Saturday, May 22, 2010

A HFT primer

As a follow-up of my previous discussions on high frequency trading, I have invited guest blogger Jennifer Groton to share with us a quick survey of various common HFT strategies used by equities and FX traders.

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High frequency trading strategies are under fire.  The recent trading spike in our national exchanges was duly noted as a short-circuit waiting to happen and drew immediate industry criticism of auto-trading robots. Before a witch-hunt ensues, perhaps a review of the common HFT strategies in stocks and Forex is in order. 

High-frequency firms employ a wide variety of  low-margin trading strategies that are implemented by professional market intermediaries who have invested heavily in technology. These firms claim that they make markets more efficient by enhancing liquidity and transparent price discovery to the benefit of investors.  The Forex market’s unique combination of high liquidity and low volatility make it an ideal environment for deploying HFT strategies, although many of the ideas and technology are from the equity markets.  The basic strategies fall into three categories: market-making, trending or predictive, and classic arbitrage.

Market-making strategies tend to focus on a single stock or currency pair.  Many firms in this area have been described as engaging in "rebate-capture trading", a reference to the credits that firms get for providing liquidity on most market centers.

The second group consists of mean-reversion and trending strategies. These utilize technical indicators for stocks or forex indicators for currencies, and seek to generate more return from individual trades.

The last group may involve a cross-section of trades from multiple markets.  The classic arbitrage strategy is a form of the “carry trade” that uses the prices of a domestic bond, a bond denominated in a foreign currency, the spot price of the currency, and the price of a forward contract on the currency.  If the market prices are sufficiently different from those implied in the model to cover transactions costs, then four transactions can be made to guarantee a risk-free profit.

High frequency trading is attributed with generating over 70% of the volume of trades on our equity markets.  Similar statistics are not available for forex markets, but speculating disguised as commercially necessary trades have been reported to be over two-thirds of the volume.  Liquidity and pricing transparency are the benefits offered by its advocates, but regulators and other market participants who disagree with this positive assessment are presently discounting these benefits.  Transaction taxes and time limits on orders have been proposed to mitigate the perceived risk created by HFT firms, but the wheels of Washington move slowly, even in crisis.  For the time being, there is no indication that their participation will be discontinued.   

14 comments:

Anonymous said...

Please web address of Groton´s blog

jb said...

In the last para, it is unclear about the HFT volume. The 70% equity HFT volume could be because of institutions now executing block trades via HFT providers. The forex volume may be more speculative but I think this needs more detail (and I don't know but would like to know). Especially, distinguishing forex/equity and other markets.

talll.com said...

Good initiative on HFTs, Thanks.

Jez Liberty said...

How about the whole potential front-running issue??..

I am not sure many HFT use trend-following as a strategy!..

Jennifer Gorton said...

This is in reply to jb's comment:

There are many Algorithmic traders who are using the benefit of computers to trade the foreign exchange market. It is thought that about 25% of trades place on foreign exchange are done using algorithms. The lower number of algorithmic trades could be because of the high liquidity in the foreign exchange markets. Institutional algorithmic trading in the equities market is used to sell big blocks of stock; they are split down to smaller lots so not to add too much liquidity at once. The foreign exchange market has so many participants and liquidity there is not as great a need for the computes, a client’s large order will usually find a suitable counterparty fairly easily. I personally find it is harder to find the edge in the currency markets, making computer programmed trading strategies less reliable than all other markets. This could be one more reason why algorithmic and high frequency trading is not as prevalent in the currency markets.

Steve said...

This probably will sound petty, but shouldn't the title read "An" HFT primer?

Dam said...

Hi
Thanks for your book Ernie.

A question concerning HFT, I am currently playing with the LOB to get a workable strategy.The cheapest broker I use of course IB.I am wondering how low is the friction cost of those who are the the HFT game ?? . Even with fees as low as IB's, it is quite hard to get a HFT strategy profitable.

Thanks

Ernie Chan said...

Jez,
I discussed the front-running issue in 2 previous posts on HFT. However, trading based on flash orders is just one out of many HFT strategies.
Ernie

Ernie Chan said...

Dam,
You may be able to get better commissions at Lime Brokerage. But to take advantage of their low commissions and fast data connection, you have to pay substantial monthly co-location fees at their facility. But if you trade large volumes, it is well-worth it.
Ernie

jb said...

Jennifer, thanks for your comment. Seeing this a bit late, though.

It is interesting that you feel that forex algo trading strategies may not be profitable.
I also heard the RBS algo trading group's head commenting that algo trading (in multiple markets) have not regained their pre-crisis profitability levels (this was as of March 2010).

I wonder if regulators have the right tools and capability to monitor misuse/manipulation (if it occurs).

I wonder if HFT hedge funds can and do raid other HFT/non-HFT strategies like those doing relatively mundane stuff like executing block orders, market impact type stuff... or those doing stat arb in the HF timeframe. It might be easier to "raid" another HFT strategy in the HF timeframe. Anyway, I'm just speculating (fondly!) on the possibilities.

Nizar said...

Ernie,

Do you know what the per share commissions are at lime for US equities?

It would obviously depend on volume, but what is the range like?

Nizar.

Ernie Chan said...

Nizar,
Lime commissions are approximately half that of IB, but more importantly, they pass on ECN rebates to you.

Ernie

Nizar said...

Hi Ernie,

This quest is not related to this particular post, so I apologise for that.

But would you know of any software available that can estimate market impact?

Thanks.
Nizar.

Ernie Chan said...

Hi Nizar,
That is a good question: I don't know of any products available to retail investors. (Maybe IB has such a tool?) For institutional investors, almost every prime brokerage provides such a tool to their clients.

Maybe other readers can point to a retail market impact program?

Ernie