Keep It Simple
By Anthony Victor
Despite the rapid advances in sophisticated trading tools, Bank of America Merrill Lynch’s Anthony Victor argues that in times of volatility a knowledge of the basics has never been more important.
While market structure and technologies may have transformed, basic trading skills are still critical to success.You do not succeed in any career unless you learn the basics and build a solid foundation in the fundamentals. For a role in electronic trading, the basics include understanding trading mechanics, market structure and technology, as well as the platforms that clients use to trade. Those old monochrome Quotron machines that were prevalent on trading floors when I started my career are now on the trash heap, replaced by state-of-the art technology, including touch-screen order management systems and workstations that supply news, market data, and analytics.
Since 2000, there have been some very dramatic changes in market structure such as decimalization, the advent of Reg. NMS and an increasing number of liquidity pools. Some of these changes resulted in a reduction of bid/offer spreads and a decrease in average trade size, which in turn, pushed market participants to use more advanced trading technology and ultimately algorithmic trading.
Algorithmic trading strategies, initially used by Portfolio Desks to manage large baskets of stocks, were eventually rolled out directly to the buy side. Trading no longer required multiple phone calls with instructions to execute an order. With a mere push of a button, these instructions could be sent electronically and trading goals could be efficiently realized. However, use of these tools still requires a good understanding of the basics and a team of support professionals that understand the nuances of how algorithmic strategies operate in the marketplace.
Within the last five years, Electronic Sales Trading (EST) desks have emerged on Wall Street to support the clients’ electronic trading activity. Unlike traditional sales trading, which focuses on what clients are trading, electronic sales trading puts the emphasis on how they are trading. Most EST desks have evolved from a pure internal support role into a client-facing, direct coverage role that assesses a client’s performance via real-time benchmark monitoring and post-trade transaction cost analysis. Electronic Sales Traders need to understand market structure and their firm’s algorithmic offering (and that of the competition) to successfully support the trading platform.
While market structure, trading tools, and trading desk responsibilities have all evolved over time, basic trading skills are still critical to success. Part of that skill set includes the ability to maintain a disciplined approach to trading amidst a barrage of news, overall market fragmentation, and a huge volume of market data. Algorithms have assisted the buy-side coping with the complexity of the marketplace, but the choice of strategy ultimately belongs to the trader.
In Q4 2008, when volatility (the amount of uncertainty or risk about the size of changes in a security’s value) peaked and preyed upon market participants’ emotions, many traders moved to more aggressive electronic trading strategies. In that tough environment, traders migrated away from passive strategies, like VWAP and lowparticipation algorithms, to more aggressive liquidity-seeking strategies, including an increased use of ‘dark pool’ aggregators. In a more volatile environment, traders felt pressure to make a stand or risk higher opportunity costs.
However, sometimes intuitive approaches do not work as expected. When analyzing the effects of the volatile market and looking at the slippage, or the difference of the execution price versus the price at time of order receipt (arrival price slippage), these aggressive strategies proved less successful than passive strategies, primarily due to the effects of volatility on spreads and depth of book. During that period, our research shows that S&P 500 spreads widened an average of 72% and book depth decreased 42% compared to Q1. Wide spreads and decreased book depth created a treacherous environment for aggressive, liquidity-seeking strategies, but favored more passive strategies.
The upside of passive
The success of passive strategies like VWAP can be attributed to several factors. VWAP orders tend to be longer in duration than other order types and in turn represent a smaller percentage of interval volume. In addition, the size of individual slices sent to the market tends to be smaller and more passively priced.
Due to the longer order duration, these less-aggressive strategies are more patient in seeking out price improvement opportunities. This results in crossing the spread less frequently, thus saving the higher cost associated with wider spreads. Conversely, aggressive order types that seek to execute quickly tend to cross the spread much more frequently.
Individual slice size is a meaningful strategy characteristic due to the fact that decreased depth-of-book also exacerbates arrival price slippage. With less available liquidity, algorithmic strategies may have to work through more price points to complete a given order slice. Slippage increases when there are more of these execution price points. At lower aggressiveness levels, the slices themselves are smaller, reducing the need to hit progressively worse price points to complete, thereby reducing the signaling risk (the risk of signaling to the market information about trading intentions) of any given slice. The larger slice sizes necessary for more aggressive order types tend to execute through more price levels, resulting in more slippage and producing a more detectable signal to the marketplace.
The cost of aggression
Though traders may have assumed that more aggressive strategies were a prudent execution method in the high volatility environment, it is evident in retrospect that the cost associated with choosing aggressive strategies was significant. Most notably, for more difficult trades (over 2% ADV), the cost difference between using an aggressive strategy over a passive one topped 44 basis points in Q4 08.
During this same period, traders were also looking for additional hidden liquidity to complement their urgent execution mentality. The result was an increase in the use of dark pool aggregators. These order types are generally midpoint-pegged, meaning that they execute at the middle of the spread. Slippage incurred was less than it would have been when fully crossing the spread, although additional costs were realized because spreads widened. As expected, the performance of these order types fell somewhere between more passive and more aggressive strategies.
Keep It Simple
In Q1 2009, as volatility and spreads began to level off and depth-of-book once again began to increase, we saw a migration away from aggressive strategies back to VWAP and lower-participation Implementation Shortfall. It seems that those traders who underperformed in the fall moved to an uncharacteristic, yet statistically more successful, passive trading style. These strategies continue to work well today.
In a high volatility environment, even with the availability of sophisticated algorithms, some of the most basic strategies have worked best. Well-worn algorithms like VWAP and Implementation Shortfall have generally been more successful than newer and more aggressive, liquidity–seeking counterparts. While perhaps contrary to their intuition, traders should consider sticking with basic, “first-wave” algorithms like VWAP and I/S in a high volatility environment. The first and simplest strategy you learned may sometimes prove to be the best.
The new high volatility environment will undoubtedly spur another evolutionary advance of next generation trading techniques and strategies. Successful traders should look to implement the lessons learned last fall by maintaining a disciplined approach to trading based on fundamentals and overall market structure expertise.