Hedge Fund Trading Technology Moving Further into Currencies

October 24, 2011

The Wall Street Journal reports that computerized, high-frequency trading is now making greater inroads into the hedge fund sector of currency derivatives. A growing number of hedge funds, plus large banks such as Credit Suisse Group AG and Royal Bank of Scotland Group PLC, are automating a process that used to eat up 25% to 50% of their currency traders’ time.

Both banks and hedge funds are using technology in niche areas such as exchange-rate derivatives and emerging market currencies.

“You can automate something where you used to have to be glued to a screen,” said Paul Buckley, head of Credit Suisse’s Advanced Execution Services foreign-exchange products globally.

However, the trend toward automation could also indicate that it’s becoming increasingly more difficult to make a profit exchanging currencies. Banks have traditionally used their role as a middleman to sell a currency high and buy low. With the rise of high-frequency trading, price gaps have narrowed. Banks are trying to make up for the shrinkage with bigger trading volumes, achieved through technology. They’re also investing in new services such as automated options hedging.

Both banks and hedge funds buy options to protect themselves on the downside when markets head south. These options contracts give them the right to buy or sell a currency at a specific price in the future. Roughly $200 billion in currency options trade hands daily, compared to the overall market of $1.5 trillion in foreign exchange.

Hedge fund traders keep a close eye on “gamma”, a measurement of how much an option’s value moves in relation to the currency. High gamma means there’s a lot of uncertainty over whether the currency will reach a level that triggers an options payout. Using an automated trading system, a hedge fund trader can set a specific limit for gamma. When that limit is reached, it triggers an automatic buy or sell of a specific currency, to reduce risk.

A trader at a $2 billion hedge fund who is testing high-frequency trading technology from Royal Bank of Scotland says it helps his fund profit from tiny moves that would be otherwise difficult to trade. “When you have a choppy market that is not really going anywhere, it’s good to have a system that just captures little moves constantly,” he said.

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