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Let’s get moving with algorithmic trading

Let’s get moving with algorithmic trading
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First Published: Mon, Mar 03 2008. 11 26 PM IST
Updated: Mon, Mar 03 2008. 11 26 PM IST
The expert committee on “Mumbai as an International Financial Centre” (MIFC) had recommended that the Indian markets open up to algorithmic trading (AT) and direct market access (with reasonable regulation) by end-2007. One could say that the timelines set by the committee were ambitious, but with every further delay in their introduction, the Indian securities market is seeming all the more ancient when compared with trading platforms on offer in overseas markets. The MIFC committee had noted that India might be losing half or more of potential order flow by erecting such regulatory barriers, since a majority of orders and trades in developed markets are from automated sources.
AT refers to orders that are automatically placed in the market by software programs built on certain mathematical models. The AT platform at the client end is connected to the exchange through direct market access (DMA). In its simplest form, AT could be a program designed to detect an arbitrage opportunity between the cash and the futures market and then place the related orders on the exchange in real time. Needless to say, computers will do this menial task much quicker than the quickest of jobbers. Incidentally, this is one algorithmic trade that the National Stock Exchange (NSE) permits currently. But that’s about it. All other trades have to be manually entered by the trading member. At the client level, the time of executing the order is even more since the trade is finally executed by the broker.
But there’s a lot more to AT and DMA than just cash-futures arbitrage. Currently, there are over 30,000 option contracts on which trading is available on NSE at various strike prices. Many contracts may be of little interest because their strike prices are far removed from current levels, but liquidity is an issue even in the remainder of the contracts. Enter AT and a number of obvious arbitrage opportunities will be up for grabs, leading to better liquidity. Besides, some firms can even run market-making operations by offering two-way quotes for illiquid contracts, where the algorithmic program could automatically hedge a position using the liquid futures market when one side of the quote is hit.
There have been concerns whether program trading leads to sharper price movements, such as the market crash in October 1987. But trading systems at the New York Stock Exchange back then were relatively primitive and couldn’t handle the surge in sell orders. It’s noteworthy that most markets that thrive on algorithmic trading and DMA have been far less volatile than the Indian markets in the recent correction. One may argue that Indian markets are inherently volatile and AT may worsen things. On the contrary, things could improve as an increase in liquidity normally provides stability to a market. When prices fall, not all automated orders are sell orders — in the case of some programs, they may well be triggers for fresh purchases. During the Indian market’s worst moments in late January, the selling was largely in the futures segment because of margin calls from brokers, leading to glaring arbitrage opportunities. Automated orders from well-capitalized players would have bridged the gap and brought stability in prices. India’s stringent position limits address any worry about manipulation, but as the MIFC committee has suggested, there has to be reasonable regulation, as well as surveillance.
AT could also lead to increased order flow at the Bombay Stock Exchange (BSE) to take advantage of arbitrage opportunities vis-a-vis NSE. Along with the possibility of market making using algorithmic programs, this could well act as a trigger in reviving BSE’s moribund derivatives segment.
Make long-term options flexible
Surprise, Surprise. A few of NSE’s long-term options actually traded on the day of their launch. Till recently, liquidity on even the three-month Nifty contracts was pathetic, and so it’s quite surprising that traders bothered about the new contracts that expire between June 2008 and June 2011.
On Monday, too, only two contracts of options expiring in May (three-month) were traded, but as many as 4,606 contracts on the September and December series’ changed hands, resulting in a turnover of Rs131 crore. But we have to keep reminding ourselves: first day trades can be artificial, produced by friendly brokers to give an impression of liquidity. (Open positions can always be hedged using the futures market or the more liquid near-month options market.) It’ll be interesting if such volumes sustain for over a month. In any case, traders haven’t stuck their neck beyond December 2008, which brings us to the pertinent question of whether long-term options can be successful exchange-traded products. By nature, these are over-the-counter products, designed by banks and brokers depending on a client’s need. Confining such players to rigid strike prices and expiry dates (as is with the current system) doesn’t make sense.
If these products have to be traded on the exchange, it would be better to allow users flexibility to design their own contract, depending on their need and then introduce it for trading on the exchange. In any case, contracts with long expiry dates (such as three-five years) can’t be expected to be very liquid. But the availability of such products enhances the pool of firms and traders that are willing to enter a market. Some firms even limit their allocation to India just because they can’t buy a long-term option to hedge market risk. The introduction of exchange-traded long-term options will help some such players, but flexibility will help attract the entire lot.
In The Money runs every other Tuesday. We welcome your comments at inthemoney@livemint.com
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First Published: Mon, Mar 03 2008. 11 26 PM IST