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Control the key for futures algos.

Ubiquitous in the equities markets, execution algorithms now have an increasingly prominent presence in the buy-side's futures toolkit, says Brian Schwieger, head of EMEA algorithmic execution at Bank of America Merrill Lynch (BAML).

Previously, the buy-side has typically used direct market access (DMA), or basic DMA order types when trading listed futures, typically for hedging purposes. But use of algorithms is growing, in parallel with pairs strategies that trade against an underlying equity.

The most popular strategies used by the buy-side in the futures markets will be familiar to single-stock specialists. Algorithms such as POV (percentage of volume) allow traders to choose a participation rate for trades in the market, while others such as TWAP (time-weighted average price) are designed for time slicing, essentially giving the trader an even market exposure over a period of time. Brokers like BAML currently offer a suite of algos including standard, established algorithms such as VWAP (volume-weighted average price), as well as implementation shortfall algos such as Ambush.

Schwieger says that futures and equities algorithms employ different means to achieve the same ends.

"We're developing consistency of branding across asset classes -- so the same suite of algos that we offer in equities, we will try to offer in other assets as well," he says. "The market structure is very different between equities and futures, so the way an algo is implemented may be different, but the overall concept is going to be the same."

One of the main structural differences between the equities and futures markets is that smart order routing in not required in the latter. And compared with equities, the typical buy-side firm's trading volumes are much lower. According to Schwieger, one of the main differences is the more granular approach to scheduling.

"Sometimes we may schedule just a single contract per slice duration, whereas in equities it's very rare that you ever see an algo trying to trade one share at a time," says Schwieger. "The differences between equities and futures algos are all down to the differences in market and micro structure."

Futures algorithms generally make the decision to buy or sell a contract based on familiar factors -- price, volume, time -- but given the added time-sensitivity, there is a decisive difference of emphasis. TWAP is a particularly popular strategy when hedging in the futures markets.

"We give more granularity of control over the algos in futures than in equities. This is because we find that traders are often very sensitive to what their exposure is second by second," comments Schwieger. "The driver is that they want a certain amount of exposure per minute, per second, and so on. In equities, because of the higher order flow, traders are more interested in ease of use than granularity of control."

The other difference between futures and equities algos is the thorny issue of expiry. Futures contracts are normally rolled over as they approach maturity, but as the trader approaches the deadline, market conditions can become difficult. Historic data used by programs such as VWAP becomes unreliable, because the volume is shifting very rapidly into the next contract. For the trader, the trick is to decide when to make the adjustment from one contract to the next. It's a crucial moment.

"We've automated the process, but it does require more checking and monitoring by our quant team than is usually needed for equities," says Schwieger. "So I'd say the futures process requires more attention than the equities process."

Use of algorithms in the futures markets has come under the microscope since a joint report by the US Securities and Exchanges Commission and Commodity Futures Trading Commission identified the algorithmic execution of a large S&P 500 E-Mini futures trade by a mutual fund as playing a significant part in the 'flash crash' of 6 May 2010. A disagreement has broken out over whether the algorithm -- designed by a third party but directed to market via a broker -- was calibrated to take account of price and time as well as market volume.

Schwieger asserts that the current row should not prevent the buy-side from continuing to use algorithms safely in the futures market. He adds that each broker algo used on the futures market has generally been adjusted and tuned for the market structure, and thus he argues that they will always provide the buy-side the ability to trade futures most effectively, provided there is sufficient liquidity. The key is simply to tailor the algos to the market, says Schwieger.

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Publication:The Trade
Date:Oct 18, 2010
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