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Knight Capital Markets Attempts to Solve the Pain of Pairs

Knight Capital Markets introduces a new pairs trading platform and pairs algorithms to help traders more effectively and more efficiently execute their pairs strategies.

If you talk to any trader, trading pairs is a thorn in their side," says Joe Wald, managing director, Knight Capital Markets. "No one is happy with the platform they have."

The few legacy systems that are used for pairs trading are clunky and far from ideal, Wald contends, adding that there is huge demand on Wall Street to improve the technology behind pairs trading and boost the rate of pairs execution. As a result, Knight has decided to take on pairs with the introduction of a new pairs trading platform coupled with six new pairs algorithms.

"We've been thinking long and hard about how to evolve the pairs paradigm and really come out with a next-generation pairs platform with respect to a more intuitive, easy-to-use pairs interface," Wald relates. He says he put the "better part of last year" into building the new interface as well as a suite of pairs algorithms, working in conjunction with Ray Ross, Knight Trading's head of algorithmic trading technology.

Rethinking Pairs

According to Wald, there has been little innovation in pairs trading technology, and the "mind-set" around what constitutes a pair hasn't evolved with the markets. Knight is hoping to change all that. For starters, rather than stick to trading the mainstream pairs, Wald says, the firm is giving traders more options by allowing them to create custom indices and base pairs on these synthetic indices. The added flexibility in creating pairs from a conglomerate of stocks will result in tighter correlations, he asserts. In addition, the new trading interface, which has been incorporated into KnightDirect, will offer a number of new algorithmic strategies (see sidebar, next page).

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Wald explains that trading pairs is particularly complex. "You have to ... try a lot of different orders in the market before you execute," he says. "There is an overwhelming amount of data that flows through a pairs trading screen that is pretty confusing. We've relegated the background noise to the background." Wald notes that Knight's system highlights the parts of the pairs that have been executed as well as data that indicates how close traders are to the ratio at which they want to trade.

The bottom line, Wald stresses, is to provide traders with a more effective way to execute a pair. "The hardest thing is getting that pair executed when the pair comes in line," he explains. "Most traders will say, 'I wish I could get executed' on what they set up." Knight's new system, Wald continues, will enable traders to view pairs on their screens and execute their strategies when those trades come in line.

The labor-intensive nature of pairs trading, from a data and infrastructure perspective, did present Knight with a challenge, Wald acknowledges. "You have many orders going to the market -- maybe 20, 50, 100 orders for one execution," he says. "Having a system that can handle that load was the first challenge we had to overcome." To overcome that challenge, Wald explains, the pairs platform leverages Knight's low-latency infrastructure.

With more pairs options and the ability to work the market with new strategies and algorithms, Knight expects pairs trading to become much more popular. "There will be an increase in pairs trading," Wald predicts, adding that pairs trading is a highly sought after strategy because of its market-neutral nature, particularly in a risk-averse environment. "A lot of people will be brought into the marketplace who want to be there but just couldn't because it was too difficult in the past."

Knight's New Algos

A key component to pairs trading is how the pair is executed, according to Joe Wald, managing director, Knight Capital Markets. "You can look for price improvement by utilizing different tactics," he says. For example, "A trader can ... execute at the midpoint using dark liquidity rather than go straight to the marketplace."

In an effort to provide traders with execution options, Knight has combined its FAN algorithm, which pings many liquidity pools to improve the probability of execution, with other strategies to create new pairs algorithms. The new offerings include:

  • • Peg Algorithm. The Peg algo pegs an order to an open limit, allowing traders to gain liquidity without manually entering new orders as the market moves, according to Wald.,

    • Alpha Peg Algorithm. The Alpha Peg algo uses peg logic but allows the trader to capture spread based on time/price parameters so the trader is not bound by Price A and Price B, for example.,

    • Dollar Neutral Algorithm. The Dollar Neutral algo allows a trader to stay in a hedged position based on the cost basis of each leg.,

    • Dollar Neutral TWAP. The Dollar Neutral TWAP algo allows a trader to work a dollar-neutral strategy over a user-defined time period. This is used for very marketable pairs. ,

    • Inverse Peg. The Inverse Peg algo is used to trade ETF and ETF inverse spreads.,

    • Unicapture. The Unicapture algo allows traders to create a spread in one issue.

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