Traders' wild volatility ride

It's hardly news that volatility has reigned supreme across global equity markets in 2008. But recently the Australian bourse has been particularly volatile.

Trading has seen the benchmark S&P/ASX200 index zig-zagging wildly above and below opening levels.

For any Australian equities index, the action has been more than unusual.

The morning of July 24 for example saw so many S&P/ASX200 directional changes that at first glance it gave the impression of extreme investor indecision.

But market professionals knew there were other dimensions at play.

Macquarie Private Wealth divisional director Lucinda Chan said quarterly options expiry was part of the explanation.

Positions that haven't expired worthless are exercised, closed or rolled to other expiry dates or exercise prices.

But professional traders have recently also been unusually active.

Traders are employed by finance houses to, among other things, boost returns on principal accounts. ``Principal'' means the house's own assets.

Traders' positions are often open and closed - perhaps multiple times - in a single day. And trading is undertaken in such large volumes that profits can be taken as securities move in increments of cents rather than dollars.

Professional traders, many of who retain employment only so long as they reap profit, seek excess returns or so-called ``alpha''.

A principal's stock may be utilised, and indeed finance houses hold such large volumes of top-20 stocks that shorting and stock lending is common.

But often traders use derivatives including options, futures, forwards, exotics and derivative strategies that mimic other derivatives known as synthetics.

Derivatives are derived from underlying securities, which in the case of the equities market may be shares or similar instruments.

In itself, derivatives trading often doesn't move share prices, as many trade on separate exchanges, are over-the-counter or cover disparate markets.

But for derivatives traders to keep positions safe, while supposedly adhering to in-house risk controls, they need to hedge their activities.

That often means buying or selling the principal's underlying holdings.

"There are a lot of participants in the market who are very trading oriented,'' Intersuisse director Howard Elton said. "These are professionals with the large institutional broking houses who are taking positions whether long or short.



"The huge volumes ... these are not the mums and dads having a flutter. And it's also not the major savings institutions, the superannuation funds doing a lot of this.''

The uninitiated might tag such trading activity as false and therefore unrepresentative of the true value of markets and their participant securities.

But the liquidity that it provides is imperative to the effective functioning of major exchanges and markets.

Liquidity simply means an investor or trader can buy and sell securities, at consensus fair prices, ostensibly when they choose.

"A lot of this is intraday trading,'' Mr Elton said. "And most will be brought about by the principal trading of the large broking houses.

"Sometimes it's fine tuning of portfolios.''

To an extent, program trading - where computer-generated orders automatically realign institutional holdings to their benchmarks - is also apparent.
"The better the computer systems, the more trading there's been over the past 10 to 15 years,'' Mr Elton said.

Tolhurst private client adviser Stephen Ellis said professional traders were responsible for a significant proportion of the recent market volatility.

"The market's being driven by traders,'' Mr Ellis said. "Private clients are topping up on top-20 stocks, but we've got traders running the market at the moment.

According to Mr Ellis, volatility is particularly a boon for institutions going short.

But for private clients, who are often longer-term investors, the sometimes violent market action can significantly increase anxiety.

Mr Ellis said funds and individuals alike could also tap considerable leverage, the availability of which has rocketed over the past decade.

"Depending on the fund you could use considerable leverage,'' he said. ``With the capacity to do it in size.''

Information flow - whether paid, cheap or free - has also become increasingly accessible.

"We know of one (quantative) fund that can do enormous size and impact share prices, but the market is made up of a lot of people,'' Mr Ellis said. "If you've got program trading and they are going in the same direction, it can certainly add to volume.

"A story can flow around the world, and you can have global traders jump on a market.''