The secrets of high frequency trading

Posted September 20, 2011 at 12:44 am

from All About Alpha

In recent years, advances in telecommunications, computing capacity and financial software platform capabilities have seen huge growth in the field of High Frequency and Algorithmic Trading (now accounting for over 70% of all equity trades placed on US exchanges and in excess of 77% in the UK). 

HFT firms (which can often make more than 80 million trades in a single day) often enter and exit trades in thousandths of a second, and are conservatively estimated to generate at least $21billion in profits every year.

To get under the skin of the world of high frequency trading, AllAboutAlpha.com interviewed Arzhang Kamarei.  Mr. Kamarei is a Partner at Tradeworx, a quantitative investment management firm with expertise in high-frequency and medium-frequency equity market-neutral strategies.  He co-founded Thesys Technologies, a Tradeworx subsidiary, in early 2009 to address the growing technology needs of high frequency traders.

AAA.com: What is the principal investment strategy behind High Frequency Trading?

Arzhang Kamarei: The majority of US Equity HFT is employed in the strategy of liquidity provisioning, also known as electronic market making.   Historically, such a service was provided by NYSE specialists and NASDAQ market makers but, with the advent of decimalization, human specialists and market makers were no longer able to keep up with the liquidity demands of investors and automated technology became necessary for this function.

To implement electronic market making strategies, HFTs use passive orders, which are limit orders that do not cross the spread, but stay on a limit order book until they are filled or cancelled. 

This allows HFTs to profit from capturing rebates and the bid-ask spread.   These profits offset losses incurred by providing liquidity to informed traders or large traders who drive stocks directionally (i.e., adverse selection or inventory risk). 

Without the rebate and spread capture employed by passive trading, the majority of HFT strategies would be unprofitable.   HFT strategies that are based on actively crossing the spread and consuming liquidity are rare, although active orders are occasionally necessary for inventory or loss management.  HFTs do not typically have enough alpha to make “all-active” strategies profitable.

A key goal in providing liquidity passively is to be on the top of the bid/offer stack, otherwise known as being at the “front of the queue” for the order book. 

The rationale for this is very simple:  adverse selection is lower for passive orders at the top of the stack than for passive orders at the bottom of the stack. 

For an intuitive understanding of why, consider the following [continue]…

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