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Intelligent Workflow - Paired

Published in Automated Trader Magazine Issue 16 Q1 2010

All the workflow issues associated with trading double when you’re trading pairs. While it’s possible to deal with some of these with intelligent software design, the challenge is to streamline the workflow without removing so much discretion that the human trader cannot deliver alpha. Gary Stone, Director of Trading Research and Strategy at Bloomberg Tradebook, explains how to strike the right balance.

When designing any trading application you're ideally looking to minimise the drudgery, while maximising the trader's opportunity to perform. This is tough enough to achieve when trading single securities, but with pairs trading you're not only concerned with two individual legs, you also have to consider their interaction and how best to facilitate the trader's control of that.

Setting up

Consider the most basic level, using merger arb as an example. Just how much value does a trader add by populating a merger arb trade ticket? What if the trading application can link to a list of all current mergers where the trader simply chooses which ones in which to participate and then clicks to have the deal ticket auto populated in the desired size? That doesn't just save the trader time in which to do something more worthwhile (such as screen the potential attractiveness of individual trades), it also minimises the risk of fat finger errors. Bloomberg Tradebook's PAIR platform delivers this by interacting intelligently with Bloomberg's MARB module (which provides details of all current deals including regulatory approvals required and market consensus on the deal completing) to auto complete deal tickets, including any cash element (if applicable).

As a second step, consider those situations where the trader has to populate the ticket manually; how best to streamline that process? Take a straight pairs trade, such as the XTO Energy/Exxon Mobil trade shown in Figure 1. While some traders will be working on the basis of trading a specific number of shares in a given ratio, others will have a specific amount of trading capital they need to put to work. Does this latter group really want to spend time with their calculators working out what size to trade? No - and they don't have to; with PAIR they can key in the cash amount available to the trade, and the software auto calculates the size.

figure 1

Figure 1

Source: Bloomberg ©2010. All rights reserved worldwide.

The right amount of leg, in the right order

While pairs trading may be less risky than directional trading in terms of market risk, one of the downsides is that the trader has two lots of potential slippage to minimise. "Max Show Leg Slice" in Figure 1 is one way of minimising this by restricting the maximum size of any trade leg that is visible to the market. The principle is similar to that of "display and reserve" commonly used for individual equity trades.

Another everyday challenge for pairs traders is managing trades where one leg is significantly less liquid than the other. Historically traders have had to deal with this by manually prioritising this leg for each slice of the total trade. The "Initiate first" checkbox in Figure 1 gives the trader the opportunity to establish this at the outset and the application will then automatically prioritise that leg as it hands off the trade to any execution algos the trader chooses to use. Alternatively, the trader can leave prioritisation to the discretion of the application, which will automatically favour the leg likely to be hardest to execute. All other things being equal, it will give the short leg priority, otherwise the hardest to trade stock.

Pick and trade

As mentioned above, integration with MARB streamlines trader workflow when using PAIR. A similar situation applies with "straight" pairs trading; here the trader has access to multiple Bloomberg analytics for testing the robustness of potential trades. Once a suitable pair is identified, a couple of clicks will auto populate the deal ticket with the correct tickers etc. If the individual legs happen to be in different currencies, the application automatically takes care of the currency translation as well.

When trading commodity/futures spreads, keeping track of the various intermonth permutations can be a major headache. This is particularly problematic where a contract has a large number of active months, such as Eurodollar futures. A further issue is that traders active in interest rate futures need to be able to see spreads at a glance expressed in either points or yield. Ergonomics play an important role as well; while an equity pair may take several days or even weeks to revert to its long term norm, in the interest rate complex reversion can occur far more rapidly, especially around major economic or central bank announcements. This has major implications for

workflow, as traders may be putting on and taking off a large number of trades in a relatively short space of time and need to be able to grasp the largest picture in the smallest amount of time. Figure 2 shows the PAIR commodity module's solution to this problem, with a multi expiry ED/ER grid complete with synthetic bid/offer spreads and market depth for each combination of contract months.

figure 2

Figure 2

Source: Bloomberg ©2010. All rights reserved worldwide.

In a perfect trading world, the trading application automates (and where possible enhances) the trading process, while freeing up the trader to do more in areas such as trade selection/sizing or (where exceptional situations arise) trade execution. In the case of all versions of PAIR - conventional pairs, merger arb and commodity/futures spreads - it is possible for the trader to pretty much "set and forget". The desired entry and exit points are established and, if no unusual circumstances arise, the whole process runs on autopilot with the application interacting with the relevant execution algos automatically to open and close the position.

Exception handling

Even where problems do arise, the trader should not always have to get involved. A classic example is when a trade becomes hung on one leg. The standard response of most applications when this happens is to either immediately go to market or alert the trader. Either approach is sub-optimal; in the first instance execution costs increase (perhaps substantially), in the second, the trader is forced to become involved, potentially prematurely.

A far better alternative is to provide interim stages of automated exception handling. Given the tendency for markets to exhibit stochastic resonance, there is always the possibility that the hung leg will drift back in the desired direction. For this reason, the PAIR Risk and Slippage Management screen lets the trader specify a time limit that allows for this. If this doesn't work out, there is a further facility that lets the trader grant the application a specific degree of price discretion. Only if this also fails to resolve the situation will a market order or trader alert finally be used. A further alternative that completely eliminates the need for intervention is to use the "Least Cost Option", which will either automatically back out the hung leg or complete the pair, whichever is cheaper.

Joining the dots

Close integration with analytics is vital in order to improve pre-trade workflow, but so also is tight integration with the execution process. With two lots of slippage and two bid/offer spreads to contend with, any pairs trading application has to have seamless access to the best algos. PAIR delivers this by linking directly to any of the Tradebook suite of algos and smart order routing technology. If the overall trade size is large enough it will also use Tradebook's smart quoting tool and distribute the quotes across the various markets. As with individual stock trades, this will redistribute displayed liquidity in real time to take advantage of venues exhibiting the highest hit rates.

As mentioned earlier, a common problem when pairs trading is the relative illiquidity of one leg of the trade. This obviously causes problems if this leg of the trade starts driving the market. Therefore a pairs trading application needs to be able to prevent this happening when interacting with execution algos; in the case of PAIR, the trader can set a maximum participation rate for each leg of the trade.

Given the increasingly competitive nature of pairs trading, a growing number of traders are developing their own proprietary analytics outside their pairs trading application. While this may improve their identification of profitable trading opportunities, it can also introduce manual activity into the trading process.

To avoid this, PAIR is accessible to external applications (such as Excel and MATLAB) via the Bloomberg API. These applications can retrieve the necessary raw data for their calculations automatically through the API. Once their modelling process is complete, they can then send trade details back through the API to automatically populate the PAIR trade ticket.

1+1+1 = 4

The best trading applications always deliver more than the sum of their parts. In the case of pairs trading, that means connecting the best analytics and data, with the most intuitive order interface, with the best algos and order routing. But it also means doing so in such a way that the trading process is stripped to the bare essentials from a human perspective. In that way, traders can always remain focused on capturing alpha, rather than performing tasks an intelligent machine can do for them.


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