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Wednesday, April 7, 2010

Commodity markets not crazy enough for you? Just wait...

Equity markets have felt the impact of the quants and their algorithms for some years now. Commodity markets, on the other hand, have been a bit more old fashioned. Investors should be aware, however, that situation is changing.

Automated trading strategies are expanding into commodities as firms look to apply these techniques to other asset classes. And it's happening at a rapid pace. It is thought that as much as 35 to 50% of volume in the most active front-end oil contracts is generated by algorithmic trading.

There are differences in automated commodities trading when compared with the way it's done in equity markets. Here are the three strategies most commonly in use in commodities markets.

The first is called ETRM which stands for electronic trading and risk management. In this scenario, which comprises the majority of automated trading in commodities, there is actually a lot of human input driving the trading with assistance from fairly standard electronic trading systems configured with risk management add-ins.

Going further along the automation curve, the next level is referred to as PTRM. Here, algorithms implement a programmatic trading approach that supports the trading decision and the risk management is more tightly integrated into the whole process. This methodology is the next step for traders that wish to more fully embrace automation.

The fully automated approach as practiced by the most advanced quants in the equity markets has not quite arrived in the commodity markets but many bits and pieces are in place already at some firms. Trend following and fundamental-driven strategies are being implemented  in software to provide long, short or flat (cash) exposure as well as functionality that will look familiar to stock traders like trailing stops.

The commodities markets offer a rich environment for quants. There is a variety of trading strategies that can yield to automation: calendar spread trades involving contracts for different months, inter-commodity trades (crude oil versus refined products,  for example), seasonal trading, exploitation of price differences between exchanges, various kinds of pairs trades and more.

So put the computers into the hands of commodity speculators, stir in a little leverage and see how the big trading desks pile into similar trades faster and with bigger positions. With commodities representing finite resources and big money chasing after profits on the way up (with long strategies) and on the way down (with short strategies), moves can be expected to be quick and extreme with prices overshooting on the way and on the way down.

Hat tip to "Wall Street & Technology" magazine for providing source material for this post

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