Algorithmic trading and the VWAP Trap

The foregone conclusion that most buy-side firms will eventually get into the practice of algorithmically carving their own trades, is bound to change the rules of the game, yet again. To put it in the parlance of the street; doing a higher volume of no-touch and low-touch transactions, becomes the cornerstone of their bid to win the “Transaction Cost” game.

The expectation here is that buy-side Order Management System (OMS) vendors will be under increasing pressure to support algorithmic trading functions or risk facing obsolescence. No different from how those same vendors scrambled to adopt electronic messaging standards, long after they have become a staple of the sell-side bag of tricks.

Unfortunately history has shown that for the most part, buy-side order management systems, almost always leave a great deal to be desired. To their defense, those vendors are increasingly finding themselves being asked to match features that are traditionally reserved for the sell-side equivalents.

In their efforts to stay ahead of the performance curve, the buy-side will instinctively start bringing algorithmic trading in-house, putting added pressure on the viability of the agency role on the street. Lost in this picture is the realization that one of the biggest problems facing the adoption of algorithmic trading is not under but rather over-utilization.

Essentially, if everybody used standardized or highly correlated algorithms, they invariably become self-defeating.

Buy-side proponents of do-it-yourself algorithmic trading, are well advised to delve into the “art,” only if they are willing to invest in the “science” of it all. As the saying goes, a little bit of knowledge could be a dangerous thing and this is one area where less than mastery of the craft, will most certainly produce less-than-desirable results.