High-Frequency Trading
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High-Frequency Trading

A Practical Guide to Algorithmic Strategies and Trading Systems

Irene Aldridge

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eBook - ePub

High-Frequency Trading

A Practical Guide to Algorithmic Strategies and Trading Systems

Irene Aldridge

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About This Book

A fully revised second edition of the best guide to high-frequency trading

High-frequency trading is a difficult, but profitable, endeavor that can generate stable profits in various market conditions. But solid footing in both the theory and practice of this discipline are essential to success. Whether you're an institutional investor seeking a better understanding of high-frequency operations or an individual investor looking for a new way to trade, this book has what you need to make the most of your time in today's dynamic markets.

Building on the success of the original edition, the Second Edition of High-Frequency Trading incorporates the latest research and questions that have come to light since the publication of the first edition. It skillfully covers everything from new portfolio management techniques for high-frequency trading and the latest technological developments enabling HFT to updated risk management strategies and how to safeguard information and order flow in both dark and light markets.

  • Includes numerous quantitative trading strategies and tools for building a high-frequency trading system
  • Address the most essential aspects of high-frequency trading, from formulation of ideas to performance evaluation
  • The book also includes a companion Website where selected sample trading strategies can be downloaded and tested
  • Written by respected industry expert Irene Aldridge

While interest in high-frequency trading continues to grow, little has been published to help investors understand and implement this approach—until now. This book has everything you need to gain a firm grip on how high-frequency trading works and what it takes to apply it to your everyday trading endeavors.

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Publisher
Wiley
Year
2013
ISBN
9781118416822
CHAPTER 1
How Modern Markets Differ from Those Past
Structural change is not new to trading in financial instruments. If fact, it is the constancy of innovation that has helped drive the leadership of modern financial institutions. High-frequency trading (HFT) has stepped into the limelight over the past few years and delivered considerable operational improvements to the markets, most of which have resulted in lower volatility, higher market stability, better market transparency, and lower execution costs for traders and investors. This chapter of the book provides the overview of dramatic changes that precipitated in the securities markets over the past 50 years, and defines HFT and core strategies falling under the HFT umbrella.
Over the past two decades, the demand for computer technology in consumer markets has led to significant drops in hardware prices across the board, as discussed in detail in Chapter 2 of this book. As a result, technology-enabled trading has become cost effective, and the ensuing investment into software has made trading platforms more accessible and more powerful. Additionally, the savings from lower errors in message transmission and data input, higher reliability of order execution, and continuity of business through computer code, deliver a business case for deepening financial firms' reliance on their technology systems. The escalating complexity of regulations also requires more advanced reporting capabilities that are becoming prohibitively expensive without substantial platforms. The lower cost base squeezes margins further, and this puts pressure on the traditional full-service model. Figures 1.1 and 1.2 illustrate the financial services landscape circa 1970s and today.
Figure 1.1 Financial Markets in the 1970s, before Electronization
Figure 1.2 Financial Markets Today
In the 1970s and earlier, the market participants were organizations and individuals now considered “traditional” players. As Figure 1.1 shows, on the portfolio management or “buy” side, the markets engaged
  • Discretionary asset managers, including pension funds, mutual funds, and hedge funds.
  • Retail flow, including individual “mom-and-pop” investors, and others with comparatively smaller capitalization.
  • Manual speculators, individuals involved in intraday proprietary trading for their own account or for the account of their bank.
    On the transaction facilitation, middle-men, or “sell” side, the markets supported
  • Manual market makers (representatives of broker-dealers), taking short-term inventory risk, providing quotations to the buy side, and generally facilitating the buy-side trading for a fee.
  • A single not-for-profit exchange in each asset class was established to curtail wild speculation by the exchange members and to lower transaction costs paid by the investors.1
The highly manual and therefore labor-intensive financial landscape of the 1970s was characterized by high transaction costs, leading to low turnover of securities; a high degree of error associated with manual processing of orders, and relatively high risk of trading, as traders predominantly relied on their experience and intuition as opposed to science in making their bets on the markets. Yet, the 1970s were also high margin businesses, with brokers receiving a large share of the spoils in the form of large commissions and, ultimately, the proverbial “fat-cat” bonuses to the tune of tens of millions of dollars.
Fast-forward to today's markets, illustrated in Figure 1.2: new entrants successfully compete using lean technology and science to hash out precise investing models, reshaping the markets in the process:
  • Quantitative money managers, such as mutual funds and hedge funds, are using the precise science of economics, finance, and the latest mathematical tools to chisel increasingly close forecasts of securities prices, improving profitability of their investments.
  • Automated market makers, for example, broker-dealers and hedge funds, harness the latest technology, studies of market microstructure, and HFT to deliver low transaction costs, taking over market share from traditional broker-dealers.
  • Automated arbitrageurs, such as statistical arbitrage hedge funds and proprietary traders, use quantitative algorithms, including high-frequency trading techniques, to deliver short-term trading profits.
  • Multiple alternative trading venues, like new exchanges and dark pools, have sprung up to address market demand for affordable quality financial matching services.
These innovations have changed the key characteristics of the markets, and largely for the better:
  • The markets now enjoy vastly democratic access: due to proliferation of low-cost technology, anyone can trade in the markets and set quotes, a right formerly reserved to members of the exclusive connections-driven club of broker-dealers.
  • Plummeting transaction costs keep money in investors' pockets; more on this later.
  • Automated trading, order routing, and settlement deliver a new low degree of error.
The extreme competition among the new entrants and old incumbent market participants, however, has also resulted in reduced margins for broker-dealers, squeezing out technology-inefficient players.
The way trading is done has changed over time and these newer approaches affected the relative power of consumers and institutions. In the 1970s' marketplace, the trading process would often proceed as follows:
1. Brokers would deliver one-off trading ideas to their buy-side clients. The ideas were often disseminated via countless phone calls, were based on brokers' then-unique ability to observe markets in real time, and were generally required compensation in “soft-dollar” arrangements—if the customer decided to trade on the idea, he was expected to do so through the broker who produced the idea, and the customer would pay for the idea in the form of potentially higher broker commissions.
2. If and when the customer decided to trade on the idea, the customer would phone in the order to the broker or the broker's assistant. Such verbal orders frequently resulted in errors: the noise on the brokers' trading floors often impeded correct understanding of customer instructions.
3. After receiving a customer's order, the broker's next steps would depend on the size of the placed order: while large orders would be taken to the market right away (potentially in smaller parcels), smaller orders would sit on the broker's desk, waiting for other similar orders to fill up a “round lot”—the minimum order size executable on an exchange. Smaller customers were thus often at a disadvantage, waiting for execution of their orders while the favorable market price slipped away.
4. Once the order or several sequential orders comprised the order size acceptable to the broker, the broker would route the order to the appropriate exchange.
5. Next, human representatives of the exchange, known as “specialists,” would match the order and send the trade acknowledgments back to the broker. It is well understood that the specialists often created preferential terms for some of their connections, at the expense of orders of others. Such behavior rewarded investment in connections and chummy networks, and resulted in exclusive Wall Street cliques capable of significant price discrimination for in-group versus out-of-group customers. Even though exchanges operated as not-for-profit organizations, influence peddling was common, and the markets were a long way away from anything resembling an equal playing field for all participants.
6. The broker notified the client of execution and collected his commissions and oversized bonuses. The brokers presided over the power of the markets and were compensated as kings.
Figure 1.3 illustrates the traditional investing process prevalent circa 1970s.
Figure 1.3 Broker-centric Investing Process Prevalent before Electronization
Fast-forward 40-something years ahead, and the balance of power has shifted. Customers have increased their expertise in quantitative analysis and are often better equipped for research than brokers. Brokers' area of expertise has decreased in scope from the all-encompassing sell-side research into securities behavior to a more narrow, albeit still important area of algorithmic execution designed to help clients navigate the choppy intraday trading waters. With such buy-side investors, the market flow evolves according to the process in Figure 1.4:
Figure 1.4 Modern Investing Process, Scenario 1: Brokers Provide Best Execution for Clients' Orders
1. Customers, not brokers, generate research based on forecasts of securities movements and their existing allocations, all within the quantitative portfolio management framework.
2. The customer places an order via electronic networks, greatly reducing errors and misunderstandings. The order instantaneously arrives on the broker's desktop.
3. The customer or the broker selects the broker's optimal execution algorithm designed to minimize the customer's execution costs and risk, speed up execution whenever possible, and minimize observability of the customer's trading actions.
4. Selected algorithm electronically parcels out the customer's order and routes the order slices to relevant exchanges and other trading venues.
5. Trading venues match the customer's order slices and acknowledge execution.
6. The broker sends the order acknowledgment back to the customer, and receives his considerably lower commission. (In 1997, the lowest broker commission on retail trades was offered by Merrill Lynch, and the commission was $70 per trade. Today, Interactive Brokers charges about $0.70 per trade, a 100-fold reduction in transaction costs available to clients.)
Some customers go even further and prefer to do away with broker service altogether, building their own execution algorithms, keeping a higher share of the profits. Plummeting costs of technology have enabled fast distribution of tick data to all interested parties, and now customers, not just brokers, can watch and time markets and generate short-term forecasts of market behavior. Customers taking the largely broker-independent route are said to engage in “direct access” to the markets, and their execution process consists of the following steps:
1. The broker grants the customer a privilege to access the exchange directly for a negotiated per-trade or per-volume fee. To grant access, the broker may allow the customer to use the broker's own identification with a specific exchange. The customer's order routing systems then use the broker's identification in order messaging with the exchange.
2. Customer computer systems or human analysts generate a high- or low-frequency portfolio allocation decision that involves one or more trading orders.
3. Customer uses his own order splitting and routing algorithms to optimally place his orders directly with exchanges and other trading venues.
4. One or several exchanges and trading venues match the orders, acknowledg execution directly to client.
5. The broker receives settlement information and charges the client for the privilege of using the broker's direct access identification.
Figure 1.5 summarizes these steps.
Figure 1.5 Modern Investing Process, Scenario 2: Clients Decide on Best Execution, Access Markets Directly
Media, Modern Markets, and HFT
While the market-wide changes have disturbed the status quo on the broker-dealer side and squeezed many a broker out of business, the changes to the society at large have been mostly positive, depositing the saved dollars directly into investor pockets. Gone are the multimillion-dollar bonuses of many brokers taking phone orders and watching markets on their computer screens. The money has been redirected to bank shareholders and end investors.
Clearly, not everyone is happy about...

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