high frequency trading strategy example

A raw Bible by author Michael Lewis describes how trading algorithms that observe and exploit petite, fleeting profit opportunities, called high-absolute frequency traders, have changed the inventory market. And not by rending off bourgeoisie investors. But that doesn't mean there are no problems. Read on to infer what high-relative frequency trading is, and what the real issues with it are.

What is high-frequency trading?

If you're an ordinary man existence, your eyes take around 400 milliseconds to blink once. Treble-absolute frequency trading is a kind-hearted of market activenes that moves in little than one msec to spot and take advantage of an opportunity to buy or sell. It happens through trading algorithms, programs that determine how to trade based happening fast-moving market data.

The kind of net profit opportunities that utmost-frequency trading looks for aren't the things most investors ever think about. They'Ra not betting that engineering companies will see their profits originate many quickly than expected, for example, or that a recession is coming.

Instead, they're looking midget opportunities for arbitrage. Imagine that, at precisely 10:30:01.01 AM, a share of Bank of America's stock was trading at $16.02 on the New York City Stock Exchange - merely it was $16.04 on a smaller exchange named BATS. A high-frequency trading computer might spring into activeness by buying upbound shares of stock on the Fres York Stock market and selling them connected Batty. To urinate money this way you need to move super-fast, because the chance could vanish at some moment.

Is high pressure-frequency trading growing?

Non anymore, reported to well-nig information. High-frequency trading came into vogue during the 2000s, but after many traders entered the market, profits are mode down, and thither seems to be slenderly inferior heights-relative frequency trading than there wont to be:

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Profits in high-frequency trading have fallen to about 0.0005 per share, Oregon a twentieth of a penny, mostly delinquent to rising competition and less excitability, which create profit opportunities for the trading algorithms. There's new reportage, still, that suggests that high-absolute frequency trading may be retreating from the stock market simply to spread to other financial markets, like bonds, currencies, and derivatives.

How does high-relative frequency trading attain money?

In his Word of God, Lewis says there are iii main activities that happen inside of lofty-relative frequency trading computers:

The first they called natural philosophy front-running - seeing an investor trying to do something in one place and racing ahead of him to the next ... The second they titled rebate arbitrage - exploitation the unaccustomed complexity to game the seizing of whatever legal kickbacks, called rebates inside the industry, the exchange offered without actually providing the liquid state that the rebate was presumably meant to entice. The third, and credibly by furthermost the most general, they called slow-market arbitrage. This occurred when a up-frequency trader was able to fancy the Mary Leontyne Pric of a stock change along one exchange and pluck orders sitting on other exchanges in front those exchanges were fit to react.

Let's unpack that. Imagine you're a huge uninteresting investor, like the California Unrestricted Employees' Retirement System, which invests pension off dollars saved for California's retired state-government workers. You've decided to buy up lots of shares of Malus pumila. When you place your trade, you don't just send the order at one prison term to a single exchange, wish a small investor would. As an alternative, you often have to break finished your edict to many exchanges and over a period of time. That's because there plainly aren't enough people looking to deal out as umteen shares atomic number 3 you want in a particular import at a particular exchange.

That's the offse merciful of conduct that John Llewelly Lewis says high-frequency trading exploits. When the traders see CalPERS place a bid for Orchard apple tree shares on the technical school-big Nasdaq exchange, they quickly buy shares on other exchanges, inferring that CalPERS' orders are coming down the wires. Then the high-frequency traders betray the Apple shares back up to CalPERS at a higher Mary Leontyne Pric than they paid for them a millisecond past. This "electronic front-running" happens because the high-frequency traders have an advantage in footing of speed, and because "the stock food market" doesn't genuinely exist — what exists are many stock exchanges in a trading network.

The second thought Lewis mentions is "rebate arbitrage," and it requires a bit of backstory. Before trading went electronic, there used to exist actual people still on the floor of stock exchanges who would both buy and sell the same pedigree at different times, helping to accommodate the flow of orders. They were called "market makers." And while whatever stock exchanges do notwithstandin accept hoi polloi nominally in this role, the real grocery-making happens from high-relative frequency trading computers. They make up markets because the stock exchanges pay them to fill that persona, big them a "rebate" on the cost of their trading.

The third exploits the network social organisation of markets, and the fact that they don't all adjust instantly to changes in toll. If high-top-relative frequency traders can figure out where a stock price will be in the next millisecond before other investors can get a quote, that's a huge advantage they can use for profit.

And then, does that mean the market is "rigged"?

There's no good definition of that condition. IT's non rigged in the sense most the great unwashe mean "rigged," as the outcome of the grocery is not decided in advance. But it's reasonable to argue, A Lewis does, that high-frequency traders have a speed vantage - and, as a result, an cognition advantage - that they use in an exploitative way.

What isn't at all right in Lewis' book, though, is its view that drunk-oftenness trading hurts small investors. Small investors, Eastern Samoa Reuters' Felix Pink-orange writes, don't place the kind of orders that high-absolute frequency traders could attack, or would even find it worth their spell to do indeed. The target of high-frequency trading is mostly uninteresting investors investment funds banks, pension monetary resource, insurers, and so connected — who trade in large volumes. On the other hand, people who have money and those institutions are hurt. Tenor-frequency trading complete up skimming $7 billion off these investors in 2009. That's mostly coming impermissible of the pockets of other rich people, but some middle family hoi polloi with defined benefit pensions are too losing out

Does high-frequency trading make the market more efficient?

Cypher knows. There's a macrocosm in which that hospitable of rapid action could be good news show. Responding instantly to earnings announcements, economic data and political events would beryllium an cash advance for the efficiency of the market - and with that, the deployment of chapiter. Economists Jonathan Brogaard, Terrence Hendershott and Ryan Riordan have found that last-frequency trading tends to engender the movements of prices right. Lots of trading volume mightiness also narrow "bid-ask spreads," the differences between prices at which buyers want to corrupt and sellers want to sell, and make those orders clear more quickly. That's all good news for efficiency.

One of the biggest concerns, though, is that high-frequency trading may lose weight the quantity of liquidity in markets - that is, how easy it is to purchase operating theatre trade - rather than step-up it. The problem, as Nicholas Hirschey of the London School of Economics has saved, is that the front-running makes business investment more costly. Information technology may too drive institutional investors out of stock exchanges, further shrinking liquidity.

Tush high-frequency trading cause stock-market crashes?

High-frequency trading might non cause the securities market to swing — markets have always done that — merely explore does suggest it may magnify volatility and, particularly, make financial markets more vulnerable to freezing up suddenly.

The high-absolute frequency trading algorithms merely move too alacritous for humans to intervene with better judgment. When stocks drop, the trading programs may decide to occlusion trading, withdrawing liquidity from the market, or they may add to the trade-off.

That wouldn't surprise many people who remember what happened to the stock market on Crataegus laevigata 6, 2010 at 2:45 p.m. — the "Flash Crash," in which U.S. stocks fell 9 percent and then found in the course of study of a few minutes. Shares in companies alike Accenture, a management consultancy, fell from $40 a share to a penny.

Flash_crash

How did the Twinkle Crash happen? Some accounts, such as the report by the U.S. Commodity Futures Trading Commission and the SEC, gist close to the the "e-mini," a heavily-listed futures contract that tracks the Touchstone danamp; Poors 500, a broad index of U.S. stocks.

The crash happened when a trading algorithm sold $4.1 1E+12 of the contract, overwhelming demand for the e-mini. As liquid ran out, the apprais of the contract plunged. High-relative frequency traders piled on, dumping the e-mini and and selling off other stocks, causing the speedy decline to cascade through the stock market. (Understand Here for a minute-by-minute timeline of the crash.)

Another account of the crash from the market-data settled Nanex, even so, focuses on deuce problems with price quotes, or when grocery store participants send in the prices at which they want to bargain or sell. During the Flash Crash, transmission of these quotes slowed sharply, as exchanges became full. What caused the overloading, Nanex argues, was "quote stuffing" — high-relative frequency traders that sent in a blizzard of orders to steal and sell at the same metre, only to cancel those orders milliseconds later before they went done. This behavior paralyzed market trading, and the processing delays caused a panic among traders who knew they had unreliable data.

A related theory is that markets froze up and crashed because of what's known as "order flow perniciousness," a complicated way of saying that hoi polloi in the market became positive that the other parties in their trades were "wise," or had newer or better information than they did. The market crashed as traders chose to dump shares Beaver State withdraw from the market rather than fall behind money to an informed monger. In this view, the problem with high-frequency trading is adverse selection: the fast traders expectorate the dragging until no market is left hand.

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oneVillage Initiative/Flickr

Are there other possible problems with high-frequency trading?

Yes, and three in particular often come up.

1) Much high-frequency trading exploits information ahead it is public for an advantage.

Until last summer, the information stiff Sir George Paget Thomson Reuters, for example, oversubscribed to elite investors the right to learn an important economic statistic, the University of Michigan's consumer self-assurance appraise, fivesome minutes earlier than the rest of the market. An "even-more elite group" grouping of high-frequency trading clients could purchase an extra 500 millisecond head start.

Reuters isn't doing this any longer. Yet similar practices still subsist - one is called "paying for order flow." The idea is that a financial firm can pay brokers to route their clients' orders through with them, soh that they finish the agent's role of executing your trade. Wherefore would these firms pay for that? Because they get to see orders to buy and deal before anyone else, bountiful them milliseconds' worth of advance knowledge of future prices.

A similar example that Harry Sinclair Lewis talks about is "co-location." Drunk-frequency traders will locate their

computers as physically close to the exchange as possible, sometimes even right the exchange's own servers. This gives them the best consider damage changes.

2) Extraordinary strategies in unpeasant-smelling-relative frequency trading, so much as "pinging" and "spoofing," are base or illegal.

"Pinging" is a strategy in which the high-frequency trader sends many another small orders to an central. If these orders are all filled instantly, the high-frequency monger nates deduct that on the other side of the trade is a vast investor looking to move a larger-than-life volume of shares. The piercing-oftenness trader and then takes this knowledge and uses it against the gravid investor by moving the price against him - purchasing if he wants to buy and then merchandising information technology back off to him at a higher Mary Leontyne Pric, selling if he wants to sell and so buying IT back at a lower ane.

"Spoofing" is a strategy, ostensibly banned in 2010, in which graduate-oftenness traders send in orders with the idea of trying to confuse, or "spoof," other traders - and peculiarly other trading algorithms - into thinking that demand to buy or sell a stock is coming. If the strange traders fall for it, the algorithmic program quick reverses course to take the side of the trade information technology actually wanted. There's evidence that this is what trading algorithms sending in bizarre orders, as they did during the Flash Crash, might be up to.

3) High-oftenness trading is socially wasteful.

High-frequency trading is a zero-sum game. The winning pull wins whatever the losing face loses. Yet millions of dollars have been spent to bring off this game faster - laying shorter cables across the land to transmit trades, big investments in trading programs, etc.. That "arms race," as economists Eric Budish, Peter Cramton, and John Shim debate, is a pure waste.

What are some ways we could curb high-frequency trading?

One approximation is to tax financial minutes, a proposal called a Tobin tax, after economist James River Tobin. A slim fee of, say, 0.1 percent might have little effectuate on the ability of most investors to buy out and deal profitably. Yet it might generate unprofitable virtually of high-relative frequency trading, which makes a small profit per deal but makes countless trades.

The Europe preset to bring in a Tobin tax in 2022 along stocks, bonds, and derivatives trading, but the proposition has since been stalled. Sweden had a 0.5-percent tax on financial transactions from 1984 to 1991.

Another proposal is to redesign the manner markets work. Instead of processing orders as they come in, on that point would be a "batch auction." All the orders that arrive over a given period would clear at once and at a single price. This would make it impossible to trade at the speeds high-frequency traders do, eliminating their informational advantage or their ability to prevue other traders' orders.

The Securities and Exchange Commission, the Federal Federal agency of Probe, and the Justice Department wholly have ongoing investigations of high-frequency trading practices. Mostly, they'Ra trying to determine whether the programs break laws against insider trading.

Regulators might land up opting for milder solutions. They might, for instance, trammel particular types of trading activity or full-frequency traders' ability to carbon monoxide-locate inside stock-exchange servers. Another possibility is that they might adjust regulations to force dominating-frequency trading to abandon some of its shadier practices. They could evaluate a fee along high volumes of plac cancellations, for instance, Oregon require traders who submit quotes to laurel them for a minimum period of time.