Trading is the ultimate competitive enterprise and all traders, whether they are scalping ticks, long-term trend followers, short-term traders or day traders, want to get their price. For commodity trading advisors (CTAs), being able to consistently execute at or near their price is key and, for some, can be the difference between success and failure.
Ensuring quality execution is a little more complex in a world of high-frequency trading. While electronic trading made life easier for CTAs and improved the overall liquidity of markets, it added an element of anonymity to market making and fewer players feel comfortable showing their size. This has led to an increased use of "iceberg" orders (orders that only show to the market a small fraction of the total order) and high-frequency trading algorithms that, at times, attempt to identify icebergs and exploit them.
"That is problematic if that is what you are relying on," says Michael Geismar, principal with Quantitative Investment Management (QIM). "Those are the ones — iceberg orders — that bots [algorithms] can detect and that is when you can get taken advantage of. If somebody knows that there is additional size behind that 10-lot order that keeps popping up, people keep moving away from that trade. If I place an iceberg order and it shows 10, but there is really 500 behind it, if I hit 10 and I see another 10 pop up, then I know or can guess that there is more behind that. Then people are going to stop hitting and they move away from you, and you are going to incur more slippage."
Bradford Paskewitz, founding principal of Paskewitz Asset Management, uses the iceberg concept, but has created his own proprietary method. "We have developed our own execution systems with a FIX engine and we use our own algorithms to split up orders," Paskewitz says. "We do break our orders up into smaller pieces and execute them algorithmically; it is an iceberg-like idea. You want to get it done in pieces and you don’t want to show size along the way."
That is easier said than done, as Paskewitz says the high-frequency traders (HFT) are looking for those orders. "The whole reason people don’t show size is because of those high-frequency traders," Paskewitz says. "You want to randomize your orders because if you keep putting out exactly the same order in smaller increments, it is easier to recognize the signature and people say ‘oh look, this same guy is doing all these orders’ and they will monitor you more; if you randomize your sizes and your times, it is harder to tell it is all one person."
While there are simple algorithms to break up orders, it is hard to stay ahead of the HFTs, and that has provided an opportunity for software firms to help managers develop execution algorithms that promise to reduce slippage.
"In every change in market structure, there is a beneficiary and there is no doubt that Portware and firms like ours are a beneficiary of the changes that are happening in the listed derivatives markets," says Scott DePetris, chief operating officer at Portware, a software firm that designs execution algorithms.
DePetris says he has seen the effect of HFT traders play out, first in equities and now in futures. "We are seeing eerily similar market structure behavior. Spreads are fairly tight in the more liquid listed derivatives space, but the visible liquidity has decreased, a lot of it is hidden like [iceberg] orders," DePetris says.