefits across other asset classes? And can the existing offerings be re-used for trading other types of securities?
There are a number of defining characteristics that sets futures, options and FX trading apart from the equities market. Understanding the execution process surrounding each non-equity asset class is therefore vital in order to gauge the extent to which algorithms can be used to supplement the trading of non-equity instruments.
Futures markets are not fragmented like the equities arena – at least not yet – with every instrument traded at a designated exchange. Typically, the nominal value of a futures contract is much greater than that of a stock. Given the present structure of the market, traders do not require a high level of automation to deal with liquidity fragmentation or trade multiple orders simultaneously. Neither do they have to work a large position by gradually split-ting it into hundreds of child orders. However, exchange-supported order types differ from venue to venue. Some futures exchanges do not offer open order-amend capabilities, while others do. Given these distinct characteristics, the typical algorithmic offerings for futures are currently gravitating towards VWAP and TWAP or synthetic ‘stop-loss’ order types.
In the US, options are traded in many market centres. The execution of an options contract tends to be dictated by both the under-lying market price of the instrument and the quantity of the underlying instrument that has already been executed in the market. Traders do not commonly work a portfolio of options trades throughout the day. However, many options investment strategies require execution of complex multi-leg transactions such as ‘strangles’, ‘straddles’, ‘butterflies’ and ‘spreads’. Execution of a multi-leg transaction requires the simultaneous and efficient execution of each underlying order / leg of the trade. Manual execution of a multi-leg transaction is difficult, especially in a fragmented market. Approaches differ among the various options exchanges in terms of how they implement these advanced order types, adding to the complexity of the whole process. Algorithms that offer smart order routing capabilities, order slicing and delta hedges are considered of benefit to options traders and can provide peace of mind in helping to facilitate execution of a multi-leg trade.
While the FX market lacks centralised exchanges, several banks offer FX quote aggregator services that allow market participants to post liquidity. Buy-side FX trading is done against two-way exchange rate quotes provided by one or more banks. Typically, the quoted spread is tighter on smaller quote sizes and greater on larger ones. In this environment, traders need to work their larger target FX positions gradually by trading smaller sized orders within tighter spreads across multiple banks that provide tradable quotes. FX slicing algorithms that can work with multiple quotes from different sources are ideally suited to this task.
Having been pioneered and tested for the equities market, algorithms have already proved their worth in improving execution performance. For established and widely used strategies like VWAP, TWAP and volume participation it is relatively easy for derivatives and FX traders to adopt existing equity algo offerings and adapt them to futures and options. This is already happening and having a meaningful impact on the execution of trades in non-equity asset classes.
