The Gateway to Algorithmic and Automated Trading

Against All the Odds

Published in Automated Trader Magazine Issue 18 Q3 2010

Kevin Twitchen, global head of algorithmic trading at Morgan Stanley, tracks the use of a non-displayed, opportunistic, non-schedule-based algorithm to dispose of a substantial position in France Telecom during an extremely challenging trading session that coincided with a bank holiday in the UK.

Kevin Twitchen

Kevin Twitchen

The Scenario: It is Sunday May 2nd 2010 and the manager of a large European hedge fund is looking to unwind a large multi-leg synthetic pairs basket trade that has been open for approximately two weeks. France Telecom is a major long component in the trade and while it has been weak over the life cycle of the position, it has nevertheless proven appreciably stronger than some of the trade's short components, which have posted declines of around 8.5% versus a more modest drop of some 5.6% for France Telecom.

The sharp recent decline of certain short components in the basket in comparison with France Telecom and the other long components has prompted the manager to decide to unwind the trade as quickly as possible while it is still significantly profitable. One concern is that increasingly negative market sentiment is already starting to seriously disrupt the historical mean reverting relationships among the trade components. (As of the previous trading session's close the CAC index is more than 6.5% off its mid April high and ongoing speculation about issues such as Eurozone stability is making for a gloomy prognosis.)

This uncertain backdrop is challenging enough, but there are further considerations. Firstly, France Telecom has a tendency towards inconsistent liquidity profiles. Secondly, tomorrow (Monday May 3rd) is a bank holiday in the UK and liquidity is therefore likely to be thin. Thirdly, at 1.02 million shares the position is substantial, representing some 5% of the average daily volume for France Telecom traded on all venues over the past year. While not insignificant, this would not normally constitute a hugely problematic trade, but in view of the UK bank holiday it is likely to represent an appreciably higher percentage of tomorrow's trading session. Therefore minimising any information leakage will be absolutely imperative to avoid severely impacting the price achieved.

Finally, the stock-specific sentiment is also less than ideal; recent figures prompted negative research notes (from JP Morgan and Zacks among others), highlighting weakness in the France Telecom's domestic business and the fact that the firm's EBITDA came in around 2.5% below most analysts' expectations.

Nevertheless, despite the concerns over trade size in what is likely to be below a lower than average liquidity environment, the manager's view is that the other considerations make speed of the essence. He therefore decides to go ahead with an immediate disposal and instructs one of his traders to dispose of the holding the following day with an average target price of €16.38. In his view, while the lack of UK participation will make the sale challenging, it might also reduce volatility and therefore result in a relatively quiet sideways trading session.

The Asset: France Telecom Paris listed shares - symbol FTE.

The Challenge: To sell 1.02 million France Telecom shares during the trading session on Monday May 3rd 2010 at a price of €16.38.

The Algo: The algorithm simultaneously seeks liquidity across dark pools, MTF non-displayed limit order books and displayed markets. While accessing multiple liquidity pools, it avoids interaction with any dark pools that have inappropriate order handling practices, thereby minimising signalling risk.

Depending on user preference and market conditions, the algorithm can be used as a stealth or aggressive trading tactic. In stealth mode it never indicates the trader's intent to the marketplace by displaying quotes or orders.

Users can specify their desired level of urgency as low, medium or high to customize their trading experience as follows:

• Low: The low urgency level is a passive order type that will not cross the spread to take the displayed quote. While on low urgency, the algo interacts with select dark pools and non-displayed MTF limit order books. It is designed not to affect the price trend of a stock, which is useful with small cap, thin or illiquid names.

• Medium: At medium urgency the algo intelligently accesses the displayed quote while interacting with select dark pools and non-displayed MTF limit order books. If the order becomes marketable, it will periodically cross the spread to take a portion of the displayed liquidity while minimising market impact.

• High: High urgency is an aggressive order type designed to capture maximum liquidity while balancing the effects of market impact. It sweeps displayed liquidity to match the order while also capturing liquidity from non-displayed MTF limit order books and resting orders within select dark pools.

In many respects the challenging nature of the trade - and particularly that it will have to be executed against untypical trading volumes due to the UK bank holiday - actually plays to the execution algorithm's strengths in that it primarily bases its activity on real-time rather than historic volume curves.

The Trader: The trader is based in Italy and as one of the fund's most experienced personnel has a slightly unusual dual role. In addition to handling trade executions on behalf of the firm's quantitative managers, he also has a small discretionary trading limit allocation. He uses a combination of classical technical analysis indicators - RSI, stochastics, CCI etc - and some less common proprietary techniques including moving linear regression. In addition to selling out of the France Telecom position, he is also responsible for exiting the other legs of the manager's overall position.

8.36am: (All times CET) The trader is working on the assumption that France Telecom will probably gap down on the back of its recent figures. Most of the previous Thursday and Friday had seen a steady trickle of negative comment from analysts, much of it focusing on the €270 million that Eurozone regulatory measures relating to reduced call termination fees would remove from its quarterly revenues. The weekend didn't bring much respite either, with Marc Furrer, the head of Switzerland's telecoms regulator telling SonntagsZeitung that the country's telephone operators (including France Telecom's Orange Switzerland business) had room to cut mobile rates by 20% to be more in line with other European markets.

On the basis that the stock will gap down - and in order to capture as much of the opening flush of liquidity as possible - the trader opts for the highest aggression setting and initially sets the limit price at the same level as his target price of €16.38.

9.01am: France Telecom behaves as expected and opens gap down (though only by €0.05) and continues falling. Reasonable liquidity under the circumstances, with in excess of 200,000 shares trading above the trader's limit price during the first minute on the primary market, including some blocks of 20,000 plus. Volume completed - 28,952.

9.10am: The stock has mostly been trading below the limit price since shortly after the open, but the RSI has given a couple of buy signals in the last few minutes. (See Figure 1, with signals highlighted in magenta and the trader's limit price as a dashed red line.) Volume completed - 28,952.

Figure 1

Figure 1

9.12am: The stock has remained fractionally below the limit price on the primary market, but has been accessible for the limit price in several dark venues including Chi-Delta and Turquoise Dark. The RSI signals are also looking increasingly plausible as the stock is now rallying. Volume completed - 30,258.

9.14am: France Telecom has spent much of the past minute flirting with the limit price but has spent enough time on or above it for the algorithm to pick up further stock in both the primary market as well as several alternative lit venues including Bats Europe and Chi-X. Volume completed - 38,004.

9.24am: Not encouraging. Most activity is still well below the limit price, but on the occasional rally upwards the algorithm has managed to pick up stock, mostly in the dark. Volume completed - 40,112.

9.29am: Further recent buy signals from both RSI and stochastics and is now regularly printing trades at or above the limit. Volume completed - 44,894.

9.36am: Progress at last, with the market moving up gradually and reasonable volume now appearing on both lit and dark venues in the past five minutes (135,000+ on Euronext Paris). A further good sign is that one of the traders proprietary tools based on moving linear regression (MLR) has given an indication that the recent rise may be developing into a more sustained rally. (See Figure 2 for a two minute chart with the signal highlighted with a magenta rectangle.) Volume completed - 61,268.

9.56am: While the predicted rally hasn't exactly taken off with a bang, the market has stayed comfortably above the trader's limit and liquidity (especially on lit venues) has been available. Nevertheless, the trade is still a very long way from complete. Volume completed - 104,541.

Figure 2

Figure 2

10.00am: A further positive trade signal from the trader's proprietary model, but liquidity has been drying up on lit venues in the last few minutes. Volume completed - 113,258.

10.08am: The signal looks good, as the market has rallied to a new high for the session at 16.45 (see Figure 3), but liquidity still only moderate. Volume completed - 171,887.

Figure 3

Figure 3

10.38am: The rally has continued and the algorithm has been selling efficiently into it on the back of steady if unspectacular liquidity, so the trader opts to reduce the algorithm's aggression setting to medium. Several decent blocks disposed of on Turquoise Dark, Bats Dark and Chi-Delta. Volume completed - 262,514.

11.18am: Further good progress as the market has eased back from what subsequently proves to be the day's high at 16.475 but liquidity has been sustained. However one concern is that both the stochastics and the trader's proprietary MLR-based model have simultaneously indicated (see Figures 4a and 4b) that the market may be turning down significantly and therefore even the reduced aggression setting of the algorithm could start to have an impact. Volume completed - 394,612.

Figure 4a

Figure 4a

Figure 4b

Figure 4b

1.24pm: The market has sold off from its earlier highs but has fortunately remained in a trading range around the 16.42 level rather than moving decisively lower and liquidity has held up - so the algorithm's aggression setting has clearly not significantly affected the market. It has regularly managed to capture the spread while also unloading substantial volume in both lit and dark venues.

1.48pm: The stock has briefly dipped back below the limit price, but has bounced back a little on unimpressive volume. Volume completed - 702,002.

2.08pm: Now trading well below the limit. Nevertheless, some neat work by the algorithm in Chi-Delta and Bats Europe has unloaded a surprising amount of stock over the past ten minutes. Volume completed - 724,993.

2.38pm: Now trading around the 16.33 level so the algorithm is inactive. Volume completed - 724,993.

3.02pm: Not looking good. The market is still declining steadily and with the better part of 300,000 shares still to unload, this is beginning to look like a lost cause. The trader calls the manager to warn him that exiting the other legs of the trade may have to be postponed and a residual hedged position left on. The manager's response is that the trade needs to be cleared today if possible, so if absolutely necessary the France Telecom position can be disposed of for an average of 16.35. Nevertheless, the trader opts to persist with the original limit of 16.38 for the time being. Volume completed - 724,993.

3.20pm: Possible cause for optimism; a buy signal from the trader's MLR model (see Figure 5). Volume completed - 724,993.

Figure 5

Figure 5

3.38pm: Further small cause for optimism as the previous signal looks good; the market has briefly traded up through the original 16.38 limit and the algorithm has managed to dispose of a further 20,000+ shares. Volume completed - 745,031.

4.08pm: Despondency again, as the market has slipped steadily back over the preceding twenty minutes. Volume completed - 745,031.

4.27pm: France Telecom has rallied briefly above 16.38, but is now dropping off. A brief flurry of liquidity on lit venues has seen a further 55,000+ shares sold. Volume completed - 800,092.

4.41pm: The market is currently oscillating to and fro across the limit, but buyers are now appearing in larger numbers. Volume completed - 832,021.

4.47pm: What may prove to be the last rally of the day on the back of significant buying volume prompts the trader to move the algorithm's setting back to the highest aggression level in the hope of beating the clock. Volume completed - 873,752.

5.00pm: The higher aggression setting has almost paid off, with a surge in buying interest keeping the stock above the limit until now. Volume completed - 962,253.

5.05pm: Excruciating to watch, with occasional selling opportunities as the stock flips in and out of limit. Volume completed - 983,003.

5.09pm: Still inching closer, as France Telecom moves above the limit for barely two minutes - and almost certainly the last time this session. Volume completed - 1,015,695.

5.22pm: So near, but not near enough - now trading at 16.365. Volume completed - 1,015,695.

5.29pm: Skin of the teeth; the algorithm manages to shed the last of the position with among the last handful of trades of the session on the primary market and Turquoise Dark at 16.38. Volume completed - 1,020,000. Average price achieved - €16.395.