Taking Cues from Europe

Terry Flanagan

In a market environment that has been globalized, traders have been increasingly basing their trading patterns on news coming out of the eurozone.

”Never before have we seen Europe dictating what happens in the U.S.,” said Gregory Treacy, director of Global Execution Services at Bank of America Merrill Lynch. “This is a phenomenon that we hadn’t seen before. It was always the U.S. that drove the wheels.”

For much of late 2011 and into 2012, U.S.-based electronic traders have had to take volatility cues from across the Atlantic, as news flow from once-obscure sources such as Italy and the Greek parliament have consistently moved global markets. With the European debt situation far from settled, traders expect volatility to continue to emanate from the east.

“Even if you’re a U.S.-focused trading desk, you look at what’s going on in Europe when you get into work,” said Joanna Horowitz, head trader at Sierra Global Management, a New York-based European long/short investment firm.

The tremendous volatility that can be seen on a daily basis as a result of the macro-uncertainty has left many market participants, particularly on the buy side, in a difficult spot, as it can be hard to make decisions based solely on a single day’s new events.

“The hardest thing for trend following managers in our portfolio is markets that flip-flop back and forth—that’s hard for trading,” said Greg Anderson, chief investment officer at Princeton Futures Strategy Fund. “With Greece, there’s been a lot of uncertainty. Some days there’s optimism, like today [Friday, March 9], and traders get in. Other days, there is pessimism, and traders get out.  Greece has been a hard market to trade for us.”

In order to deal with this paradigm shift, technology and speed need to be leveraged by traders and investors to quickly get in or out of positions at the right time.

In the event of a Greek default and a third bailout, “there will be a large number of risk mitigation strategies in play in trade on the euro and Hellenic Bonds, as well as significant opportunity in credit default swaps”, said Dr. Jock Percy, chief executive of Perseus Telecom. “The traders best placed to maximize profits will be those who can execute most expeditiously on the right side of the market median. To be the fastest, traders require a combination of infrastructure components to augment their strategy and software. This includes low latency connectivity, colocation in proximity to the matching host and optimal compute and network hardware.”

It remains to be seen whether or not this is a long-term shift, or one that will go by the wayside if there is a long-term debt solution put into place.

“The markets right now are driven by geopolitical and policy risk,” said Jamie Selway, managing director at ITG. “There is so much uncertainty around what policymakers will and won’t do. That needs to be removed before the markets will head to higher levels and feel more stable.”

Traditionally, news coming out of the U.S. had dictated the direction of global markets. That began to turn in the other direction in 2010, when fear began to settle in among investors regarding rising debt levels in Europe along with the possibility of a Greek default. Since then, there has been a constant stream of news from out of Europe, with each announcement seemingly able to cause drastic swings in the markets.

Because of the eurozone’s substantial influence, observers have noted that the markets are no longer based on fundamentals. Companies have been posting strong profits in recent earnings periods, yet that has not necessarily been reflected in their share prices. The markets seemingly fluctuate largely on a plethora of factors that are not related to the actual underlying fundamentals.

Because of the unpredictability of the markets, many investors have chosen to sit on the sidelines until the picture becomes clearer. Market observers and participants have noted that retail and institutional segments often reduce their day-to-day trading activity in times of volatility.

Equities trading volume in the U.S. has averaged about 6.9 billion shares per day thus far in 2012. This is down from the 7.9 billion seen during the same period last year, which was in turn down from the 9 billion in early 2010. This has inevitably put the squeeze on market participants, particularly exchanges and broker-dealers, which generate revenue based on trading activity.

Bulge bracket bank JPMorgan Chase experienced a 23% drop in profit year-on-year as of its latest earnings report as its investment banking division was surpassed by its consumer credit card and auto loans unit.

Market activity has also seen spikes in the middle of the U.S. trading day, during what used to be a malaise. Prior to the European debt crisis taking center stage, U.S. traders generally saw the most volatility and trading activity in the first and last half hour of each trading day. That was usually when the most equities shares changed hands and when the largest price fluctuations occurred.

“U.S.-based investors and the market in general are focusing more on the period after the European close,” said John Nunziata, New York-based director of global execution services for the Americas at BNP Paribas. “We’re seeing increased volatility around the European close.”

The Vstoxx index, which measures the implied volatility of the Euro Stoxx 50, a European blue chip index for the eurozone, spiked in the late summer months to the mid-50s as the debt concerns in the U.S. and Europe came to a head. The index, which trades under the symbol V2X, was at about 25 as of March 9, while the Chicago Board Options Exchange’s Volatility Index, a measure of the implied volatility of S&P 500 index options, was trading at about 18.

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