Tuning to the new market reality

The ongoing concerns over European and US economies show no signs of abating and will require buy-side traders to configure their trading styles to suit volatile market conditions.
By None

If it's September, I guess it's time for some real work after the summer lull, no?

What summer lull? The first half of August saw substantial volatility and inflated trading volumes because of increased sell pressure.

Turnover on European exchanges almost doubled in the first half of August, climbing to between €58-70 billion daily, compared to an average of between €30-40 billion over the rest of the year, according to figures from multilateral trading facility BATS Europe.

European volatility, measured by the VSTOXX index, which reflects price fluctuations in EURO STOXX 50 options, also rocketed, reaching a year-high of 49.85 on 9 August.

Where did all this panic come from?

In autumn 2008 it was the banks that required a bailout. This time, it's entire countries that are in trouble, following a confluence of debt concerns in Europe and US.

Ratings agency Standard & Poor's downgraded US government debt for the first time in its history on 5 August, while at the same time Italy, Spain and Greece, Portugal and Ireland struggled to meet their debt obligations, forcing the European Central Bank to intervene.

These worries filtered through to the equity market, as banks that held a significant amount of government debt suffered a decline in their stock prices, sparking the mass sell off.

Is the situation improving as we move into autumn?

Not really. The conditions have spilled over into September, with many European indices fluctuating considerably at the start of September. For instance, Germany's DAX fell to its lowest level since August 2009 on 5 September as politicians struggled to agree on the best course of action for the EU, before rallying the next day.

Volatility has also showed no signs of abating, with the VSTOXX remaining above 40 since the start of September.

What are the chances that the market will face a winter of discontent?

Most remain sceptical of a recovery happening anytime soon. With so many EU states suffering well documented problems over the past year, market participants are wondering who will be the next to fall, particularly given the large exposures French and German banks have to struggling eurozone economies. Quite simply, there might not be enough bailout money to go around.

There are also knock-on effects as investors flock to ”safer' assets such as gold or Swiss francs, which amplifies the pressure on these instruments.

The timing of past financial meltdowns won't provide much comfort for market participants either, with September and October notorious for being rocky months.

Most recently, on 15 September 2008, Lehman Brothers filed for bankruptcy sparking the most recent economic turmoil.

Black Monday on 19 October 1987 marked the start of a severe market decline in the US and UK, which many at the time attributed to a rise in program trading that exacerbated losses with heavy selling pressure.

Going further back, the Wall Street Crash in October 1929 signalled the start of the Great Depression and abruptly halted years of stock market gains that had fuelled an era of wealth and excess.

This all sounds a bit ominous. Is there anything equity traders can do to cope with the adverse conditions?

Comfort with algorithms and the current range of execution options is a big factor in h how buy-side desks respond, if August is anything to go by.

Those traders that are avid users of algorithms may have favoured aggressive, liquidity-seeking strategies, rather than volume or participation-based strategies that can deliver unpredictable results during volatile periods. Increased use of aggressive strategies was a tactic employed by buy-side traders during the extreme volatility in 2008 sparked by the collapse of Lehman Brothers.

But traders that do not use algorithms frequently may have stopped using them altogether. Conversely, some brokers have reported a rise in algorithmic trading during August, because of the secrecy and immediacy they can provide over more manual forms of trading.

Many dark pools also suffered during the recent volatile period, as traders became wary of resting an order in the dark for fear of receiving a price away from prevailing market levels. Dark volumes in Europe declined at the start of August, accounting for around 2.2% of overall market share, compared to normal levels of just over 3%.

But perhaps one of the most sensible options – albeit one not available to all – for long-only buy-side traders was to simply wait on the sidelines until the uncertainty subsided before executing trades.

Click here to vote in this month's poll.

«