Firms employing arbitrage strategies have been ringing the cash register over the last six months. Their main allies have been volatility and wider spreads, and yesterday’s price swings could serve as the poster child for their success.
The Chicago Board Options Exchange’s Volatility Index-or VIX-registered in the low 40s at the end of the day. More than 13.5 billions shares were traded. And the Dow Jones Industrial Average climbed 214 points.
For those traders, and particularly the high-frequency market makers, who make money on the small differences in price between highly correlated stocks, the price swings have been good business.
“Yesterday was definitely a volatile day,” said Will Sterling, global head of direct execution at UBS. “And I’m sure it was a good day for high frequency market makers.”
Pairs and arbitrage-related trading strategies are hot right now. They benefit market liquidity and there’s money to be made using them, industry experts say.
These strategies have thrived over the past six months or so because the turmoil in the markets has kept volatility high and spreads wide. It has also forced a large number of market participants to the sidelines, or out of the game altogether-primarily the proprietary trading desks at the bulge bracket firms.
As a result, the markets have been operating less efficiently with the wider spreads. And these conditions favor pairs and arb-type strategies that capitalize on the temporary price discrepancies.
“We have seen an uptick in both portfolio rebalancing and pairs trading,” said Andrew Silverman, head of sales and distribution for electronic trading at Morgan Stanley.
Volatility has been the primary engine. Conditions are generally considered volatile when the VIX measures at least 25.
By last May, 2008 was shaping into one of the most volatile years since the Great Depression. The VIX was clearing 25 routinely, and even hit 32.24 in March after Bear Stearns fell.
In mid-September, the VIX blasted into the stratosphere following the news on Lehman Brothers, Merrill Lynch and AIG. The VIX averaged in the 60s for much of the rest of the year, and even crossed 80 more than once. In 2009, the VIX has settled down into the 40s-still incredibly volatile by historic standards.
Brokers and technology vendors measure the increase by client demand for services and products that enable them to employ arb strategies. Since about October, execution management developer FlexTrade has seen a greater than 40 percent increase in new customer demands geared toward arbitrage trading of one variety or another, said Vijay Kedia, the firm’s president and chief executive.
“I was wondering myself initially why suddenly this uptick [in new customers for these strategies]. We thought people would give less importance to technology in these times,” Kedia said. “But it has been quite the opposite.”
Kedia pointed to the wild price swings as the driver. “As a result, in such scary, dislocated markets, it’s much safer to do arbitrage trading,” he said. “Then, it’s all about efficiency: how cheaply you can do it, how efficiently and how fast.”
Vendors and brokers agree that arb strategies can be lucrative in the right environment. Those who can execute such strategies cheaply can take advantage of large spreads and make money, according to Andrew Herriot, who has followed the U.S. arb space closely. He is currently a London-based sales trader who executes pairs and various arbitrage strategies on an agency basis for CA Cheuvreux, Credit Agricole Group’s European equity broker.
With the increase in volatility since summer 2008, there have been some large disparities in stock prices that usually are highly correlated, Herriot said.
And anybody who has been using pairs with options is making a fortune right now with the volatility, said Eric Goldberg, chief executive of the EMS maker Portware. “The last [12] months have just been a dream for these guys.”
Pairs and arb traders have accounted for some of the strongest growth in Portware’s client base of late, Goldberg said. Originally, Portware’s EMS was built as an index-arb system, he added.
Also, the changing landscape for market participants has played a role in the increase in arbitrage strategy use, experts say. One important factor was how proprietary trading desks at the big banks-formerly large players in the relative value, and risk and merger arbitrage spaces-have been quiet for the past several months.
“There aren’t a great deal of prop desks currently trading,” Herriot said. “Flow from the major desks has been decimated over the past 12 months.”
In the past, prop traders have helped close the gaps in prices with their arbitrage trading. But their absence has opened up opportunity for others.
“Very few are brave enough to call the direction of the market; clients prefer to be hedged and market-neutral,” Herriot said. “Pairs trading is probably the most accessible and best way of doing that.”
In the meantime, arb players continue to fill in the pricing gaps and add liquidity. “More market participants realizing potential arbitrage opportunities provide greater liquidity,” said Court Crane, an executive director with Morgan Stanley in electronic trading.
One buyside trader, who spoke to Traders Magazine on background, said he expects the prop trading business to return at some point. But will the window of favorable conditions for arb strategies remain open indefinitely?
No, Kedia said. Arbitrage opportunities, which squeeze out the inefficiencies that exist, by definition, arise for short durations and might last a few months, or a year.
“That’s why customers who come to us really wanted [the technology for arbitrage strategies] yesterday,” he said.
And as the window closes, it will become increasingly difficult to take advantage of arb opportunities, Herriot said.
“More people looking at these trades tend to actually flatten out some of the arbitrage, and your abilities to pick out and trade the peaks and troughs have to get smarter and faster,” he said.
