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June 18, 2008

Get Used to It:

Traders have, when it comes to volatility

By Ian Domowitz

Also in this article

Postmortem analysis is nearly a cultural obsession. Witness the popularity of ESPN's "SportsCenter," which may be trumped only by daily postmortems relating to the U.S. presidential campaign. A viewer cannot turn on the television without a review of how a candidate might have improved her chances, or how he "misspoke" and certainly how each event had a cumulative effect on the (still forecast) outcome of the election.

The market dislocation beginning in August of last year offers numerous possibilities for postmortems' combination of hindsight and soothsaying. Titles such as "What Happened to the Quants in August 2007" and "Deciphering the 2007/2008 Liquidity and Credit Crunch" now appear regularly on conference agendas. No surprise here: Anything out of the ordinary offers an opportunity to check a favorite theory against events.

Questions on Costs

Transaction research is no exception, and the queries have been coming in. Are transaction costs rising with volatility? What about those spreads? And we see a shift toward VWAP trading in the second half of 2007-tell us why.

VWAP aside, there is an interesting lesson for trading cost analysis from that period. Intuitive and familiar influences may have failed to predict trading costs in the short term. Yet shifts in trader behavior, as predicted, and even guided, by transaction research, resulted in a rapid return to average performance, despite the continuation of a tumultuous environment.

As volatility trends go, the period from August 2007 to the first of this year is an excellent illustration. Depending on your favorite measure, volatility rose between 50 and 70 percent. The levels of, say, the VIX, are not unprecedented historically. On the other hand, transaction research only began to "come of age" in 2002, and retrospective analyses often focused on the drop in equity transaction costs during the 2002-2005 period, as volatility declined.

It is difficult, however, to link transaction costs to changes in volatility in today's environment. Over the last three years or so, the correlation between transaction costs in our database and 60-day averages of forward-looking volatility is less than 3 percent, for example. That figure moves around by a few basis points, depending on whether one looks at buys, sells or capitalization differences and the like, but the relationship between the level of transaction costs and volatility is tenuous, at best. In contrast, the correlation between bid-ask spreads and volatility during the period is more than 30 percent. It seems almost a shame that, post-decimalization, spreads lost predictive power with respect to transaction costs.

Short Climb

Just as the bottom line in the presidential campaign must be the election result, the important thing here is trading performance as measured by trading costs, since the shortfall chisels away investor returns. So, what happened to transaction costs following August 2007? They climbed-all the way to their average value since August of 2004. Equity trading costs looked about the same in January 2008 as they did in June 2007 or December 2006.

The real news is not in the levels of cost, nor the lack of relationship with two-sided price movements, but rather the path by which costs reached their January level.

Costs rose sharply in the aggregate following August, tracking volatility for a short period. Trading strategies then changed. The decline in costs from the peak was almost 40 percent, and began within a couple of months after the initial volatility spike.