Advanced Trading: How can a buy-side trader be assured that their third-party algorithms have been tested properly?
Broker-Dealer:The most important part is that they understand how they work in the first place. The broker dealer should be able to explain to the user what each toggle within the algorithm means. Basically there is a [screen] that comes up when you slug an algo and you can select if you want to be passive or aggressive, obsessed with volume on each trade.
You have to know how it works. The next thing is even some algo providers will tell you: One toggle you select may counteract another toggle as well." If something says, if you want to be passive when you send in to your order but if you have a trigger that says, "If you get to this price, go to the market" - well, those things contradict each other.
You have to know how you're managing your algorithm.
For more helpful broker-dealer tips, check out How the Buy Side Can Protect Against Rogue Algos, Broker Error by Justin Grant.
Advanced Trading: So how do you trust your algo provider?
Broker-Dealer:The main questions is, how do you trust it? Well, you have to in order to use their algo. With Knight Capital, they are saying that it was dormant code within that algo [that went rogue on August 1st]. That is a huge error, obviously. Perhaps the people who put the dormant code in there did not remove it quickly and the person or the people who tested it did not have the conditions in the real world to bring that error into the test environment.
You really don't have a choice in whether you're going to trust the algorithm or not. People are betting on the solidity of the company and it's efforts to create an efficient trading algorithm.
Advanced Trading: It sounds like traders go with a broker-dealer's reputation and past experience as well?
Advanced Trading: Can a hedge fund test a broker's algos themselves?
And the issue comes to a head when you're saying 'I want to test this algo and if it goes bad it is going to cost myself and the investors money so … why should I take that risk?' Let it happen to someone else.
Whenever I was going to use a new algorithm, I won't touch it for the first six months until they work all the bugs out.
Advanced Trading: Really? Back when you were a buy side trader?
Broker-Dealer:Yes, even on the sell side when you are offered an algo, you shouldn't touch it until all the bugs are worked out.
Another issue: Today all algos have to be monitored and retooled over a short time period because there are other strategies out there, and regulations and market structure effects that may deteriorate the capability of the algorithm.
So you have to watch out for that as well.
Advanced Trading: Waiting six months to use an algorithm, is it still viable? Is it still fresh? Don't you want the most up-to-date algorithms?
Broker-Dealer:Six months may be a long time to wait, I admit, but that's when you have to err on the side of caution. You might want to wait a month before you actually use it.
This interview was conducted for the October 2012 digital edition of Advanced Trading. Download it here.