Institutional Investor's Alpha Magazine - November 2007 - (Page 71)

Algorithmic Trading aggressive ones or to broker-handled trades. Many traders reliant on slow execution algorithms froze like deer caught in headlights. “We did not see a substantial shift toward moreaggressive algorithms,” says Soﬁanos, “and that was kind of surprising. Where there is high execution risk, you want to trade more aggressively.” Sofianos did find that although most algorithm users stuck with the versions they had in play before the market volatility, not everyone was complacent. Adam Sussman is the author of “Modular Algorithms: The Growing Choice of Buy-Side Execution Strategies,” a report published by TABB Group in September that looks at the history, current usage and future direction of algorithms. While researching his report, Sussman interviewed several hedge fund traders and managers, many of whom told him that they did in fact shift to more-aggressive algorithms to deal with the market’s volatility. He found that the larger, more sophisticated hedge funds led the way — but that even they ran into problems. Despite shifting to more-aggressive algorithms, many fund managers still found their trades bogged down in August’s swamped broker networks, says Sussman. “The algorithms did what they were programmed to do, but brokers couldn’t handle the ﬂow,” he says. “Execution reports began to slow down. Everything began to grind to a halt. The traders began to call brokers, saying, ‘What the heck is going on here?’” The worst trading bottlenecks occurred during the early morning and late afternoon rush hours at exchanges. Traders tend to base decisions on the opening and closing prices of stocks; most algorithmic programs and models in use today are set to wake up at the opening and close of trading. “Few models are based on intraday prices,” explains Ernest Chan, who runs Ernest P. Chan Consulting — a New York–based quantitative consulting firm. “Before the close these models start running, and if they are triggered by certain price levels, they will accelerate market trends — strategies that manage billions of dollars.” Chan says many ﬁrms tend to rely unﬂinchingly on risk assessment models, so when such models interpreted the market’s August gyrations as a sign to sell, many fund managers immediately plugged large sell orders into their algorithms. But when prices rebounded, selling often turned out to be a costly mistake. The trick to making money in August’s volatile market, posits Chan, was not just choosing the right execution algorithm but also correctly interpreting the warnings from risk models. “Most people tend to adhere to the risk model,” he says. “But I’m sure that some people overruled their risk models and chose not to sell.” Execution delays had the greatest impact on high-volume traders who had big bets dependent on rapid order execution. Some firms bypassed the broker jams by using inhouse electronic trading architectures to access exchanges and alternative markets directly. “The guys who built their own infrastructure and were using their own proprietary algorithms had an advantage,” asserts Sussman. Quantlab Capital Management of Houston, an investment management ﬁrm known for executing hundreds of thousands of trades a day, had done exactly that. “We were able to deal with the extra volume because of our bandwidth and the robustness of our system,” explains John Huth, Quantlab’s director of portfolio management. Quantlab relies on a suite of execution algorithms and inhouse trading architecture designed and built internally. Huth says that one big help for active traders is algorithms with built-in “intelligence” to monitor market conditions and automatically correct execution methods. Quantlab’s algorithms appear to have functioned well in the recent difficult markets, he says, by making adjustments in execution methods as needed. “The main complaint people had was that their algorithms were going too slowly,” he says. The high costs of building and running such systems, however, make them a luxury available to only the largest firms. — ADAM SUSSMAN, ANALYST, TABB GROUP TABB’s Sussman estimates that the construction cost of a basic execution algorithm architecture runs close to $1.6 million, while annual maintenance runs an additional $900,000. Still, enough firms have armed themselves with in-house electronic trading capacities to make brokers say they were a noticeable presence in August. “We saw the more sophisticated groups executing directly into gyrating markets,” says Carl Carrie, global head of algorithmic products at JPMorgan Chase & Co. “They were more automated. They were using dark pools and other liquidity merchants to ﬁnd liquidity.” Still, smaller ﬁrms unable to write their own algorithms or build their own trading systems aren’t completely out of the game. Brokers and vendors offer guidance for choosing among available execution algorithms, and a handful of companies have even begun offering software that helps users identify the best algorithm for their needs and for different market situations. Though some traders chose to completely shun algorithms during the volume crunch, most have since resumed reliance on them. Execution algorithms remain a highly efﬁcient way to trade, and their usage and the share of overall trading they control are expected to continue to grow. There is even some evidence that their efficiency helped pull the market back smoothly and quickly when investors decided that the rapid price drop in equities had created bargains. “The crisis in conﬁdence wasn’t so much on execution, it was on investment decisions,” Sofianos says. “Fundamental issues caused the market turmoil, but executions themselves were not the cause.” “The guys who built their own infrastructure and were using their own proprietary algorithms had an advantage.” NOVEMBER 2007 • INSTITUTIONAL INVESTOR’S ALPHA • 71

Table of Contents Feed for the Digital Edition of Institutional Investor's Alpha Magazine - November 2007

Institutional Investor's Alpha Magazine - November 2007 Contents Letter from the Editor Longs & Shorts Pension Corner: Patriot State The Good Guys: College Connection Interview: Currency of Change Cover Story: Comeback Kid Strategies: Masters of Art Research Center: Alpha Awards: Top Technology Providers Top Analysts Alpha Bytes: Critical Choice Unhedged: Commentary: Banking on a Bubble

Institutional Investor's Alpha Magazine - November 2007

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