High-frequency trading
Encyclopedia
High-frequency trading (HFT) is the use of sophisticated technological tools to trade securities like stocks or options, and is typically characterized by several distinguishing features:
In high-frequency trading, programs analyze market data to capture trading opportunities that may open up for only a fraction of a second to several hours. High-frequency trading (HFT) uses computer programs and sometimes specialised hardware to hold short-term positions in equities, options, futures, ETFs, currencies, and other financial instruments that possess electronic trading capability. High-frequency traders compete on a basis of speed with other high-frequency traders, not long-term investors (who typically look for opportunities over a period of weeks, months, or years), and compete with each other for very small, consistent profits. As a result, high-frequency trading has been shown to have a potential Sharpe ratio
(measure of reward per unit of risk) thousands of times higher than the traditional buy-and-hold strategies.
By 2010 high-frequency trading accounted for over 70% of equity trades taking place in the US and was rapidly growing in popularity in Europe and Asia. Aiming to capture just a fraction of a penny per share or currency unit on every trade, high-frequency traders move in and out of such short-term positions several times each day. Fractions of a penny accumulate fast to produce significantly positive results at the end of every day. High-frequency trading firms do not employ significant leverage, do not accumulate positions, and typically liquidate their entire portfolios on a daily basis.
One financial industry source claims algorithmic trading, including high-frequency trading, substantially improves market liquidity. An academic study shows additional benefits, including lowering the costs of trading, increasing the informativeness of quotes, improved linkage between markets, and other positive spillover effects, at least in quiescent or stable markets; the authors of this study also note that "it remains an open question whether algorithmic trading and algorithmic liquidity supply are equally beneficial in more turbulent or declining markets...algorithmic liquidity suppliers may simply turn off their machines when markets spike downward." Also noteworthy is that HFT only takes place in markets that are already deemed liquid, hence calling its necessity into question.
Algorithmic and high-frequency trading were both implicated in the May 6, 2010 Flash Crash, when high-frequency liquidity providers were in fact found to have withdrawn from the market. A July, 2011 report by the International Organization of Securities Commissions
(IOSCO), an international body of securities regulators, concluded that while "algorithms and HFT technology have been used by market participants to manage their trading and risk, their usage was also clearly a contributing factor in the flash crash event of May 6, 2010."
- and even microsecond
s. Until recently high-frequency trading was a little-known topic outside the financial sector, with an article published by the New York Times in July 2009 being one of the first to bring the subject to the public's attention.
. Many high-frequency firms are market makers and provide liquidity to the market which has lowered volatility and helped narrow Bid-offer spread
s making trading and investing cheaper for other market participants.
In the United States, high-frequency trading firms represent 2% of the approximately 20,000 firms operating today, but account for 73% of all equity orders volume. The Bank of England
estimate similar percentages for the 2010 US market share, also suggesting that in Europe HFT accounts for about 40% of equity orders volume and for Asia about 5-10%, with potential for rapid growth. By value, HFT was estimated in 2010 by consultancy Tabb Group to make up 56% of equity trades in the US and 38% in Europe.
Most high-frequency trading strategies fall within one of the following trading strategies:
Some high-frequency trading firms use market making as their primary trading strategy. Automated Trading Desk, which was bought by Citigroup
in July 2007, has been an active market maker, accounting for about 6% of total volume on both NASDAQ and the New York Stock Exchange. Building up market making strategies typically involve precise modelling of the target market microstructure
together with stochastic control
techniques.
These strategies appear intimately related to the entry of new electronic venues. Academic study of Chi-X entry into the European equity market reveals that its launch coincided with a large HFT that made markets using both the incumbent market, NYSE-Euronext, and the new market, Chi-X. The study shows that the new market provided ideal conditions for HFT market-making, low fees (i.e., rebates for quotes that led to execution) and a fast system, yet the HFT was equally active in the incumbent market to offload nonzero positions. New market entry and HFT arrival are further shown to coincide with a significant improvement in liquidity supply.
Filter trading is one of the more primitive high-frequency trading strategies that involves monitoring large amounts of stocks for significant or unusual price changes or volume activity. This includes trading on announcements, news, or other event criteria. Software would then generate a buy or sell order depending on the nature of the event being looked for.
at high-frequencies is actively used in all liquid securities, including equities, bonds, futures, foreign exchange, etc. Such strategies may also involve classical arbitrage strategies, such as covered interest rate parity
in the foreign exchange market
, which gives a relation between 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. High-frequency trading allows similar arbitrages using models of greater complexity involving many more than four securities. The TABB Group estimates that annual aggregate profits of high-frequency arbitrage strategies currently exceed US$21 billion.
s making trading and investing cheaper for other market participants. One financial industry source claims algorithmic trading, including high-frequency trading, substantially improves market liquidity. A recent academic study claims additional benefits, including lowering the costs of trading, increasing the informativeness of quotes, improved linkage between markets, and positive spillover effects, at least in quiescent or stable markets. The effects of algorithmic and high-frequency trading in volatile markets are the subject of ongoing research since regulators claim these practices contributed to volatility in the May 6, 2010 Flash Crash, as discussed later in this section.
The speeds of computer connections, measured in milliseconds or microseconds, have become important.
More fully automated markets such as NASDAQ
, Direct Edge, and BATS, in the US, have gained market share from less automated markets such as the NYSE. Economies of scale
in electronic trading have contributed to lowering commissions and trade processing fees, and contributed to international mergers and consolidation of financial exchanges
.
Competition is developing among exchanges for the fastest processing times for completing trades. For example in 2009 the London Stock Exchange
bought a technology firm called MillenniumIT and announced plans to implement its Millennium Exchange platform which they claim has an average latency of 126 microseconds. Since then, competitive exchanges have continued to reduce latency and today, with turnaround times of three milliseconds available, are useful to traders to pinpoint the consistent and probable performance ranges of financial instruments. These professionals are often dealing in versions of stock index funds like the E-mini S&P
s because they seek consistency and risk-mitigation along with top performance. They must filter market data to work into their software programming so that there is the lowest latency and highest liquidity at the time for placing stop-losses and/or taking profits. With high volatility in these markets, this becomes a complex and potentially nerve-wracking endeavor, where a small mistake can lead to a large loss. Absolute frequency data play into the development of the trader's pre-programmed instructions.
Spending on computers and software in the financial industry increased to $26.4 billion in 2005.
The brief but dramatic stock market crash of May 6, 2010 was originally alleged to be caused by high-frequency trading. However, CME Group
, a large futures exchange
, stated that, insofar as stock index futures traded on CME Group were concerned, its investigation had found no support for the notion high-frequency trading was related to the crash, and actually stated it had a market stabilizing effect. This conclusion is contradicted in a report on the Flash Crash by the U.S. Securities and Exchange Commission and the Commodity Futures Trading Commission
, where regulators stated that the actions of high-frequency trading firms on May 6, 2010 contributed to volatility during the crash. Despite the original perception, financial industry sources claim high-frequency traders typically cause no market price impact, and have a stabilizing effect in times of volatility, and one observer suggests may actually have been a major factor in minimizing and partially reversing the flash crash, though later reports determined that high-frequency trading had significant price impact and a destabilizing role during the Flash Crash, helping to drive prices down.
After almost five months of investigations, the U.S. Securities and Exchange Commission and the Commodity Futures Trading Commission
issued a joint report identifying the cause that set off the sequence of events leading to the Flash crash. The report found that the cause was a single sale of $4.1 billion in futures contracts by a mutual fund, identified as Waddell & Reed Financial, in an aggressive attempt to hedge its investment position. The joint report also found that "high-frequency traders quickly magnified the impact of the mutual fund's selling." The joint report "portrayed a market so fragmented and fragile that a single large trade could send stocks into a sudden spiral," that a large mutual fund firm "chose to sell a big number of futures contracts using a computer program that essentially ended up wiping out available buyers in the market," that as a result high-frequency firms "were also aggressively selling the E-mini contracts," contributing to rapid price declines. The joint report also noted "'HFTs began to quickly buy and then resell contracts to each other—generating a 'hot-potato' volume effect as the same positions were passed rapidly back and forth.'" The combined sales by Waddell and high-frequency firms quickly drove "the E-mini price down 3% in just four minutes." As prices in the futures market fell, there was a spillover into the equities markets where "the liquidity in the market evaporated because the automated systems used by most firms to keep pace with the market paused" and scaled back their trading or withdrew from the markets altogether. The joint report then noted that "Automatic computerized traders on the stock market shut down as they detected the sharp rise in buying and selling." As computerized high-frequency traders exited the stock market, the resulting lack of liquidity "...caused shares of some prominent companies like Procter & Gamble
and Accenture to trade down as low as a penny or as high as $100,000." While some firms exited the market, high-frequency firms that remained in the market exacerbated price declines because they "'escalated their aggressive selling' during the downdraft."
Despite studies reporting positive findings about high-frequency trading, including that high-frequency trading reduces volatility and does not pose a systemic risk, and both lowers transaction costs for retail investors, and at the same time does so without impacting long term investors, high-frequency trading is the subject of increased debate. This debate has been fueled by U.S. Securities and Exchange Commission and Commodity Futures Trading Commission
empirical findings that high-frequency trading contributed to volatility on the May 6, 2010 Flash Crash. Politicians, regulators, journalists and market participants have all raised concerns on both sides of the Atlantic. In September 2010, SEC chairperson Mary Schapiro
signaled that US authorities were considering the introduction of regulations targeted at HFT, such as a minimum "time in force" rule, to prevent buy orders being canceled very soon after being issued. Criticisms of this proposed law are that currently exchanges allow excess message traffic to queue up at their servers' ports, where it is processed sequentially at a fixed rate and as a result poses no threat to the exchanges. In addition to this equity options markets produce far more message volume than equity markets and has consistently handled the data without issue. Some HFT systems cancel many of their orders almost immediately after placing them as they don't intend the trades to carry through, the false orders are used as part of a pinging tactic to discover the upper price other traders are willing to pay. Some high-frequency trading firms state so many orders get canceled because the orders people get are not the same ones they send. This happens frequently because of an existing regulation regarding re-priced orders.
Another area of concern relates to flash trading
. Flash trading is where certain market participants are allowed to see incoming orders to buy or sell securities very slightly earlier than the general market participants, typically 30 milliseconds, in exchange for a fee. According to some sources, the programs can inspect major orders as they come in and use that information to profit. Currently, the majority of exchanges either do not offer flash trading, or have discontinued it, although the exchange Direct Edge
currently does offer it to participants. Direct Edge's response to this is the data that flash trading
reduces market impact
, increases average size of executed orders, reduces trading latency, and provides additional liquidity. Direct Edge
also allows all of its subscribers to determine whether they want their orders to participate in flash trading
or not so brokers have the option to opt-out of flash orders on behalf of their clients if they choose to. Due to the fact that market participants can choose to utilize it for additional liquidity or not participate in it at all Direct Edge believes the controversy is overstated stating:
Critics of the practice contend this creates a two-tiered market in which a certain class of traders can unfairly exploit others, akin to front running
. Exchanges claim that the procedure benefits all traders by creating more market liquidity and the opportunity for price improvement.
Direct Edge's response to the "two-tiered market" criticism is as follows:
and market gateways are becoming standard tools of most types of traders, including high-frequency traders. Broker-dealers now compete on routing order flow directly, in the fastest and most efficient manner, to the line handler where it undergoes a strict set of Risk Filters before hitting the execution venue(s). Ultra Low Latency Direct Market Access (ULLDMA) is a hot topic amongst Brokers and Technology vendors such as Goldman Sachs
, Credit Suisse
, and UBS. Typically, ULLDMA systems can currently handle high amounts of volume and boast round-trip order execution speeds (from hitting "transmit order" to receiving an acknowledgment) of 10 milliseconds and under.
Such performance is achieved with the use of hardware acceleration
or even full-hardware processing of incoming Market data
, in association with high-speed communication protocols, such as 10 Gigabit Ethernet
or PCI Express
.
More specifically, some companies provide full-hardware appliances based on FPGA
to obtain sub-microsecond end-to-end Market data
processing.
, Getco LLC, Citadel LLC, and Goldman Sachs
.
- It is highly quantitative, employing computerized algorithms to analyze incoming market data and implement proprietary trading strategies;
- an investment position is held only for very brief periods of time - even just seconds - and rapidly trades into and out of those positions, sometimes thousands or tens of thousands of times a day;
- there is no net investment position at the end of a trading day;
- it is mostly employed by proprietary firms or on proprietary trading desks in larger, diversified firms;
- it is very sensitive to the processing speed of markets and of their own access to the market.
In high-frequency trading, programs analyze market data to capture trading opportunities that may open up for only a fraction of a second to several hours. High-frequency trading (HFT) uses computer programs and sometimes specialised hardware to hold short-term positions in equities, options, futures, ETFs, currencies, and other financial instruments that possess electronic trading capability. High-frequency traders compete on a basis of speed with other high-frequency traders, not long-term investors (who typically look for opportunities over a period of weeks, months, or years), and compete with each other for very small, consistent profits. As a result, high-frequency trading has been shown to have a potential Sharpe ratio
Sharpe ratio
The Sharpe ratio or Sharpe index or Sharpe measure or reward-to-variability ratio is a measure of the excess return per unit of deviation in an investment asset or a trading strategy, typically referred to as risk , named after William Forsyth Sharpe...
(measure of reward per unit of risk) thousands of times higher than the traditional buy-and-hold strategies.
By 2010 high-frequency trading accounted for over 70% of equity trades taking place in the US and was rapidly growing in popularity in Europe and Asia. Aiming to capture just a fraction of a penny per share or currency unit on every trade, high-frequency traders move in and out of such short-term positions several times each day. Fractions of a penny accumulate fast to produce significantly positive results at the end of every day. High-frequency trading firms do not employ significant leverage, do not accumulate positions, and typically liquidate their entire portfolios on a daily basis.
One financial industry source claims algorithmic trading, including high-frequency trading, substantially improves market liquidity. An academic study shows additional benefits, including lowering the costs of trading, increasing the informativeness of quotes, improved linkage between markets, and other positive spillover effects, at least in quiescent or stable markets; the authors of this study also note that "it remains an open question whether algorithmic trading and algorithmic liquidity supply are equally beneficial in more turbulent or declining markets...algorithmic liquidity suppliers may simply turn off their machines when markets spike downward." Also noteworthy is that HFT only takes place in markets that are already deemed liquid, hence calling its necessity into question.
Algorithmic and high-frequency trading were both implicated in the May 6, 2010 Flash Crash, when high-frequency liquidity providers were in fact found to have withdrawn from the market. A July, 2011 report by the International Organization of Securities Commissions
International Organization of Securities Commissions
The International Organization of Securities Commissions is an association of organisations that regulate the world’s securities and futures markets....
(IOSCO), an international body of securities regulators, concluded that while "algorithms and HFT technology have been used by market participants to manage their trading and risk, their usage was also clearly a contributing factor in the flash crash event of May 6, 2010."
History
High-frequency trading has taken place at least since 1999, after the U.S. Securities and Exchange Commission (SEC) authorized electronic exchanges in 1998. At the turn of the 21st century HFT trades had an execution time of several seconds, whereas by 2010 this has decreased to milliMillisecond
A millisecond is a thousandth of a second.10 milliseconds are called a centisecond....
- and even microsecond
Microsecond
A microsecond is an SI unit of time equal to one millionth of a second. Its symbol is µs.A microsecond is equal to 1000 nanoseconds or 1/1000 millisecond...
s. Until recently high-frequency trading was a little-known topic outside the financial sector, with an article published by the New York Times in July 2009 being one of the first to bring the subject to the public's attention.
Market growth
In the early 2000s, high-frequency trading still accounted for less than 10% of equity orders, but this proportion was soon to begin rapid growth. According to data from the NYSE, high-frequency trading grew by about 164% between 2005 and 2009. As of the first quarter in 2009, total assets under management for hedge funds with high-frequency trading strategies were $141 billion, down about 21% from their peak before the worst of the crises. The high-frequency strategy was first made successful by Renaissance TechnologiesRenaissance Technologies
Renaissance Technologies is a hedge fund management company of about 275 employees and more than $ billion in assets under management in three funds...
. Many high-frequency firms are market makers and provide liquidity to the market which has lowered volatility and helped narrow Bid-offer spread
Bid-offer spread
The bid–offer spread for securities is the difference between the prices quoted for an immediate sale and an immediate purchase...
s making trading and investing cheaper for other market participants.
In the United States, high-frequency trading firms represent 2% of the approximately 20,000 firms operating today, but account for 73% of all equity orders volume. The Bank of England
Bank of England
The Bank of England is the central bank of the United Kingdom and the model on which most modern central banks have been based. Established in 1694, it is the second oldest central bank in the world...
estimate similar percentages for the 2010 US market share, also suggesting that in Europe HFT accounts for about 40% of equity orders volume and for Asia about 5-10%, with potential for rapid growth. By value, HFT was estimated in 2010 by consultancy Tabb Group to make up 56% of equity trades in the US and 38% in Europe.
High-frequency trading strategies
High-frequency trading is quantitative trading that is characterized by short portfolio holding periods (see Wilmott (2008)). All portfolio-allocation decisions are made by computerized quantitative models. The success of high-frequency trading strategies is largely driven by their ability to simultaneously process volumes of information, something ordinary human traders cannot do. Specific algorithms are closely guarded by their owners and are known as "algos".Most high-frequency trading strategies fall within one of the following trading strategies:
- Market making
- Ticker tape trading
- Event arbitrage
- LayeringLayering (finance)Layering is a strategy in high-frequency trading where a brokerage firm makes and then cancels orders that they never intended to carry out. It is considered a form of stock market manipulation.-Instances:...
- High-frequency statistical arbitrage
Market making
Market making is a set of high-frequency trading strategies that involve placing a limit order to sell (or offer) or a buy limit order (or bid) in order to earn the bid-ask spread. By doing so, market makers provide counterpart to incoming market orders. Although the role of market maker was traditionally fulfilled by specialist firms, this class of strategy is now implemented by a large range of investors, thanks to wide adoption of direct market access. As pointed out by empirical studies this renewed competition among liquidity providers causes reduced effective market spreads, and therefore reduced indirect costs for final investors.Some high-frequency trading firms use market making as their primary trading strategy. Automated Trading Desk, which was bought by Citigroup
Citigroup
Citigroup Inc. or Citi is an American multinational financial services corporation headquartered in Manhattan, New York City, New York, United States. Citigroup was formed from one of the world's largest mergers in history by combining the banking giant Citicorp and financial conglomerate...
in July 2007, has been an active market maker, accounting for about 6% of total volume on both NASDAQ and the New York Stock Exchange. Building up market making strategies typically involve precise modelling of the target market microstructure
Market microstructure
Market microstructure is a branch of finance concerned with the details of how exchange occurs in markets. While the theory of market microstructure applies to the exchange of real or financial assets, more evidence is available on the microstructure of financial markets due to the availability of...
together with stochastic control
Stochastic control
Stochastic control is a subfield of control theory which deals with the existence of uncertainty in the data. The designer assumes, in a Bayesian probability-driven fashion, that a random noise with known probability distribution affects the state evolution and the observation of the controllers...
techniques.
These strategies appear intimately related to the entry of new electronic venues. Academic study of Chi-X entry into the European equity market reveals that its launch coincided with a large HFT that made markets using both the incumbent market, NYSE-Euronext, and the new market, Chi-X. The study shows that the new market provided ideal conditions for HFT market-making, low fees (i.e., rebates for quotes that led to execution) and a fast system, yet the HFT was equally active in the incumbent market to offload nonzero positions. New market entry and HFT arrival are further shown to coincide with a significant improvement in liquidity supply.
Ticker tape trading
Much information happens to be unwittingly embedded in market data, such as quotes and volumes. By observing a flow of quotes, high-frequency trading machines are capable of extracting information that has not yet crossed the news screens. Since all quote and volume information is public, such strategies are fully compliant with all the applicable laws.Filter trading is one of the more primitive high-frequency trading strategies that involves monitoring large amounts of stocks for significant or unusual price changes or volume activity. This includes trading on announcements, news, or other event criteria. Software would then generate a buy or sell order depending on the nature of the event being looked for.
Event arbitrage
Certain recurring events generate predictable short-term response in a selected set of securities. High-frequency traders take advantage of such predictability to generate short-term profits.Statistical arbitrage
Another set of high-frequency trading strategies are strategies that exploit predictable temporary deviations from stable statistical relationships among securities. Statistical arbitrageStatistical arbitrage
In the world of finance and investments, statistical arbitrage is used in two related but distinct ways:* In academic literature, "statistical arbitrage" is opposed to arbitrage. In deterministic arbitrage, a sure profit can be obtained from being long some securities and short others...
at high-frequencies is actively used in all liquid securities, including equities, bonds, futures, foreign exchange, etc. Such strategies may also involve classical arbitrage strategies, such as covered interest rate parity
Interest rate parity
Interest rate parity is a no-arbitrage condition representing an equilibrium state under which investors will be indifferent to interest rates available on bank deposits in two countries. Two assumptions central to interest rate parity are capital mobility and perfect substitutability of domestic...
in the foreign exchange market
Foreign exchange market
The foreign exchange market is a global, worldwide decentralized financial market for trading currencies. Financial centers around the world function as anchors of trading between a wide range of different types of buyers and sellers around the clock, with the exception of weekends...
, which gives a relation between 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
Forward contract
In finance, a forward contract or simply a forward is a non-standardized contract between two parties to buy or sell an asset at a specified future time at a price agreed today. This is in contrast to a spot contract, which is an agreement to buy or sell an asset today. It costs nothing to enter a...
on the currency. High-frequency trading allows similar arbitrages using models of greater complexity involving many more than four securities. The TABB Group estimates that annual aggregate profits of high-frequency arbitrage strategies currently exceed US$21 billion.
Low-latency strategies
A separate, "naive" class of high-frequency trading strategies relies exclusively on ultra-low-latency direct market access technology. In these strategies, computer scientists rely on speed to gain minuscule advantages in arbitraging price discrepancies in some particular security trading simultaneously on disparate markets.Effects
Many high-frequency firms are market makers and provide liquidity to the market, which has lowered volatility and helped narrow Bid-offer spreadBid-offer spread
The bid–offer spread for securities is the difference between the prices quoted for an immediate sale and an immediate purchase...
s making trading and investing cheaper for other market participants. One financial industry source claims algorithmic trading, including high-frequency trading, substantially improves market liquidity. A recent academic study claims additional benefits, including lowering the costs of trading, increasing the informativeness of quotes, improved linkage between markets, and positive spillover effects, at least in quiescent or stable markets. The effects of algorithmic and high-frequency trading in volatile markets are the subject of ongoing research since regulators claim these practices contributed to volatility in the May 6, 2010 Flash Crash, as discussed later in this section.
"The fast-growing practice of high-frequency trading, in which traders place vast flurries of securities trades, is speeding up execution times for all investors, making it cheaper to buy or sell and posing no risk to small investors." - Chicago Board Options ExchangeChicago Board Options ExchangeThe Chicago Board Options Exchange , located at 400 South LaSalle Street in Chicago, is the largest U.S. options exchange with annual trading volume that hovered around one billion contracts at the end of 2007...
The speeds of computer connections, measured in milliseconds or microseconds, have become important.
More fully automated markets such as NASDAQ
NASDAQ
The NASDAQ Stock Market, also known as the NASDAQ, is an American stock exchange. "NASDAQ" originally stood for "National Association of Securities Dealers Automated Quotations". It is the second-largest stock exchange by market capitalization in the world, after the New York Stock Exchange. As of...
, Direct Edge, and BATS, in the US, have gained market share from less automated markets such as the NYSE. Economies of scale
Economies of scale
Economies of scale, in microeconomics, refers to the cost advantages that an enterprise obtains due to expansion. There are factors that cause a producer’s average cost per unit to fall as the scale of output is increased. "Economies of scale" is a long run concept and refers to reductions in unit...
in electronic trading have contributed to lowering commissions and trade processing fees, and contributed to international mergers and consolidation of financial exchanges
Financial market
In economics, a financial market is a mechanism that allows people and entities to buy and sell financial securities , commodities , and other fungible items of value at low transaction costs and at prices that reflect supply and demand.Both general markets and...
.
Competition is developing among exchanges for the fastest processing times for completing trades. For example in 2009 the London Stock Exchange
London Stock Exchange
The London Stock Exchange is a stock exchange located in the City of London within the United Kingdom. , the Exchange had a market capitalisation of US$3.7495 trillion, making it the fourth-largest stock exchange in the world by this measurement...
bought a technology firm called MillenniumIT and announced plans to implement its Millennium Exchange platform which they claim has an average latency of 126 microseconds. Since then, competitive exchanges have continued to reduce latency and today, with turnaround times of three milliseconds available, are useful to traders to pinpoint the consistent and probable performance ranges of financial instruments. These professionals are often dealing in versions of stock index funds like the E-mini S&P
E-mini S&P
E-Mini S&P, often abbreviated to "E-mini" and designated by the commodity ticker symbol ES, is a stock market index futures contract traded on the Chicago Mercantile Exchange's Globex electronic trading platform...
s because they seek consistency and risk-mitigation along with top performance. They must filter market data to work into their software programming so that there is the lowest latency and highest liquidity at the time for placing stop-losses and/or taking profits. With high volatility in these markets, this becomes a complex and potentially nerve-wracking endeavor, where a small mistake can lead to a large loss. Absolute frequency data play into the development of the trader's pre-programmed instructions.
Spending on computers and software in the financial industry increased to $26.4 billion in 2005.
The brief but dramatic stock market crash of May 6, 2010 was originally alleged to be caused by high-frequency trading. However, CME Group
CME Group
The CME Group bases prices for US gasoline on Brent Crude rather than West Texas Intermediate Crude , which many believe is responsible for artificially high gas prices for US consumers...
, a large futures exchange
Futures exchange
A futures exchange or futures market is a central financial exchange where people can trade standardized futures contracts; that is, a contract to buy specific quantities of a commodity or financial instrument at a specified price with delivery set at a specified time in the future. These types of...
, stated that, insofar as stock index futures traded on CME Group were concerned, its investigation had found no support for the notion high-frequency trading was related to the crash, and actually stated it had a market stabilizing effect. This conclusion is contradicted in a report on the Flash Crash by the U.S. Securities and Exchange Commission and the Commodity Futures Trading Commission
Commodity Futures Trading Commission
The U.S. Commodity Futures Trading Commission is an independent agency of the United States government that regulates futures and option markets....
, where regulators stated that the actions of high-frequency trading firms on May 6, 2010 contributed to volatility during the crash. Despite the original perception, financial industry sources claim high-frequency traders typically cause no market price impact, and have a stabilizing effect in times of volatility, and one observer suggests may actually have been a major factor in minimizing and partially reversing the flash crash, though later reports determined that high-frequency trading had significant price impact and a destabilizing role during the Flash Crash, helping to drive prices down.
After almost five months of investigations, the U.S. Securities and Exchange Commission and the Commodity Futures Trading Commission
Commodity Futures Trading Commission
The U.S. Commodity Futures Trading Commission is an independent agency of the United States government that regulates futures and option markets....
issued a joint report identifying the cause that set off the sequence of events leading to the Flash crash. The report found that the cause was a single sale of $4.1 billion in futures contracts by a mutual fund, identified as Waddell & Reed Financial, in an aggressive attempt to hedge its investment position. The joint report also found that "high-frequency traders quickly magnified the impact of the mutual fund's selling." The joint report "portrayed a market so fragmented and fragile that a single large trade could send stocks into a sudden spiral," that a large mutual fund firm "chose to sell a big number of futures contracts using a computer program that essentially ended up wiping out available buyers in the market," that as a result high-frequency firms "were also aggressively selling the E-mini contracts," contributing to rapid price declines. The joint report also noted "'HFTs began to quickly buy and then resell contracts to each other—generating a 'hot-potato' volume effect as the same positions were passed rapidly back and forth.'" The combined sales by Waddell and high-frequency firms quickly drove "the E-mini price down 3% in just four minutes." As prices in the futures market fell, there was a spillover into the equities markets where "the liquidity in the market evaporated because the automated systems used by most firms to keep pace with the market paused" and scaled back their trading or withdrew from the markets altogether. The joint report then noted that "Automatic computerized traders on the stock market shut down as they detected the sharp rise in buying and selling." As computerized high-frequency traders exited the stock market, the resulting lack of liquidity "...caused shares of some prominent companies like Procter & Gamble
Procter & Gamble
Procter & Gamble is a Fortune 500 American multinational corporation headquartered in downtown Cincinnati, Ohio and manufactures a wide range of consumer goods....
and Accenture to trade down as low as a penny or as high as $100,000." While some firms exited the market, high-frequency firms that remained in the market exacerbated price declines because they "'escalated their aggressive selling' during the downdraft."
Controversy
High-frequency trading has been the subject of intense public focus since regulators claimed these practices as contributing to volatility on May 6, 2010, popularly known as the 2010 Flash Crash, a United States stock market crash on May 6, 2010 in which the Dow Jones Industrial Average plunged to its largest intraday point loss, but not percentage loss in history, only to recover much of those losses within minutes. Another area of controversy, related to SEC and CFTC findings in its joint report on the Flash Crash that equity market "market makers and other liquidity providers widened their quote spreads, others reduced offered liquidity, and a significant number withdrew completely from the markets" during the Flash Crash, is whether high-frequency market makers should be subject to regulations that would require them to stay active in volatile markets. As SEC Chairman Mary Schapiro said in a speech on September 22, 2010, "...high frequency trading firms have a tremendous capacity to affect the stability and integrity of the equity markets. Currently, however, high frequency trading firms are subject to very little in the way of obligations either to protect that stability by promoting reasonable price continuity in tough times, or to refrain from exacerbating price volatility."Despite studies reporting positive findings about high-frequency trading, including that high-frequency trading reduces volatility and does not pose a systemic risk, and both lowers transaction costs for retail investors, and at the same time does so without impacting long term investors, high-frequency trading is the subject of increased debate. This debate has been fueled by U.S. Securities and Exchange Commission and Commodity Futures Trading Commission
Commodity Futures Trading Commission
The U.S. Commodity Futures Trading Commission is an independent agency of the United States government that regulates futures and option markets....
empirical findings that high-frequency trading contributed to volatility on the May 6, 2010 Flash Crash. Politicians, regulators, journalists and market participants have all raised concerns on both sides of the Atlantic. In September 2010, SEC chairperson Mary Schapiro
Mary Schapiro
Mary L. Schapiro is the 29th chairperson of the U.S. Securities and Exchange Commission .She is the immediate past chairperson and CEO of the Financial Industry Regulatory Authority , the securities industry self-regulatory organization for broker-dealers and exchanges in the United States, and...
signaled that US authorities were considering the introduction of regulations targeted at HFT, such as a minimum "time in force" rule, to prevent buy orders being canceled very soon after being issued. Criticisms of this proposed law are that currently exchanges allow excess message traffic to queue up at their servers' ports, where it is processed sequentially at a fixed rate and as a result poses no threat to the exchanges. In addition to this equity options markets produce far more message volume than equity markets and has consistently handled the data without issue. Some HFT systems cancel many of their orders almost immediately after placing them as they don't intend the trades to carry through, the false orders are used as part of a pinging tactic to discover the upper price other traders are willing to pay. Some high-frequency trading firms state so many orders get canceled because the orders people get are not the same ones they send. This happens frequently because of an existing regulation regarding re-priced orders.
Another area of concern relates to flash trading
Flash trading
Flash trading, otherwise known as a flash order is, according to industry trade publication, Traders Magazine, defined as “a marketable order sent to a market center that is not quoting the industry's best price or that cannot fill that order in its entirety...
. Flash trading is where certain market participants are allowed to see incoming orders to buy or sell securities very slightly earlier than the general market participants, typically 30 milliseconds, in exchange for a fee. According to some sources, the programs can inspect major orders as they come in and use that information to profit. Currently, the majority of exchanges either do not offer flash trading, or have discontinued it, although the exchange Direct Edge
Direct Edge
Direct Edge is a Jersey City, NJ-based stock exchange operating two separate platforms, EDGA Exchange and EDGX Exchange. Since March 2009, Direct Edge has had a market share in the range of 9%-12% of U.S. equities trading volume, regularly trades 1 billion to 2 billion shares per day...
currently does offer it to participants. Direct Edge's response to this is the data that flash trading
Flash trading
Flash trading, otherwise known as a flash order is, according to industry trade publication, Traders Magazine, defined as “a marketable order sent to a market center that is not quoting the industry's best price or that cannot fill that order in its entirety...
reduces market impact
Market impact
In financial markets, market impact is the effect that a market participant has when it buys or sells an asset. It is the extent to which the buying or selling moves the price against the buyer or seller, i.e. upward when buying and downward when selling...
, increases average size of executed orders, reduces trading latency, and provides additional liquidity. Direct Edge
Direct Edge
Direct Edge is a Jersey City, NJ-based stock exchange operating two separate platforms, EDGA Exchange and EDGX Exchange. Since March 2009, Direct Edge has had a market share in the range of 9%-12% of U.S. equities trading volume, regularly trades 1 billion to 2 billion shares per day...
also allows all of its subscribers to determine whether they want their orders to participate in flash trading
Flash trading
Flash trading, otherwise known as a flash order is, according to industry trade publication, Traders Magazine, defined as “a marketable order sent to a market center that is not quoting the industry's best price or that cannot fill that order in its entirety...
or not so brokers have the option to opt-out of flash orders on behalf of their clients if they choose to. Due to the fact that market participants can choose to utilize it for additional liquidity or not participate in it at all Direct Edge believes the controversy is overstated stating:
"Misconceptions respecting flash technology have, to date, stirred a passionate but ill informed debate."
Critics of the practice contend this creates a two-tiered market in which a certain class of traders can unfairly exploit others, akin to front running
Front running
Front running is the illegal practice of a stock broker executing orders on a security for its own account while taking advantage of advance knowledge of pending orders from its customers...
. Exchanges claim that the procedure benefits all traders by creating more market liquidity and the opportunity for price improvement.
Direct Edge's response to the "two-tiered market" criticism is as follows:
"First it is difficult to address concerns that may result, particularly when there is no empirical data to support such a result. Furthermore, we do not view technology that instantaneously aggregates passive and aggressive liquidity as creating a two-tier market. Rather, flash technology democratizes access to the non-displayed market and in this regard, removes different "tiers" in market access. Additionally, any subscriber of Direct Edge can be a recipient of flashed orders."
Advanced trading platforms
Advanced computerized trading platformsElectronic trading platform
In finance, an Electronic trading platform is a computer system that can be used to place orders for financial products over a network with a financial intermediary. This includes products such as shares, bonds, currencies, commodities and derivatives with a financial intermediary, such as a...
and market gateways are becoming standard tools of most types of traders, including high-frequency traders. Broker-dealers now compete on routing order flow directly, in the fastest and most efficient manner, to the line handler where it undergoes a strict set of Risk Filters before hitting the execution venue(s). Ultra Low Latency Direct Market Access (ULLDMA) is a hot topic amongst Brokers and Technology vendors such as Goldman Sachs
Goldman Sachs
The Goldman Sachs Group, Inc. is an American multinational bulge bracket investment banking and securities firm that engages in global investment banking, securities, investment management, and other financial services primarily with institutional clients...
, Credit Suisse
Credit Suisse
The Credit Suisse Group AG is a Swiss multinational financial services company headquartered in Zurich, with more than 250 branches in Switzerland and operations in more than 50 countries.-History:...
, and UBS. Typically, ULLDMA systems can currently handle high amounts of volume and boast round-trip order execution speeds (from hitting "transmit order" to receiving an acknowledgment) of 10 milliseconds and under.
Such performance is achieved with the use of hardware acceleration
Hardware acceleration
In computing, Hardware acceleration is the use of computer hardware to perform some function faster than is possible in software running on the general-purpose CPU...
or even full-hardware processing of incoming Market data
Market data
In finance, market data is quote and trade-related data associated with equity, fixed-income, financial derivatives, currency, and other investment instruments. Market data is numerical price data, reported from trading venues, such as stock exchanges...
, in association with high-speed communication protocols, such as 10 Gigabit Ethernet
10 Gigabit Ethernet
The 10 gigabit Ethernet computer networking standard was first published in 2002. It defines a version of Ethernet with a nominal data rate of 10 Gbit/s , ten times faster than gigabit Ethernet.10 gigabit Ethernet defines only full duplex point to point links which are generally connected by...
or PCI Express
PCI Express
PCI Express , officially abbreviated as PCIe, is a computer expansion card standard designed to replace the older PCI, PCI-X, and AGP bus standards...
.
More specifically, some companies provide full-hardware appliances based on FPGA
Field-programmable gate array
A field-programmable gate array is an integrated circuit designed to be configured by the customer or designer after manufacturing—hence "field-programmable"...
to obtain sub-microsecond end-to-end Market data
Market data
In finance, market data is quote and trade-related data associated with equity, fixed-income, financial derivatives, currency, and other investment instruments. Market data is numerical price data, reported from trading venues, such as stock exchanges...
processing.
Large high-frequency trading firms
In the US equity markets, some of the highest volume high-frequency traders include Knight Capital GroupKnight Capital Group
Knight Capital Group is a global financial services firm based in Jersey City, New Jersey that provides access to the capital markets across multiple asset classes to buy- and sell-side firms and corporations.Knight is a specialized firm with highly developed market-making and trading capabilities...
, Getco LLC, Citadel LLC, and Goldman Sachs
Goldman Sachs
The Goldman Sachs Group, Inc. is an American multinational bulge bracket investment banking and securities firm that engages in global investment banking, securities, investment management, and other financial services primarily with institutional clients...
.
See also
- Algorithmic tradingAlgorithmic tradingIn electronic financial markets, algorithmic trading or automated trading, also known as algo trading, black-box trading or robo trading, is the use of electronic platforms for entering trading orders with an algorithm deciding on aspects of the order such as the timing, price, or quantity of the...
- Market makerMarket makerA market maker is a company, or an individual, that quotes both a buy and a sell price in a financial instrument or commodity held in inventory, hoping to make a profit on the bid-offer spread, or turn. From a market microstructure theory standpoint, market makers are net sellers of an option to be...
- Statistical arbitrageStatistical arbitrageIn the world of finance and investments, statistical arbitrage is used in two related but distinct ways:* In academic literature, "statistical arbitrage" is opposed to arbitrage. In deterministic arbitrage, a sure profit can be obtained from being long some securities and short others...
- Data miningData miningData mining , a relatively young and interdisciplinary field of computer science is the process of discovering new patterns from large data sets involving methods at the intersection of artificial intelligence, machine learning, statistics and database systems...
- Erlang (programming language) used by Goldman SachsGoldman SachsThe Goldman Sachs Group, Inc. is an American multinational bulge bracket investment banking and securities firm that engages in global investment banking, securities, investment management, and other financial services primarily with institutional clients...
- Sergey AleynikovSergey AleynikovSergey Aleynikov is a former Goldman Sachs computer programmer. He was convicted of stealing computer code that Goldman Sachs used to perform proprietary trading...
- Sergey Aleynikov
- Mathematical financeMathematical financeMathematical finance is a field of applied mathematics, concerned with financial markets. The subject has a close relationship with the discipline of financial economics, which is concerned with much of the underlying theory. Generally, mathematical finance will derive and extend the mathematical...
- Computational financeComputational financeComputational finance, also called financial engineering, is a cross-disciplinary field which relies on computational intelligence, mathematical finance, numerical methods and computer simulations to make trading, hedging and investment decisions, as well as facilitating the risk management of...
- Complex event processingComplex Event ProcessingComplex event processing consists of processing many events happening across all the layers of an organization, identifying the most meaningful events within the event cloud, analyzing their impact, and taking subsequent action in real time....
- Quantitative trading
- Flash tradingFlash tradingFlash trading, otherwise known as a flash order is, according to industry trade publication, Traders Magazine, defined as “a marketable order sent to a market center that is not quoting the industry's best price or that cannot fill that order in its entirety...
- Flash Crash
External links
- High Frequency Trading Event
- The Future and Challenges of High- Frequency Trading
- BusinessWeek.com - SEC Risks Harm With High-Frequency Trading Curbs, CME CEO Says
- Regulatory Issues Raised by the Impact of Technological Changes on Market Integrity and Efficiency, Technical Committee of the International Organization of Securities Commissions, July, 2011
- Detailed description of high-frequency trading - Tradeworx Inc
- Preliminary Findings Regarding the Market Events of May 6, 2010, Report of the staffs of the CFTC and SEC to the Joint Advisory Committee on Emerging Regulatory Issues, May 18, 2010
- Findings Regarding the Market Events of May 6, 2010, Report of the staffs of the CFTC and SEC to the Joint Advisory Committee on Emerging Regulatory Issues, September 30, 2010
- The Microstructure of the ‘Flash Crash’: Flow Toxicity, Liquidity Crashes and the Probability of Informed Trading, David Easley (Cornell University), Marcos López de Prado (Tudor Investment Corp., RCC at Harvard University) and Maureen O'Hara (Cornell University), The Journal of Portfolio Management, Vol. 37, No. 2, pp. 118–128, Winter 2011
- The Flash Crash: The Impact of High Frequency Trading on an Electronic Market, Andrei A. Kirilenko (Commodity Futures Trading Commission) Albert S. Kyle (University of Maryland; National Bureau of Economic Research (NBER)) Mehrdad Samadi (Commodity Futures Trading Commission) Tugkan Tuzun (University of Maryland - Robert H. Smith School of Business), October 1, 2010
- The G-BOT Algorithmic Trading Project - T. Gastaldi (University of Rome)
- Where is the Value in High Frequency Trading?, Álvaro Cartea (Universidad Carlos III de Madrid, Spain) José Penalva (Universidad Carlos III de Madrid, Spain), November, 2010