Algorithmic trading is old news. While the technology gets faster and a bit more sophisticated with every passing year, the idea that machines can actually trade stock automatically based on pre-programmed strategies is…old-hat. Granted, algorithm providers must continue to innovate as the buy side continues to select trading partners based in large part on the tools they can provide. Beyond microsecond savings and smarter ways to access dark liquidity, the question is, how much more exciting can this get?
This ignores an often forgotten fact however – there is a world beyond equities. The use of equity options has boomed in recent years. Volatility is at levels not seen in more than five years, commodity prices are going through the roof and the credit crisis has sent institutional investors scrambling for new ways to reduce risk and find alpha.
Listed options are increasingly traded via high-speed electronic platforms. Options exchanges are accelerating their move to electronic trading with three out of seven venues already fully automated – with hybrid models seeing more volume trading away from the floor daily. The combination of market forces and electronic exchanges has driven volumes ever higher. Nearly three billion option contracts were traded in 2007 – a CAGR approaching 40% for the past two years. That has helped to drive messaging rates skyward with peaks over one million messages per second.
How can an individual trader be expected to catch up? Frankly, they cannot do it on their own, which is why algorithms are front-page news…again.
Automated trading for options has been around for several years in the form of smart order routers, but has gone partly unnoticed due in large part to changes in terminology. Shortly after the ISE began trading in 2000, encouraging a broad move toward electronic options trading, smart order routers came on the scene to seek out the best price across the five options exchanges. The logic was simple compared to today’s standards. Speed was still measured in seconds, but these early smart order routers were algorithms nevertheless.
There is a continued debate within the industry as to when or if a smart order router should in fact be considered a trading algorithm. In their most basic form, smart order routers help determine where to execute an order, whereas algorithms are thought to help resolve when and how to trade. Today, many smart order routers creep into the when and how territory, while the majority of algorithms incorporate the where decision.
The question then becomes, just how smart must a smart order router be to earn the title of algorithm?
The answer is, it does not matter. What does matter is that the buy-side trader who is paying to use technology provided by a broker or software vendor understands what it is he is getting. Some need sophisticated delta-hedging algorithms; others only need help finding the best price.
In the equities world, 10 years of innovation and marketing have created a more universal understanding of what defines what. Not only is automated trading technology for options in its infancy, but the education of buy-side end users has barely begun. In a recent conversation, a trader at a large hedge fund told us he believed “algorithms for options trading are nonsense.” This does not translate into ‘the buy side lacks interest in algorithms for options trading;’ rather, it reveals merely a gap in the buy side’s knowledge of what is out there.
The algorithms that many buy-side traders have grown accustomed to in the past decade were developed solely for the equities markets. Taking these same ideas and applying them to options does not work, hence a common view the algorithms will not be as successful for options trading.
It is the job of the algorithmic providers to educate their eventual users, and it is conversely the job of the buy side to understand the tools that are now available to it. Smart order routers, liquidity seeking, delta hedging and numerous other new algorithms have now been designed specifically for the options world.
It is not algorithms themselves that are old news, but narrow views of their effectiveness across products that are boring and out-of-date. TABB Group estimates show that by 2010, nearly 35% of the buy side’s options trading will be done via algorithms. This is up from virtually zero only three years ago.
The worldwide web of today is much different than it was in the 90s, commonly dubbed Web 2.0. Such is the world of algorithms for options trading. Get ready for Algorithms
2.0.
