02.16.2012
By Terry Flanagan

Effect of Vol on Algo Trading

The extended period of volatility seen in recent months has had a substantial impact on algorithmic trading.

During much of 2011, when market volatility was at highs not seen since 2008, market participants had to adjust their strategies, which had other unintended effects.

“In general, when volatility goes up, trading costs also go up substantially,” said one algorithmic trader. “However, the increase in trading costs affected different algorithms differently. The cost of some algorithms went up a different amount than others. Overall, the cost of trading went up, but the more sophisticated algorithms went up by less.”

Volatility was on the minds of all market participants during the latter half of 2011. In August, global equities markets began experiencing heightened volatility and volume, with the CBOE Volatility Index reaching its highest level since 2008, increasing by 76% within a matter of weeks. Despite an increase in trading volume, available liquidity actually decreased and became more expensive. Quoted spreads increased by 23% and the depth of shares available at the National Best Bid and Offer fell by 57%, according to industry research. The average realized implementation shortfall cost and total implementation shortfall cost rose dramatically as well, 59% and 69%, respectively.

In addition, unlike other periods of high volatility, traders did not go away from algorithms as much as they have in the past.

“Typically, when there is an increase in volatility, you see a shift away from low-touch into higher touch,” said one electronic trader. “We didn’t see that happen as much in this last volatility spike.”

Buy-side traders became aware of the changing environment, changed their trading styles and were sending more aggressive limit orders rather than passive limit orders, and sent fewer market orders presumably to trade more aggressively while avoiding impact.

Market volatility has itself been volatile, as the Chicago Board Options Exchange Volatility Index indicated. Two and three percent intraday swings became the norm. The surges came in the wake of a slew of macroeconomic events, including the European debt crisis and the U.S. debt downgrade. The VIX reached a high of 48 on Aug. 8, 2011, as the markets reacted to the lengthy U.S. debt ceiling negotiations and the Standard & Poor’s downgrade of U.S. debt. As of mid-day Feb. 16, the VIX was trading at about 19 after having hovered around 18 for several weeks.

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