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Two of the more recent and prominent themes within the capital markets involve the unambiguous "risk-on" and "risk-off" environment and the heightened prominence of high-frequency trading (HFT). While these two themes might appear to be entirely disparate, they can, in fact, be closely related. Moreover, the relationship among HFT, asset correlations, and trading costs is one that equity trading desks need to monitor in order to ensure the best trade executions on behalf of their clients.
Outlining HFT's defining characteristics may provide some perspective on the current trading environment. High-frequency traders rapidly buy and sell securities, typically with a holding period of less than 10 seconds, in an attempt to capture relatively minor profits across a number of trading venues. This rapid activity gives high-frequency traders a broad presence in the equity markets, and they are generally responsible for up to 70% or more of the overall daily trading volume. But while most high-frequency traders use algorithms—that is, mathematic formulas used to execute trades—not all traders who use algorithms are high-frequency traders.
Proponents of HFT suggest that its market presence can compress bid/ask spreads and, therefore, improve liquidity within the equity market. But narrower bid/ask spreads comprise a relatively small cost in the trading process. A much larger cost is incurred when the execution of a trade affects market prices. For example, if a buy order pushes the price of a stock higher as the trade is being executed, this movement can negatively affect the return on that investment.
Due to HFT's effects on trading conditions, executing a trade without influencing a stock's price has become more challenging. This is the primary reason why HFT can affect the creation of alpha1 by investors who remain focused on investment fundamentals. As a result, these investors need to take the proper precautions to mitigate the effects of HFT.
Techniques Focus on "Footprints"
High-frequency traders use several techniques, many of which begin by identifying time or volume schedules that fundamentally focused traders may use to avoid influencing market prices when trading. The identification of these "footprints" provides the HFT program with an opportunity to trade ahead of existing orders at better prices.
One HFT technique that can influence market prices involves the relatively small rebates offered by equity exchanges in order to generate trading flow and, consequently, revenue. Once an HFT program identifies the footprint of an existing order, it can trade ahead of that order—thus, potentially affecting the price of the stock—while also collecting a rebate. The HFT could then fill the existing order at a price that is disadvantageous to that investor. Meanwhile, the high-frequency trader would benefit from the rapid accumulation of rebates that it collected from the various trading venues.
Another way an HFT program might transact with an investor is in the market-making capacity. This process may start with an HFT program identifying an existing order and how much price discretion the order has to buy or sell stock. Price discretion could be determined, for example, by the existing order's response to a series of offers to sell stock from a high-frequency trader. Once this discretionary amount is identified, the HFT program could trade ahead of the existing order and then fill that order at its price threshold. As a result of this process, the market maker would provide the investor with liquidity, but at a potential cost of moving from its initial price towards its discretionary threshold.
HFT programs also can use so-called predatory algorithms. Once an HFT program identifies an order, it might adjust its quotes for the stock, therefore prompting the investor to adjust as well. For example, if this process results in an investor raising its bidding price for a stock, the HFT program might sell the stock short2 to the investor at that price. Yet, considering that the sequential bidding process inflated the price of the stock, the HFT program could cover its short position once the stock price presumably reverts to its previous level.
Prior to HFT's emergence, one trading rule of thumb was that an order comprising 15% or less of a stock's average daily trading volume might be executed without unduly influencing its market price. Yet the tendency of high-frequency traders to influence stock prices while a trade is being executed means that smaller trades may be more likely to influence market prices. And when many of these trades occur throughout a trading day, they can contribute to increased market volatility and higher degrees of correlations.
Depending on whether risk is on or off, an HFT program may be set to buy several asset classes reflecting that particular environment. The ability to position for risk-on or risk-off conditions was enabled by the expansion of the exchange-traded fund industry across asset classes. The culmination of this HFT positioning can have the effect of automating levels of correlations across securities, asset classes, and levels of the capital structure.
If risk is on during a particular trading day, this might be reflected by rising values of, for example, futures on the S&P 500® Index,3 the euro, and the price of put options on the VIX index.4 By conducting a series of trades across asset classes that reflect the risk-on environment, potential arbitrage5 opportunities may be diminished as the assets move in tandem, thus giving the impression of an automated response to market conditions.
This automation has been readily apparent during recent periods of volatility, which is when HFT strategies tend to become more active and potentially more profitable. Take, for instance, the change in trading conditions and in HFT activity that occurred following the downgrade of the U.S. credit rating on August 5, 2011.
The post-downgrade period has come to epitomize intense market volatility as the VIX index surged to levels not seen since the financial crisis of 2008–09. As the markets gyrated, trading volume jumped by about 80%, with most of that trading volume coming from high-frequency traders, who increased their trading volume by about 300% during that time, according to Bloomberg. In all, this group was responsible for about 75% of the trading volume during the post-downgrade period.6
As market volatility and HFT activity increased, so too did the correlation levels among major equity categories. For example, correlations among constituents of the S&P 500 jumped to 0.93 following the downgrade, whereas it had been at 0.56 six months earlier. Similar surges in correlation occurred within broader large cap and small cap equity indexes. (See Chart 1.)
Based on correlations levels within the S&P 500, Russell 1000,7 and Russell 20008 indexes
The value of investments in equity securities will fluctuate in response to general economic conditions and to changes in the prospects of particular companies and/or sectors in the economy. Investments in small companies involve greater risks not associated with investing in more established companies, such as business risk, significant stock price fluctuations, and illiquidity.
While the exact relationship between HFT and asset correlations may be difficult to quantify at a given point in time, the post-downgrade period shows that an association between the two factors exists and can be measurable to a degree.
Given the amount of rhetoric in the press about HFT, there are indications that U.S. regulators will continue to look at the practice and its effects on the capital markets. While any initiative to regulate order types, quote cancellations, holding periods, or trading rebates could be a positive development, institutionally sized trading desks still need to implement their own measures to insulate their trades from HFT's influence.
The first step a firm can take to protect its trades against HFT's influence involves avoiding the trading patterns that these programs might identify.
One preventive measure regards the selection of a trading venue that provides the “purest” source of liquidity for investors. Indeed, certain trading centers, such as Liquidnet, do not allow rebates, predatory algorithms, or HFT market makers. With those exclusions, Liquidnet can provide a source of seamless liquidity between institutionally sized buyers and sellers, which may be to the benefit of their clients.
The way traders submit orders to the numerous venues can also avoid recognition by HFT programs. The submission process can be important, because an order that is routed to a specific exchange could be identified by an HFT program that, subsequently, cancels its quote, requiring the order to move to a different market center, where it might be executed at a different price. In order to avoid that scenario, a firm may use a customized algorithm that simultaneously submits orders at up to 60 market centers. This method can ensure access to the volume needed to fully execute an intended order, but without needing to move to a new venue and a new price. This submission process can also throw off HFT programs because it may prompt them to execute trades sooner than intended.
While the use of trading algorithms can automate the trading process, they also require constant monitoring and frequent modifications when in use. Indeed, a firm might interrupt an algorithm’s schedule anywhere from 10 to 300 times as a trade is being executed. When traders go silent for an hour or two, this often leads an HFT program to unwind a position at a favorable price, which in essence is using the speed of an HFT program against it.
These steps can produce tangible results in terms of not influencing the execution of a trade. Indeed, the average institutional trade in the third quarter of 2012 affected a stock's performance by 33 basis points (bps), according to an evaluation by a trading analytics firm.9 For Lord Abbett, trading executions had 10 bps less of an impact during the same period. (See Chart 2.)
Data based on trading statistics in third quarter 2012
Note: This trade cost analysis is based on an entry strike price and measures the basis points of market impact of all Lord Abbett's domestic equity trades and compares them with those within the Able/Noser universe, which is composed of more than $7.4 trillion transactions per year. The analysis provides information on one element of transaction costs and does not consider the impact of other trading costs, commissions, and fees.
Past performance is no guarantee of future results.
The attention placed on electronic-trading issues, including HFT's influence on trading conditions, Knight Capital's recent $440 million trading error,10 and the trading problems surrounding Facebook's initial public offering, may make it seem that software programs are running amuck in the equity markets.
Yet the greater point may be that in an environment increasingly dominated by electronic trading, human monitoring of these processes has also become more critical. The need for heightened human oversight is underscored by the patience, experience, and spontaneity required of traders and investors to mitigate the influence of HFT in order to receive the best trade executions for their clients.
Ted Oberhaus, Lord Abbett Partner & Director of Equity Trading, is responsible for overseeing the firm's trading and execution programs for its domestic and international equity products and is responsible for a team of traders who execute trading strategies through the major exchanges and various electronic communications and crossing networks. A proponent of using technology to enhance trading efficiency, Mr. Oberhaus was an early adopter of implementing algorithmic trading strategies for client accounts and is considered a pioneer in this area. Mr. Oberhaus began his career in the financial services industry in 1982. He joined Lord Abbett in 1983 as an Equity Trader. He was promoted to Director of Equity Trading in 1996, and was named a Partner in 2002. Prior to joining Lord Abbett, Mr. Oberhaus worked on the floor of the New York Stock Exchange as a Brokerage Clerk for Brimberg & Co. Mr. Oberhaus presents at a number of industry conferences and is often featured in financial publications, including BusinessWeek, Pensions & Investments, USA Today, and The Wall Street Journal. In 2006, he was included in Advanced Trading magazine's "Traders Gold Book." Mr. Oberhaus earned a BA in economics from Ohio Wesleyan University.
The bid/ask spread is the amount by which the lowest offer to sell stock exceeds the highest bid to buy stock.
Equity exchanges are marketplaces where equity securities are traded.
An exchange-traded fund is a security that tracks a market or segment of a market and trades daily on a securities exchange.
Correlation measures how closely two securities trade in relation to one another.
Put options provide the owner with the right to sell a specified amount of a security at a specific price and at a specific time.
A Note about Risk: Investing involves risk, including the possible loss of principal. The value of investments in equity securities will fluctuate in response to general economic conditions and to changes in the prospects of particular companies and/or sectors in the economy. Investments in small companies involve greater risks not associated with investing in more established companies, such as business risk, significant stock price fluctuations, and illiquidity. No investing strategy can overcome all market volatility or guarantee future results.
The opinions in the preceding commentary are as of the date of publication and subject to change based on subsequent developments and may not reflect the views of the firm as a whole. This material is not intended to be legal or tax advice and is not to be relied upon as a forecast, or research or investment advice regarding a particular investment or the markets in general, nor is it intended to predict or depict performance of any investment. Investors should not assume that investments in the securities and/or sectors described were or will be profitable. This document is prepared based on information Lord Abbett deems reliable; however, Lord Abbett does not warrant the accuracy or completeness of the information. Investors should consult with a financial advisor prior to making an investment decision.
Investors should carefully consider the investment objectives, risks, charges, and expenses of the Lord Abbett funds. This and other important information is contained in each fund’s summary prospectus and/or prospectus. To obtain a prospectus or summary prospectus on any Lord Abbett mutual fund, contact your investment professional or Lord Abbett Distributor LLC at 888-522-2388 or visit us at www.lordabbett.com. Read the prospectus carefully before you invest.