Sunday, April 19, 2015

As with all dealing, risks in algorithmic trading must be managed | …but ignoring algo is not an option

While we at OmiCronFX  have spent much time in developing our Forex trading software so that it can be consistently profitable, we know that it is of vital importance that we also concentrate on the risks that are becoming more and more apparent in relation to trading in general, and algorithmic trading in particular.

Computers have the ability to act and react rapidly – that is the point in developing and using algorithmic routines. Unfortunately, this can be double edged sword, which will be obvious in a situation where losses, instead of profits, are in the course of being rapidly multiplied, for whatever reason. So operators of trading software have a real responsibility and incentive to thoroughly test their creations, and to implement the safeguards that have been built up over the years to protect systems where software is being put in place anywhere, not just for Forex or stock trading. The faulty implementation of accounting software in a manufacturing company, for example, can be just as disastrous for that company, in terms of its ability to safely manage its business, as the out-of-control buying of a losing security by a hedge fund when its High Frequency Trading software malfunctions.

And, as far as trading is concerned, computers are not just in play in the HFT trading funds. They also now control and manage everything that happens at the brokerage, exchange, market-making, and price and exchange-rate determination level, and even for compliance with trading regulations by the SEC and similar bodies around the world. These computers also have the capacity to malfunction, as has been shown in the case of the so called “flash crash” of May 6th 2010, when the Dow Jones Industrial Average dropped over 1000 points, or 9%, in a matter of minutes. One factor in the events leading up to the crash were so-called “technical glitches” in the reporting of prices on the NYSE that tended to lead to delays in quotes, with subsequent wholesale confusion for traders who mistakenly thought they were in loss making situations, which they naturally attempted to liquidate.

Ignoring algo is not an option

The cumulative effect of all of these interlinked computers for the operation of the markets can lead to the extraordinary amplification of what would otherwise be notable, but not necessarily disastrous, occurrences.  The best example of this in recent times was the melt-down in the exchange rate between the Euro and the Swiss franc on the occasion of the sudden removal, by the Swiss Central Bank, of the cap it had maintained on the value of its currency to prevent its rate against the Euro (shown by the EURCHF currency pair) going below 1.20 (a fall in EURCHF means a strengthening Swiss franc [CHF]). Many Forex players had been so convinced by the strong rhetoric of the SNB prior to this, to the effect that it would defend the cap by whatever action was needed to do so, that they had used high leverage to take long positions in EURCHF (betting it would go up) as it approached the level of the cap at 1.20. Some of these funds were wiped out when the SNB announced that the cap was being abandoned. A number of Forex brokers were placed in receivership, while others had to absorb losses running to hundreds of millions.

The lesson from all of this is that computers and algorithms are already ubiquitous in trading. The dwindling number of manual traders will find two things: (1) they are at a disadvantage because of the sheer speed, lack of emotion and infinite patience of their algorithmic opponents’ computers and (2) they are at the mercy of possible malfunction of the computers that they must interact with in any event, and / or the magnification of effects that these machines can bring about.

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