Adapting Algorithms to Realities of Asian Markets

Issue 08 Q1 2008
Automated Trader Magazine

If execution algorithms are to be adopted widely in the Asian markets, both providers and users must be aware of the unique characteristics of trading in the region, says Dr Usman Malik of P. E. Lynch LLP.

Many providers of execution algorithms are looking at Asia as the next market for rapid growth of algorithmic trading. However, anyone who believes that an algorithm designed to trade in Europe or the US will work as well in Asia is in for a nasty shock. Asia has some unique features which make it a very distinct market. Startling differences between Europe and Asia can be seen by looking at factors such as tick size, market capitalisation, intraday volatility and market rules. This article shows that algorithms need to be specifically customised to trade effectively in Asian markets.

Tick size and spread

Many Asian stocks have very large spreads. NTT DoCoMo, the Japanese mobile communication company, for example, has a median spread of 60 basis points. The larger spreads are due to tick sizes in Asia being greater than in Europe. Securities with large tick sizes (in basis points) will generally have bigger bid-ask spreads than stocks with smaller tick sizes. Figures 1a and 1b show the tick-size distribution for the 1,100 most-traded stocks in both Europe and Asia (Japan and Hong Kong). By comparing the two tick-size distributions, it can be seen that Japan and Hong Kong have significantly more stocks in the 10-60 basis-point range.

Similarly, Figures 2a and 2b show the median spread distributions for the 1,100 most-traded stocks in both regions. In this case, Japan and Hong Kong have significantly more stocks in the 20-60 basis-point range than Europe. If a stock has a smaller bid-ask spread, it will be easier to trade since the cost of execution will be smaller (in percentage terms relative to the stock price). It is harder to trade in Asia compared to Europe due to the fact that tick sizes and spreads are larger in Asia. The gap between spreads in the two regions will most likely increase in the foreseeable future as tick sizes in Europe appear to be decreasing faster than in Asia. The London Stock Exchange reduced tick sizes last year and Euronext is moving to further decrease tick sizes in 2008.

“It is harder to trade in Asia compared to Europe due to the fact that tick sizes and spreads are larger …”

Market capitalisation

The general rule in Europe is that the larger the market capitalisation the easier it is to trade the stock using an execution algorithm. By looking at Figures 3a and 3b, it can be seen that in Europe the highest market capitalised stocks (ranked 1-100) have the smallest spreads on average. In Europe, stocks have small bid-ask spreads when there are many shares available to buy and sell. However, in Japan the largest stocks by market cap have similar spreads to the lowest market cap stocks (i.e. those ranked 1,001-1,100).

The price that needs to be paid in order to execute trades in Japan is relatively higher than in Europe, even when there are a large number of shares available to buy and sell. Consequently, using market capitalisation as an indicator to recognise easy-to-trade stocks is not possible (or, at least, advisable) in Asia. ...

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