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January 1, 2005

Volumes Grow as Firms Open: The Black Box

By Peter Chapman

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Wedbush Morgan Securities is not usually associated with the powerhouses of trading, but that could change.

The small retail brokerage and clearing firm has joined heavyweights such as Knight Trading and Charles Schwab on Nasdaq's weekly list of top liquidity providers. In fact, Wedbush ranked second for the week ended December 6.

In Thomson's AutEx/BlockDATA share volume rankings, however, the firm has placed no higher than 50 in recent years. So why is Wedbush making the Nasdaq list? How did it come to rub shoulders with some of the most active trading houses on the Street? The answer is black boxes.

"Black boxes produce a tremendous amount of volume," says Harvey Cloyd, in charge of Wedbush's professional trading group. "It's become a significant portion of our business."

Wedbush is one of a growing number of brokers catering to the expanding universe of black box traders. Black box, or auto-, traders, as individuals or in groups, program computers to execute trading strategies impossible to do manually.

Market Conditions

Black box trades can involve the simultaneous and/or periodic execution of hundreds or even thousands of orders. The trades are based on strategies that range from the aggressive price predictive momentum variety to more conservative arbitrage schemes. Executions are triggered by current market conditions or short-term forecasts.

The practice, driven by faster and cheaper technology, can be seen as a democratization of the "program" trading conducted by bulge bracket firms since the 1980s.

Former daytraders, PhDs, and others now have the ability to devise and run their own strategies across multiple asset classes. If they have already developed a successful strategy with five stocks they can automate and apply it to 100 or 200. If they want to trade thousands of pairs at one time, they can.

Traders typically work with software developers to build customized boxes based on their ideas. Many of the custom houses are obscure outfits operating with a handful of programmers such as New York's Radial Systems and Austin, Texas' WatchCat. Other traders may opt for off-the-shelf products from vendors such as Neovest or 4th Story [See Q&A].

It is estimated that most black box trading strategies - perhaps as many as nine in 10 - fail. "They are very successful on paper," says Amit Livnat, a principal at Radial Systems, "but lose money in the market."

The designers are inexperienced, Livnat adds. They often fail, for example, to properly account for slippage, or the difference between the expected price and the actual fill price.

John Paul DeVito, president of Bon Trade Solutions, a three-year-old connectivity provider, has also seen black boxes come and go. "We have run through so many of them," DeVito says. "In three years, we've seen only a few that were consistently profitable."

Automated trading is occurring at all levels of Wall Street, but the term "black box" trading generally refers to the activities of professional individuals, investment partnerships and small hedge funds. It is the low end of the professional market, but increasingly accounts for considerable share volume.