Thrills and Chills

Traders adjust to historic levels of volatility

As trading environments go, the current one almost couldn’t get any wilder. Experts say today’s equities market hasn’t been this volatile since the Great Depression. The large jumps in prices have meant greater risk, higher volumes and wider spreads for traders intermittently for more than seven months.

But the buyside hasn’t crumbled in despair. And their latest electronic tools haven’t led them off a cliff, as some expected. Instead, traders have tackled the volatility and adapted. Many have made some key changes to their trading strategies and found ways to lower costs and find opportunities.

On its face, the volatility presented great challenges to traders. And it appears many have met them.


“Regardless of whether you’re on the buyside or the sellside, volatility certainly poses challenges,” says Jason Lenzo, head of trading for equities and fixed income at Tacoma, Wash.-based Russell Investments. “The biggest challenge that faces anyone, regardless of where they sit in the whole financial cycle, is that you have to alter the way you look at the world because market norms have changed dramatically.”

Those market norms began to change around August 16, 2007.

On that date, the Dow Jones Industrial Average careened more than 540 points between its high and low for the day before it settled on a modest drop at the close. A new round of volatility had arrived. And judging by the market conditions that produced it, it was going to stay for a while.

Fasten Your Seat Belts

More important than the gyrations themselves, fear about subprime-mortgage-backed securities and emerging credit troubles was growing in the hearts and minds of many. That fear created a powerful whirlwind of uncertainty which tore into the equities market.

And though the volatility’s intensity has risen and fallen in successive waves since then, it’s still here. In fact, it’s here to such a degree that according to one industry study, 2008 is shaping up as the most volatile year in seven decades.

Some major gauges paint a particularly impressive picture. According to a Standard & Poor’s study, the market-year-to-date through much of March is as volatile as it’s been since 1938.

The ratings firm measures S&P 500 volatility by daily changes in the index of at least 1 percent, either up or down (see page 38). This year the number of major daily market moves stands at a staggering 51.9 percent-the highest since 1938, when 57 percent of the days saw significant index moves.

By comparison, the number of significant daily index changes for 2006 was 11.6 percent. And the figure was 12.9 percent for the first six months of 2007, or just before the volatility struck.

For context, the S&P 500 on March 7, 2003, started its steady, yet jagged, climb to a four-year high point when the subprime implosion began. It moved from 828.89 that day to 1,553.08 on July, 2007.

The Chicago Board Options Exchange’s Volatility Index, or VIX, had mostly been holding in the low to mid-teens since early 2004. But since mid-August, when it jumped to 30, the VIX has registered at least 25 periodically ever since-including early September, much of November, half of January, most of February and all but one day in March.

Whence Comes Volatility

In fact, March 17 was a particularly volatile day in a particularly volatile month. Then, the Dow gyrated almost 470 points over the course of the day and the VIX reached 32.24. The number is the highest the VIX has measured using the CBOE’s new methodology since March 2003.

Volatility, or the rapid and extreme fluctuation in stock prices, stems from uncertainty. And volatility has persisted because the factors that created the uncertainty have persisted, says Ian Domowitz, managing director of ITG solutions networks at Investment Technology Group.

To begin with, huge losses related to the subprime crisis continue to be unearthed. Also, rampant recession talk and speculation in the news keep volatility’s cinders burning.

“It’s the uncertainty of what is yet to come,” says Tom Price, senior analyst with the Needham, Mass.-based research firm TowerGroup. “Is there another Bear Stearns out there? Who are my trading partners? What kind of risk am I assuming if I do business with any of them? And then it’s the equation of: How much more in write-offs are we going to see? That drives a certain level of volatility.”

All Together Now

In addition, some say high-frequency traders, such as quantitative funds and hedge funds, who rely on mathematical data to trade, play a role. Large numbers of these traders run similar models that can weaken in a similar fashion, says Lenzo. Simultaneously, they get calls from their clients to pull funds and end up liquidating similar assets.

“There’s an amplification that occurs,” Lenzo says, “that really adds to the swings in the market and the volatility.”

Merrill Lynch saw a lot of quant fund trading during the volatile periods in August, December and January, says Lee Morakis, managing director within portfolio and electronic trading there. “What we’ve found over the last six months is there are a lot of quantitatively managed funds who look at a lot of similar factors,” Morakis says, “and when they trade,thesemovementstend to be highly correlated andcause marketvolatility.”

The volatility tide washed over the entire cash equities environment, but its overall effects have been mixed.

Volatility challenges the buyside with a cocktail of mostly wider spreads, smaller transaction sizes, more volume and more risk.

Total trading volume averaged 8.9 billion shares per day in January 2008, versus 4.8 billion in January 2004. And according to one bulge bracket firm, the average spreads in S&P 500 names doubled from July 2007 to January 2008. And over the same period in small-cap names, they tripled.

In such an environment, trading stocks manually becomes difficult and using capital expensive, experts say.

Despite all of that, trading costs have not kept pace with the volatility. According to ITG’s transactions costs data (see page 38), costs rose when the turbulence touched down in mid-August, but leveled off in November and slowly declined as traders adjusted their strategies to suit the conditions.

Holding Back

But volatility could also discourage the buyside from trading. To some money managers, one way to deal with volatility is not to trade at all.

Volatility tends to push long-only managers to the sidelines, says Ray Tierney, global head of equity trading at Morgan Stanley Investment Management.

“What you’re seeing is that long-only managers are trading less frequently,” he says. “They’re building up their cash positions, so that when the volatility dies down and the uncertainty comes out of the marketplace, they’ll have a greater ability to participate.”

The volatility might make PMs less aggressive, says John Russell, senior vice president and director of U.S. Trading at Franklin Templeton Investments, while discussing the challenges of trading blocks. “There’s so much volatility that they would rather not make a big bet, only for it to trade against them the next day,” he says.

Depending on one’s strategy, though, buyside traders who are patient and can wait through intraday volatility can often find their price, Russell adds.

Adapt or Suffer

The key to riding out the volatility has involved adapting one’s trading strategies. Doing so, Domowitz, says, allowed traders to keep transactions costs lower than they otherwise would have been.

In the very beginning, volatility catches the traders off guard, he adds. His transactions costs will rise as the volatility rises.

But when he modifies his trading behavior, he can bring the transactions costs back down. Traders accommodate the higher volatility, Domowitz says, so they don’t spend as much money on the trade, because their trading strategies fit the volatile environment better.

Making Algos Work

Contrary to standard thinking, adapting can also mean using algorithms, insiders say. Prior to August, conventional wisdom held that algos would be less effective in turbulent times. This didn’t prove to be the case, because algos have gotten better at reading the market, according to buyside sources.

As with its entire trading process, Russell Investments has approached algo trading with “a very real-time, tactical ability to adjust to changing market conditions,” according to Lenzo. To have success in a volatile market where historical data is less relevant,algos must be lookingat both historical and real-time data to make decisions, Lenzo adds. Oftentimes with volatility, real-time conditions can render some models ineffective, and algorithms that adapt to those changes will perform the best. “Clearly,” he says, “the savvy trader must understand when this is the right tool to use in given market conditions.”

Merrill Lynch understands this well. The firm has seen increasing volume in program and algorithmic trading during the volatility, according to Morakis.

And Merrill has seen the buyside use more liquidity-seeking strategies, versus those that look at price discovery. In this environment, Morakis says, clients are willing to shorten their trading time frames to avoid excess costs if the market turns against them.

This past quarter, Morakis says, Merrill saw a 24 percent increase over the last quarter in 2007 in algorithms using liquidity-searching strategies versus longer, more passive-based strategies. For success in this scenario, algos use must consider short-term daily volatility and intraday volatility forecasts, he adds.

“A lot of people have been waiting for higher-volatility times to test algos,” Morakis says. “We’re constantly tweaking our volatility forecasting. So, our volatility forecasting in January was better than it was one year earlier.”

Volatility’s impact on the character of the market makes algo trading a good option, according to Deutsche Bank.

The brokerage has seen an increase in trading volume to go along with a marked decrease in transaction size throughout the period.

“Anytime you have smaller transactions and more volume, what happens?” asks Robert Flatley, global head of Autobahn Equity, Deutsche Bank’s equities electronic trading platform. “You’re having more transactions in the marketplace. And it becomes extremely difficult, in terms of physical human reaction time, to actually trade these stocks manually.”

Risky Capital

Brokers are still committing capital for block trades in this environment, but the volatility is still leaving a mark.

When Morgan Stanley’s Tierney looks at what he calls “strategic balance sheet trades”-or trades of greater than $100 million that usually take place off of a trading desk-the flow has slowed to a trickle.

Two reasons: general volatility and the rising cost of capital. As a result, those trades end up smaller.

“I’m not going to get the same price I did back six months ago for the same piece of business,” Tierney says. “I’d rather price $100 million down 2 percent than price $500 million down 10 percent.”

Large, strategic, balance sheet trades take a lot of creativity and innovation to price properly, he says. And he’s seeing fewer of those trades than he did just six weeks ago.

At Russell Investments, Lenzo sees less portfolio and single-stock level risk-taking at some firms that commit capital because their risk profiles have changed.

“That really highlights the value of identifying natural positions to trade against,” Lenzo says, “if you’re talking about [looking] on an ECN, or on a non-displayed pool of liquidity.”

Knowing the Names

Still, when the buyside needs to get in and out of positions more quickly, brokerages will step in and make capital available, says Louis Parks, senior managing director of equity trading at Raymond James. Volume at the brokerage has jumped more than 25 percent in 2008. And with it has come an incremental increase in requests for capital, Parks says.

Raymond James specializes in providing research on roughly 700 mid-cap names, and its traders focus their capital commitment in those names as well. Knowing these names as well as they do, he adds, means knowing which accounts have positions that lead them to find the other side of the trade.

“We’re more tolerant,” Parks says “We believe we know our names well enough that we can moderate any principal risk factors.”

How much longer can this last? To paraphrase the playwright Arthur Miller, some say we’ve yet to touch the bottom of this swamp.

Standard & Poor’s senior index analyst Howard Silverblatt writes in his March volatility study that the coming earnings season should add to the market uncertainty, and likely keep the market volatile for a time.


Earning estimates are unusually wide, given how close to the quarter end we are,” Silverblatt writes. “By now we typically see a Street consensus emerge on the company level, with only a handful of outliers. However, the estimates remain wide apart, which means that there are going to be a significant number of surprises out there, which will translate into additional buying and selling pressure.”

For his part, ITG’s Domowitz argues that history teaches that, as uncertainty is resolved, volatility moderates. Though he adds that he leaves forecasting to volatility-driven options and futures traders, Domowitz offered one small prognosis.

“I would fully expect for uncertainty to resolve itself in many of the dimensions that are currently at the root of increased volatility today,” he says, “and therefore would not expect it to increase without bound over the next few years.”

Editor’s Note: This story was prompted by interviews from last month’s cover story, in which traders said that volatility, at times, proved to be as big a hurdle to best execution as fragmentation.

SIDEBAR: I Love Rock ‘n Roll

Volatility is not bad news for everyone. Market makers like it, as it usually means more volume and increased profits when prices jump.

This rang true for Knight Capital Group, which saw its fourth-quarter 2007 net trading revenue skyrocket over that of the previous quarter and year. Knight’s fourth-quarter share volume also rose over the same periods, as the equities market remained volatile.

The firm reported net trading revenue of almost $113 million for the quarter-a 95 percent jump from the third quarter and more than double that of the same period in 2006. And volatility had more than a little to do with the data, says Tom Joyce, Knight’s chairman and chief executive.

“Volatility went up,” he told analysts during a January conference call. “We attracted more volumes from new clients and more volumes from old clients. So, if you look at it as I think you’ve all heard me say before, volume and volatility are our friends.”

Wholesaler Bernard L. Madoff Investment Securities has also seen more volume and trading opportunities during the volatility, according to Mark Madoff, director of trading there. As a private company, the brokerage did not reveal earnings, but Nasdaq monthly share volume for Madoff shows a 7.3 percent increase in fourth-quarter 2007 volume from the previous quarter, as well as an overall increase from the same period in 2006.

A volatile market can be one that’s up, or one that’s down, Madoff reasons. And if the market is up by 420 points, many traders can get good prices.

“A volatile market isn’t necessarily bad,” he says “It’s a continuously declining market that is a problem for many participants.”

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