High Frequency Trading – What It Is

Posted by Chris on March 4th, 2010 filed in Trading

What is High Frequency Trading?  In the most basic sense, it’s trading done completely by computers over networks with humans babysitting them.  Maybe a little history would help?

Trading, a super short history

In the beginning, there was the marketplace.  And it was… primitive.  Multiple places in Europe started different kinds of exchanges to trade things.  Shares in companies, government securities, tulip futures (famously), etc.  For hundreds of years, it was open outcry at exchanges.  People would literally huddle in groups for each thing being traded and make deals in person.  They would write down what happened for the deal on pieces of paper and reconcile at the end of trading.  Phone lines elsewhere on the floor were added, runners would go to their brokers after getting a call from someone else who saw the price on the ticket, etc.  NASDAQ came around and was electronic.  It revolutionized the industry.  Other exchanges slowly came around until now nearly everything is electronic.

The rise of computers

Computers changed quite a few things.  Speed and reliability of execution were improved by an incredible degree.  Costs were lowered.  Barriers to entry removed.

Seats on the CME start at $750,000 for example link.  Nasdaq?  $2000 application fee and montly fees for membership ($3500 or so). Link

Per trade fees are also lower than they used to be.  Combined with networking advances, it’s the perfect recipe for high frequency trading.

Enabling factors

There are a few things that have to happen for this to work.  A firm wanting to get involved in high frequency trading needs kind of a perfect storm to make it in the market.

Fast data feeds from one or more markets.

The feed is a stream of data coming from the exchange listing what is happening.  People are bidding on products, people are offering products for sale, and sales are occuring.  The feed tells you all of them.

Fast connections back to the matching engine.

The matching engine is what it sounds like.  It matches up the buyer with the seller for a given product at a given price and sends that data back via the feed

Computer power to actually figure out if there’s a profitable trade to be made.

Companies usually locate their servers as close as physically possible to one or more exchanges.  The datacenters themselves are amazing.

Cheap trading.

(talked about more later).

So this all means?

Computers take in the feed, which is just what is going on in the market, and decide to make trades.  It’s fast.  How fast?  Less than 200 microseconds to make a decision and send it back out is completely reasonable.  Two hundred millionths of a second.  And it has to do a lot of other things.  If you are long (own) too many, you want to make it slightly less likely you’ll buy so you don’t end up with too many at the end of the day.  If you’re short(have sold more than you have), you have to track all of that.  High frequency trading is, quite simply, trading that’s done by computers, and only incidentally are humans involved.

We (the people) think of the strategies, turn them into parameters the computers can understand, test them, and then let the computers run them with someone watching.  Usually, someone spots or thinks they spot some advantageous idea and goes from there.  Some people will write it into the programming itself – meaning that the program that does the trading itself is re-written to account for the new idea.  Others will let the program modify itself – the people thinking up the ideas will enter programming language-like-code that then gets run by the trading program.

The rest of the posts will be more about specific areas I thought were interesting when I was there – or areas I was involved in a lot.

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