Fair Game

Thanks to anti-gaming technology, trading strategies for large-cap securities are now available for small-cap stocks.  By Michael Shashoua

By adding a small-cap execution management strategy to its anti-gaming technology, institutional electronic brokerage Pipeline Trading Systems is making it possible for its clients to use opportunistic trading strategies for small-cap stocks that previously were only workable for mid-cap or large-cap securities.

With the anti-gaming technology now handling small-cap trading, users also avoid adverse selection, in which trading is exceedingly slow if the market is going to move against them, or if the market has high participation in trading the security, the price drops.

"Gaming is one of the mechanisms that causes adverse selection," says Henri Waelbroeck, director of research at Pipeline. "If an order has left too much of a footprint, other participants can detect those footprints and know that the order is there."

The addition of the small-cap strategy, announced in December of last year, provides "specific mechanisms to detect when the fair price model should be questioned and we should pull back and let the market discover a new price," says Waelbroeck. "That was the piece of the puzzle that was solved that is really specific to the small-cap strategy."

Small-cap stock trading can be sporadic, notes Waelbroeck, and "when something happens, you need to be engaged in a strategy that enables you to capture the opportunity," he adds. "In liquid names, discovering the fair price is not quite so problematic because there is a lot of trading activity from a lot of market participants and the market tends to find its price pretty continuously. Small caps can get stuck at a price point and trade potentially a significant number of basis points away from what other market participants view as a fair price, without correcting, because there is very little activity to force the price to a new level. So it's much more important to keep an eye on your fair price model, make sure it's accurate and make sure it is validated by market events."

Pipeline's small-cap execution management strategy uses an algorithmic trading switching engine it started developing four years ago, then launched two years ago. About a year ago, Pipeline began examining whether the engine could address the issue of adverse selection in trading small-cap stocks. The newest version of the engine was released in June 2009.

"The engine finds a great deal of predictability in the order flow from other participants in the market," says Waelbroeck. "Once you understand that predictability, you can select algorithms that trade in a manner complementary to what is going on in the market, to minimize your footprint, impact costs and adverse selection. That is the basis of the switching engine."

In addition, the small-cap strategy is an improvement on fair price models deployed for the same purpose, according to Waelbroeck. "A small-cap algorithm needs to be opportunistic because the liquidity is very spotty," he says. "The next step is to ask when to accept opportunities or decide the price is wrong. The problem, we heard from our clients, is that fair price models don't question their own analytics when market events are unfolding. Traders tell us they really need an opportunistic strategy where if they see certain events on the market, they should be ready to question the fair price model." -->