Markets

Michael P. Regan is a Bloomberg Gadfly columnist covering equities and financial services. He has covered stocks for Bloomberg News as a columnist and editor since 2007. He previously worked for the Associated Press.

If the wild gyrations in oil prices are making your head (and your P&L) spin, at least you can take some comfort knowing that you're in good company. 

Even the famous money-making algorithms at Virtu Financial -- which propelled the firm to a stretch of at least six years with only one day of trading losses -- had a hard time dealing with the crude futures curve in the fourth quarter.  In fact, the whole period was a soft spot for the high-frequency trader (or automated market maker, if that's your preferred term). Fourth-quarter revenue decreased 17 percent, to $176.9 million. Indeed, most of Virtu's segments posted declines in trading income last quarter: 

Soft Quarter
Virtu experienced declines in most of the asset classes it trades in last quarter.
Source: Virtu earnings report

But the slump in commodities trading, its second-largest business during the period after stocks in the Americas, may have been one of the biggest disappointments because the factors that usually help Virtu make money -- increases in volatility and trading volumes -- were certainly present in the energy markets. 

Virtu makes markets in crude oil futures for delivery years in the future, and apparently the type of volatility seen on the so-called futures curve last quarter was, according to CEO Doug Cifu on a conference call,  "a bit of a challenge for our market-making algorithms. And so our crude numbers in particular, which as you can imagine are a large subset of what we do in commodities, struggled."

Futures Curve Ball
Virtu's trading algorithms had a tougher time navigating the WTI crude-oil futures curve last quarter.
Source: Bloomberg
Gap indicates some contracts had not started trading yet.

Does this mean Virtu lost money in the oil markets last quarter? Perish the thought. Cifu said: "Did we make money being a market maker in crude products in the fourth quarter? Of course we did. Did we make as much money? No, so our capture rate went down in that particular instance and that has a magnifying effect" because of crude's substantial role in commodities trading.

A welcome side effect of Virtu going public last year is that it requires the company to disclose and discuss its business to some degree, slightly lifting the veil on the strategies of much-maligned high-speed traders. Cifu was asked by analyst Kenneth Worthington of JPMorgan to elaborate on the notion of "good volatility" versus "bad volatility" and the response was somewhat enlightening:

When you're trading a single object and just trying to be a two-sided market maker, with respect to a single object -- whether it's a share of JPMorgan or whether it's a spot crude contract or whatever it is we do around the world -- sharp volatility obviously in that situation can be a challenge. You're posting bids and offers, and if there are sharp sudden moves you're going to get swept. And our risk controls, as you know very well, will kick in. And we're not going to sit there and hold a position and hope for mean reversion, it's just not what we do. We're not a hope-and-pray type of firm.

Those types of sudden moves, however, are beneficial to another part of the firm's business: arbitraging the difference in values between various products tracking large swaths of the market:

(When) you're trading a one-to-one strategy where you're trading a future against an ETF or even an ETF against its components, you will see opportunities because there's price dislocations. And what we do as a market maker is obviously harmonize prices across clearinghouses, asset classes.

You can almost hear the groans coming from critics of high-frequency trading in Chatham, N.J., and Winnetka, Ill., at the notion of "harmonizing" prices, but that's a topic for another day. The immediate question for Virtu shareholders, who are looking at a nasty drop of as much as 10 percent in the shares, is whether the firm's algorithms have lost their mojo

That'll be hard to know for sure,  but there are signs that this could be a good time to be Virtu. U.S equity trading volume is averaging more than 9.2 billion shares a day so far in the first quarter, a third higher than the first quarter of 2015. The VIX gauge of volatility has averaged 23.38 this year, 41 percent higher than the first three months of 2015. The firm -- which trades more than 12,000 financial instruments in 230 market venues in 35 countries, all with only 148 employees -- is looking to expand even further without adding headcount. Its outreach effort to fend off "Flash Boys" critics has produced new business opportunities to trade on behalf of big buy-side clients like T. Rowe Price, as John Detrixhe and Annie Massa report.

With an indicated dividend yield of 4.4 percent and the firm dangling the possibility of a special year-end payout, it may be worth taking Cifu's advice to ignore quarter-to-quarter fluctuations in earnings and focus on the long term. 

This column does not necessarily reflect the opinion of Bloomberg LP and its owners.

To contact the author of this story:
Michael P. Regan in New York at mregan12@bloomberg.net

To contact the editor responsible for this story:
Daniel Niemi at dniemi1@bloomberg.net