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Wild swings in  volatility have plagued the markets since 2008, as shown by spikes in the Chicago Board Options Exchange's Volatility Index.

With volatility the new normal, traditional traders evolve strategies to remain relevant

by Nick Przybyciel
June 04, 2012

May capped off a hectic trading month, and while some traders are preying on the perpetual state of market volatility, others are being forced to evolve new strategies to stay relevant.


The latest bad economic news -- fears of Greece defaulting on its debt -- helped prompt the market's fear gauge, the Chicago Board Options Exchange's Volatility Index, or VIX, to shoot up 40 percent last month. Trading of VIX options hit record levels, with CBOE reporting 2,000,154 contracts switched hands in May, an increase of 101 percent from the 993,990 contracts during the same period last year.


But what happened in May wasn't out of touch with contemporary history, as volatility has become the new normal in markets since the Great Recession hit in 2008. For some traders, such as speculators utilizing high frequency trading strategies and technologies, market chaos provides opportunity to move in and out of positions and make a quick dollar.


“Everything right now is so macro and short-term, that this is a great environment for the algorithms and a terrible environment for others,” said Rich Ilczyszyn, founder and chief strategist of Chicago-based futures broker iiTrader. “Retail traders are just getting chopped up.”


Critics often contend that high frequency traders not only profit from volatility, but actually exacerbate it, owing to the enormous volume and millisecond speed of their trade executions. This is creating a headache for a lot of buy-side and other traditional institutional traders.


“High-frequency trading makes it impossible for investment managers to predict stock prices with any degree of accuracy-–in the short term,” said Brenda Wenning, founder of the retail investment management firm Wenning Investments, in Newton, Mass.


As such, Wenning's investment strategy has evolved from being focused on fundamentals to one that incorporates in equal parts, if not more, technical analysis and computer modeling. Like many other investors, she's fighting fire with fire by embracing proprietary technologies to compete on the same playing field as high-frequency traders.


“Before high-frequency trading, investment managers could identify quality stocks based on a fundamental analysis and know that, more often than not, their work would be rewarded with appreciation in the stock's price,” she said. “Today, though, fundamentals no longer mean a lot in the short term. Even the best investment manager can't compete with a super-powered computer.”


Wenning deploys an “active management” approach, which utilizes sophisticated technologies and economic data to create proprietary models that generate alerts or stops for when it is time to buy or sell. By focusing on longer-term market trends, she strives to position her clients above the day-to-day volatility that market-timing and high-frequency approaches embrace.


“[Active trading] helps overcome the market distortions created by high-frequency trading,” Wenning said.


Some money managers are going a step further than Wenning when it comes to deploying technology.

Algos – Street-speak for “algorithmic trading” – require no human interaction to execute orders. Once almost exclusively the domain of speculators involved in high-frequency trading, they are now being designed to accommodate different strategies. For example, a long-position funds manager may be interested in a “time-splice” program that breaks a large sell order into several chunks and sells it over time, so as not to flood the market and cause the security or contract to drop in value.


While the demand for these programs from the buy-side is still marginal overall, some industry analysts expect the continuing increases in volatility and volume to push more managers towards these solutions. According to the TABB Group, an investment strategy firm, the number of buy-siders in the futures markets using algos will increase from from 4 percent to 11 percent this year.


“As trading volume grows, larger buy-side firms will invest in automated solutions that help them to trade more efficiently, using tools that can both minimize trading costs and help them execute more-complex strategies,” wrote Andy Nyobo, TABB principal and director of derivatives in a recent research paper.


TABB estimates there will be nearly $1 billion in execution fees and $2.3 billion in clearing revenues across the futures markets in 2012. To fight for this slice of pie, brokers are creating algo and other high-tech offerings to lure buy-side firms. Credit Suisse's Advanced Execution Services, Goldman Sachs' RediPlus and Morgan Stanley's Passport are a few of the more popular.


“Because the costs associated with development and support can be substantial, buy-side firms are increasingly looking at broker offerings to support activities, especially firms new to the futures space,” Nybo wrote.


Computerized high-speed trading is causing other market participants to make adjustments as well. iiTrader's Ilczyszyn is a 20-year veteran trader who began his career as a “local” on the floor of Chicago's derivatives markets. He is interested in possibly adopting algos one day, but for now, feels that he and other traditional short-position traders can profit from just the awareness of how high frequency traders move markets.


Ilczyszyn is a prime example of traders who are not necessarily embracing new technologies to account for the market swings caused by high frequency traders, but is overtly conscious of their clout and puts their impact prime and center is his trading strategy.


“We've got gold at a key level – at around 1530 – and we see there's a lot of algorithmic trading in that level, to try to press the market, to trigger stops, to get some kind of big move to happen. And the longer it sits without breaking a new low, you will see a program come in and just buy up everything from that level,” Ilczyszyn said.


Knowing how the algos are designed to react enables Ilczyszyn to jump in front of market trends.


“The longer [a price level] just sits there, the more likely it is to go the other way shortly,” he said. “If you're watching it all day, you can do okay, just as long as you keep it short.”


While technology has changed, the game essentially remains the same for Ilczyszyn , and he hasn't had an issue with adopting to the impact of high-frequency trading.


“It's the old scalper's mentality,” he said, referencing the tiny-profits tactic he used as a floor broker in CBOT's pit. “It's the same concept, only much faster and much bigger.”