Aclick of a mouse is all it takes to trade a market. Like the toddler in the E*Trade commercial demonstrates, electronic trading provides unprecedented access by anyone at anytime to a multitude of global markets and trading information. Conceptually, electronic trading began a number of years ago; but it wasn’t until technology provided the speed, reliability and easy access that electronic trading took off. Is electronic trading the answer to the trading industry’s prayers, or its ultimate challenge? Let’s take a look.
PROS
Electronic trading and the increased market access it provides has turned sideline investors into traders. Individuals who would not normally have traded in the past can now put on a trade themselves before they go to work, or after they come home. Easy access to market-related news stories, price alerts, alarms and charts via laptop or phone, allow new traders and seasoned professionals to trade in ways that were not imaginable 20 years ago when electronic trading began in the futures markets. The dramatic growth in the futures markets is also a result of the opportunity the futures markets provide for traders to diversify their investments with easy market access virtually 24 hours a day.
This global assembly of buyers and sellers has resulted in soaring record market volumes. “Globex growth engine” shows the affect of the Globex electronic platform on CME Group volume. The first chart indicates overall volume growth and growth of Globex volume and the second chart shows the percentage of overall volume that is executed on Globex.
When the New York Mercantile Exchange (Nymex) listed its products on Globex, it led to exponential growth (see “Electronic energy”). “From the ground up” illustrates the consistently increasing global participation on the all-electronic European exchange Eurex.
Increasing trading volume indicates market liquidity, meaning that contracts can be easily bought and sold with very tight bid ask spreads. And the tight spreads lower the cost of trading. Add in favorable tax treatment for futures trading profits and losses, and you’ve got a winning combination.
Electronic trading also provides the opportunity for a market to easily change from a local market to a global market. Private and institutional traders worldwide are routinely trading both U.S. and non-U.S. markets. The world is borderless with the global access of electronic trading.
Electronic 24-hour markets allow traders to make trading decisions beyond the local market or cash market trading hours. Good examples of this are futures on stock indexes. Cash and equity markets are still mainly traded during regular New York business hours in the United States. A futures trader can now express an opinion of the U.S. stock market or react to a news event by making a trading decision before the open or after the close.
Electronic markets have changed how traders manage trades. The 24-hour market allows more flexibility on trade entry and exit, and this also means more flexibility for the trader’s risk management strategies. Now traders can work a stop order to protect a profit or manage a loss while they’re sleeping, and not be surprised by a price gap that can occur between the close of the local market’s trading session and the opening of the next. The almost continuous trading that electronic markets provide has dramatically decreased the typical gap between trading sessions. The highest probability for a gap to occur is between Friday’s close and Monday’s open in Asia, which is the Sunday night open in the United States.
The buying and selling of stocks has also felt the impact of electronic trading. Many individual stocks are traded in multiple time zones, creating a type of 24-hour market for that particular stock. Traders, however, didn’t have access to the trading that occurred in other countries. Electronic trading has changed all that. The electronic market allows brokers to expand their offerings to traders globally.
Electronic markets and technology have leveled the trading playing field. Information that was once available only to professional traders is now accessible to private traders. Whether it’s market news or price information, instant access to market information has decreased the professional trader’s edge over the private trader. This instant information access also means that global market participants can react faster to the market, adding volume and increasing liquidity, which dramatically increases the ease of trade entry and exit. In addition, electronic exchange order handling systems, such as the CME Group’s Globex platform, provide the capability of first-in first- out order processing. In other words, if a private trader places an order to buy one contract, and an institutional order for 10,000 contracts is placed after that, the private trader’s one contract order will be filled first. There is no order preference with electronic trading.
Institutionally, this evolution of electronic markets and trading has provided opportunities for firms to create new ways to interface with the markets. These new methodologies range from proprietary trading rooms where individual traders identify and manage positions, to order routing algorithms that break down large orders so they can be efficiently routed and inconspicuously executed in the market, to trading algorithms that automatically identify and execute buy and sell signals. The ability of an institution to become a market maker electronically is faster, easier and possibly less costly than establishing floor operations.
Opportunities created by the growth of electronic markets have led exchanges to switch from a mutual organization model to a for-profit model and their bottom lines show it, a revolution in its own right. Right off the top, infrastructure cost decreases dramatically with electronic markets. Traditionally, for an exchange to create a 24-hour trading continuum for one of its products, it would have to establish trading relationships with other exchanges around the world to trade their products in different time zones. Additionally, consideration would have to be given to product clearing and offsetting capabilities of trading that product in different cultural, regulatory and technological environments. Electronic markets, however, allow an exchange to trade a product in a 24-hour market within its own structure and regulatory environment without having to deal with the potential challenges and staffing requirements that an open outcry operation requires.
Electronic trading provides exchanges with the ability to introduce new products at lower cost, without having to design a pit (floor trading space) and filling it with staff, locals and brokers. Electronic trading enhances exchanges’ product development process by not requiring market makers to be physically located on the trading floor of the exchange. This in turn lowers the cost for market makers. A new exchange product can gain liquidity more rapidly as market makers in a multitude of locations can easily add that product to their electronic systems. All these factors allow exchanges to explore and introduce new products in a cost-effective way.
THE CONS
If speed of order execution is critical to a private trader’s trading strategy, then up-to-date technology and communication lines are a necessity. The costs for both technology and communication lines have come down, but that type of trading strategy requires continuous investment in the latest technological developments. This can become costly.
Institutions also need to keep up with the latest in technology. The technology costs required to create the speed of execution necessary for an institutional arbitrage firm can be staggering. For example, many of these firms will pay additional costs to locate their servers next to the exchange’s servers to shorten the physical distance the trade signal has to travel. There are companies that can execute 10 trades in the time it takes a private trader to push a button on a computer keyboard. There are, however, only a small number of firms globally that operate at this level well. What some of these arbitrage firms, as well as proprietary trading firms, are recognizing, is that there may be a point of diminishing returns in trying to reduce the speed of execution by a few more milliseconds.
Many people debate whether electronic markets can hold up under the stress of huge volatility. Can exchange technology handle the increase in order flow and quotes being sent by market makers? Some exchanges monitor message flow from market makers to make sure that all systems’ throughput can handle the necessary data requirements. But how much is too much?
An advantage of open outcry over electronic trading is “loyalty to order flow.” Locals on the floor of an exchange in an open outcry market are always ready to take the other side of trades that brokers are trying to execute. Locals are willing to do this because they can buy at the bid and sell at the offer, allowing them to capture that difference as profit. Their willingness to take the risk can keep markets orderly and liquid with a tight bid ask spread. This “loyalty to order flow” is absent in an electronic market.
Mentioned above was the ability to break up large orders to present them to the market inconspicuously and avoid tipping the market to your size. These so called “ice berg” orders can also produce a distorted picture of market liquidity. A floor broker in an open outcry market sees and hears the action in the pit and can use this information to determine when and how much of a large institutional order should be presented to the market in order to obtain the best price for their client. This ability to “work an order” becomes much more challenging in an electronic market where the broker does not have the sights and sounds of the trading pit, and what you see in the order book is not necessarily an accurate picture.
On the securities side there has been an explosion in so called “dark pools” so that large traders can work size away from a transparent open market. The possible expansion of block trading facilities has the potential to do this on the futures side, which could harm transparency and ultimately liquidity.
Technology has driven electronic trading to where it is today, and it shows no sign of slowing down anytime soon. The technology that is driving electronic trading also has provided easy access to a tremendous stream of news and market price information. With all of the choices and possibilities this information brings, a trader can easily lose focus. When this happens “analysis paralysis” can set in, leaving the trader frozen and feeling the need to have “all” the information before a trading decision is made. The result is no trading decision, because the trader never has “enough” information.
Likewise, with all the market information available, it’s very easy for a trader to become overwhelmed and reach a saturation point. This is the point where the trader’s mind goes blank as he tries to absorb more and more information. The increase in information can actually have a negative impact on a trader’s ability to make a trading decision and react to the market.
THE FUTURE OF TRADING
Electronic trading has spurred the growth of algorithmic order routing and trading systems in the futures markets. The development of algorithmic systems has tremendous growth potential as new technology capabilities continue to grow (see “Automated high-frequency retail trading,” page 56). We have only touched the surface in this area.
Electronic trading has revolutionized the concept of a market. And as more and more markets become globalized, providing unprecedented access to instant market information and order execution, traders must develop trading strategies to be successful. The time to trade markets has never been better. And as with any investment, it is critical that the investor understand the products and what they represent and have specific, well-researched trading strategies.
The bottom line is that the trading revolution that was brought about by electronic trading and electronic markets will undoubtedly continue.
Daniel M. Gramza is President of Gramza Capital Management Inc. He has presented courses to traders from over 35 exchanges, 450 institutions and 35 countries. He can be reached at dmgramza@att.net.
