Do Execution Algos Work in Extreme Volatility?
The VIX has spiked to its highest level since 2008. The stock market has had the fastest bear market correction ever. Oil fell 33% in overnight markets, in one night. We’re seeing 6% moves in the S&P in the matter of 14 minutes. Suffice it to say, things have been volatile and spreads are widening.
We’re quants and algos people, not politicians or economists looking to answer what all this means. But in light of the current situation, our clients are asking us one simple question:
“Is it ever too volatile for Algo Execution?”
Our short answer would be no. Our more nuanced answer would involve changing the question a bit – to: “Does one Algo work better than another during extreme volatility?”
To answer that, let’s look at what happens in uncertain economic times with volatile price movements. One, we typically see sharp increases in volumes. Indeed, the CME reported that they had an all time volume record of 6.8 million contracts traded in energy futures and options on March 9th.
This huge increase in volume can invalidate some of the historical parameters that are key factors in certain participation-based algorithms, such as a VWAP’s. In such times, it may be better to look at other algo types that are dynamic and rely more on real-time market conditions. We’re talking more opportunistic, short-term pricing signals that may prove to be advantageous to execution traders, who are busy attempting to make sense of price action in the markets.
So, if not a VWAP, what kind of algo is the best to use? In rough waters when a position must be exited or initiated, and clear price discovery is difficult to understand, there are three types of execution algos that might be able to get your execution closer to expectations:
- TWAP
What: An algo execution strategy that executes at a consistent rate over a defined time interval.
Why: This helps to minimize slippage against time weighted average price over the course of the order. - Implementation Shortfall (IS)
What: An algo execution strategy that executes in a dynamic opportunistic fashion looking to minimize risk-adjusted trading costs relative to arrival price.
Why: IS minimizes risk adjusted slippage relative to arrival price by balancing the price risk of spreading the order out against the slippage cost of trading immediately. - POV
What: This strategy executes at a consistent percentage rate in line with the market.
Why: This follows along directly with the day’s trading activity providing real-time market movement.
It’s important to understand that just using an algo for execution isn’t a solution in and of itself. You need the right algo not just for your trade style, but for the market environment as well. In addition, all algos aren’t created equally. Some are created by quants-only. Others, like those at RCM-X have been designed, coded, tested, and implemented by our team of quants with real world trading experience. And some aren’t even on the menu, being custom designed with specific needs and market environments in mind. All that is to say – be careful out there. And make sure you know what Algo these volatile times call for. It doesn’t look to be ending anytime soon.