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February 1, 2004

A Special Black Box Trader?

By Peter Chapman

The trend has even made its way into the halls of academia. Two years ago, the department of computer and information science at the University of Pennsylvania launched the Penn-Lehman Automated Trading Project. With financial and intellectual support from the quantitative trading group at Lehman Brothers, the project pits teams of traders against each other in a money-making competition. The project's goal is a "broad investigation of algorithms and strategies for automated trading," according to the university.

Despite the presence of in-house technology at Echo, Radial Systems has made inroads at the prop shop. A handful of Echo's 300 traders use Radial's system to automate their strategies.

Brian Ferdinand, in charge of Echo's New York office, explains that the assistance the computer gives traders is useful during quarterly earnings seasons. Traders can automate their traditional strategies while manually trading stocks subject to earnings announcements.

"This allows them to stay focused on earnings season," Ferdinand said, "while still implementing those other strategies."

Radial was founded by Azoulay and Amit Livnat in 2000 and is run out of a small room in Pax Clearing's New York offices. The vendor has made most of its initial sales to proprietary day trading brokerages such as Echo, Canada's Swift Trade and the now-defunct Worldco.

Proprietary day trading brokerages employ traders to trade the firm's capital. They are distinguished from "retail" day trading shops where traders use their own capital, but the firm's technology and offices. Prop traders split their profits with the house. Retail traders pay the house a commission.

Auto-trading, like all trading, can be boiled down to entry and exit strategies. That means when to put on or take off a position; how big of a position to trade; at what price to get in or out; and where to trade.

Once a position is put on, Radial's technology manages the trade in line with a trader's risk guidelines. That, in essence, means deciding how much money he can afford to lose in a day, either across his pad or on an individual stock basis. Loss parameters can be based on dollar amounts, say $5,000 per symbol, or the number of trades in that name. (e.g., "three loss-making trades and I'm out." )

Knowing when and how to enter and exit is dependent on a trader's assessment of market conditions. That assessment is boiled down to a number of if/then statements to form a strategy. For instance, if a stock has reached its high for the day, then maybe it's time to sell.

Trader decision-making is typically much more involved than that, of course, but "reading" the market is a key part of what Radial does. The technology sucks in every tick - every bid and offer and every sale - for every security being traded and then analyses the data and puts on the positions using the trader's if/then statements.

Testing, Azoulay says, is a crucial part of the process. Strategies are tested with paper money before, during and after the system goes live with traders' algorithms. There are four phases of testing.