UBS, as part of an emerging trend, is developing a cross-asset algorithm that facilitates arbitrage and hedges trades in the cash equities and futures markets.
The technology permits a trader to access both markets with a single algorithm. That makes it possible for a trader to quickly lock in price for both instruments.
The firm is building two algorithms-one for single stock trades and another for portfolio trades. Both algos should be available around the end of the second quarter, said Will Sterling, global head of Direct Execution Services at UBS.
“Right now, everybody has built algorithms in silos: you have your stock algos and your futures algos,” Sterling said. “These would combine them. You could buy a stock, and sell a future simultaneously.”
As an example, UBS’s single-stock algo would make it easier for a trader who, for example, wants to buy Home Depot and sell the S&P 500 futures against it-someone who is betting on the spread. The firm developed the algorithm to better manage the timing risk when simultaneously establishing and hedging a position.
“There could be a little bit of timing risk if you don’t hedge as soon as the executions are happening,” Sterling said. “So, if you bought $100,000 worth of Home Depot, you want to have $100,000 hedged right away. This algorithm basically eliminates that timing risk and the manual component involved.”
The UBS algo technology could be used to reduce price uncertainty when establishing a large position in a stock while simultaneously hedging that position with a futures contract. Or, it could be used to execute an arbitrage strategy faster in the two markets.
These algos are a good idea, said Henri Waelbroeck, Ph.D., and director of research at Pipeline Trading Systems. He is also the architect behind the firm’s Algorithm Switching Engine.
“An algo that executes a market-neutral transaction by buying a stock and selling the future will be useful to somebody interested in exploiting arbitrage opportunities between the different liquidity pools,” Waelbroeck said. “As natural liquidity expands into derivative markets, we’ll start seeing multi-asset algo styles that acquire an exposure across asset classes, much as today dark aggregators collect hidden liquidity from ECNs and dark pools.”
Arbitraging the cash equities market and the futures market is not new, of course. Neither is hedging a cash equities position with futures contracts.
Up until this development, however, a trader self-trading had to access each marketplace separately. Direct market access platforms helped in this regard, but algorithms have generally been asset-specific. The development of cross-asset algorithms is significant.
Cross-asset trading-the ability to trade two different asset classes against one another in a single transaction, or strategy-gained momentum last year. Previously, most traders structured their systems and strategies along single asset class lines.
As the technology to trade multiple asset classes on a single platform has evolved, it’s made it easier for traders to develop more advanced cross-asset strategies, according to Harrell Smith, head of EMS maker Portware’s product strategy group. Last year, Credit Suisse developed algos to trade equities, futures, options and foreign exchange simultaneously-and they’re likely not alone in this.
Algorithmic trading suits several futures order types well, UBS’s Sterling said.
Among those, common orders often include instructions such as: Trade this order from 8:00 a.m., until the cash market closes, or trade that order in the first two hours after the open. As with equities, today’s futures algos help traders seek greater efficiency or price improvement, route electronic orders to the appropriate venues and reduce the risk of price impact, according to Sterling.
UBS can build cross-asset algos because it is electronically connected to the cash markets’ displayed and non-displayed venues, as well as to the futures markets, Sterling said. A cross-asset strategy will use UBS’s algorithmic trading engine to send high-speed orders to the best venues-trading both asset type legs. A common scenario for using the algorithm would be a pairs strategy, with an equity order on one leg of the pair and a futures order on the other.
The objective on the program side is the same as that of the single-stock, Sterling said. The algo helps users who want to liquidate a hedged portfolio remove the hedge in the same ratio, he added.
In such a strategy, the algo ensures users aren’t restricted to using a very schedule-based algo, such as VWAP, but instead any single-share algo, Sterling said.
“As soon as the executions are happening, the algos start tracking them,” he said. “And it’s taking the hedge off in relation to that.”
The next stage for UBS algos, Sterling said, is to offer the same functionality using multiple futures contracts.
