Volatility puts algo trading under pressure

By Simon Falush - Analysis

LONDON (Reuters) - Recent market turbulence has tested banks' technology and is putting a question mark over whether increasingly popular computer-generated algorithmic trading is suited to volatile conditions.

Algorithmic trading -- where computers make multiple trades in fractions of a second -- has soared to make up 30 percent of equity trading volume according to industry analysts AITE group.

It is also increasing popular in the $3.2 trillion a day in foreign exchange market.

EBS, the biggest interbank venue for foreign exchange trading, says algorithmic trading has doubled from around 15 percent of its volumes at the start of 2006 to 30 percent now.

But traders say current volatility is showing the limitations of this form of trading, in equities and forex.

"Algorithmic trading works by taking historical moves to predict what will happen in the future," said Lee Ferridge, senior proprietary trader at Rabobank.

"When market moves bear little resemblance to what has happened in the past all types of model will struggle."

This certainly appears to be the case for Morgan Stanley (MS.N) who reported a $480 million loss in the third quarter from the bank's in-house equities trading desk that employed computer generated models to drive returns.

Hedge funds using algo are also likely to have been hit.

The Hennessee Hedge Fund Index fell 0.96 percent in August compared with an 10.16 percent increase for the year as a whole.

Performance was particularly bad for portfolios employing algorithmic models, said Mehraj Mattoo, global head of alternative investment strategies at Commerzbank Corporates and Markets.

"The losses were caused by sharp moves causing many of the models to trigger sell orders on the same securities at the same time, causing a vicious downward spiral. In some cases high degrees of leverage caused further magnification of losses."

The most aggressive risk takers appear to have tried to avoid this kind of loss by pulling out of algorithmic trading when markets were at their most choppy on August 16.

"A lot of the high frequency guys like hedge funds and the proprietary trading platforms at banks switched off their engines until the worst of the volatility receded," said a source at a major trading platform.

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