Last Vestige

Traditional Small-Cap Trading Fades as Algorithms Gain Sway

Traders Magazine, April 2012

James Armstrong

With the majority of equities being traded with algorithms, the handling of small-capitalization stocks has been one of the last vestiges of old-school trading. For small-cap stocks, the buyside will actually pick up the phone, call up sales traders and ask them to use their capital or know-how to move some shares. But those days are fading. Algos are now conquering smaller stocks as well.

That's remarkable considering that not long ago, the conventional wisdom was that traders would never want to use algos for small-cap stocks. Today, more than half of all small-cap trades use algos, more than double the number five years ago, according to experts. Goldman Sachs and UBS have recently unveiled new algos specifically designed for small-cap names. And small-cap algo use is expected to continue to rise.

Brokers today do not have the appetite for capital commitment that they used to, and the Volcker rule could further curb their ability to commit capital. Plus, both the buyside and sellside have pared back their trading desks, which means fewer people are around with the expertise necessary to handle small-cap names. As if that weren't enough, fragmentation means there are more venues traders have to search to find the limited liquidity in smaller issues.

All of these things have pushed the buyside to use algos when trading small caps. And with the growth of new small-cap algos, a final holdout of old-guard trading is balancing on the brink. 

Jose Marques, global head of electronic equity trading at Deutsche Bank, said his firm's algos are now trading "easily double" what they used to for small caps. And Enrico Cacciatore, a senior trader at ING Investment Management, said his firm currently does "at least" 50 percent of its small-cap trades with algos, and that number could eventually climb to 75 percent, 80 percent or even higher. 

Before the crisis of 2008, brokers had few takers on the buyside for small-cap algos. The importance of that crisis is often overlooked when it comes to the growth of algos, said Jeff Bacidore, managing director and head of algorithmic trading at ITG.

"Capital wasn't as available as in the past, and people were forced to do things that they may not have otherwise done," Bacidore said.

In 2008, a few algos were available for trading illiquid stocks, but they had not been frequently used, especially in high-stress situations. The crisis provided an incentive to use algos for small caps, and it offered a unique testing ground to see how they worked during extraordinary events.

For more information on related topics, visit the following channels:

• Algos/DMA
• Brokerage
• Buyside