High Frequency Trading – Strategies

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

Once you have all the access, machines, network, middle office, clearing, etc etc etc, what do you do now?  Well, you need to figure out what to do.  There are two basic things folks do here, one of which is basically a subset of the other.  How do you pay for it?  And What do you do with it?

Market Making and Market Taking

The individual markets want action.  They want you to be able to buy or sell easily on their markets.  Sure, they go for big numbers, too, but what they want is liquidity.  If average Joe on the street can’t go into BillyBob Exchange, LLC and buy 100 shares of That Gargle Interweb thing, but can elsewhere, they’re not going to be an exchange for much longer.

MarketMakers add liquidity to the market

There’s not always enough people in the market at a given time to make it liquid enough for every single instrument traded on it.  So the exchanges have people called MarketMakers.  Their job is literally that – to make the market.  If you’re a registered marketmaker, you have to be in the market for a given amount of time or get in trouble.   You can be a marketmaker for one symbol or a hundred, it’s whatever you can keep up the action for.  Marketmakers can make an okay living doing this, but it can be risky too.  They live on both sides of the “price” for a symbol.  If something is “worth” some arbitrary amount of money, they will buy it for a little less than that, and sell it for a little more.  (Bid and Ask)  If the market moves too quickly in one direction, there’s a risk that they are making bad trades because they haven’t updated their prices to account for the risk.  More risk means trading wider around the price.  You can also adjust your price to account for your position.  If you’re long something, you may be willing to take slightly less money to unload so you don’t have that position.  In return for this risk – the exchanges “bribe” the marketmakers.  They get a nice discount on their trades.

While it may cost you $7.95 per trade, a marketmaker can pay 1/1000 of that – or less.  Or nothing.  Or they can get paid to trade.

It’s in the ratio.  Quoting (marketmaking) gets you a rebate, taking liquidity costs you money.  Marketmakers also have an obligation to quote a certain amount and hours per day.  That doesn’t mean they can’t quote extra wide, but they’re not making money then and not making the exchange happy.

Arbitrage

I love arbitrage.   In it’s most basic definition, it is taking advantage of price differentials.  Say the price of AAPL on the TSX is $201/share, on Nasdaq it’s $200 a share.  So you buy it on Nasdaq and sell it on the TSX and pocket the dollar, minus any fees.  My favorite is Berkshire Hathaway (BRK) – it has two classes of stock, A and B.  They’re related – you can exchange A for B.  One class-A share equals 30 class-B shares.  Since most people don’t buy BRK to vote, there is a very, very strong relationship between the two.  So if it’s ever not very very close to a 30:1 price ratio, there’s a simple arbitrage opportunity.

A surprising amount of what the proprietary trading companies do is arbritage.  Everything from distance (latency, really) based, to ratios like the BRK example, to the symbols within a larger context.  For example, you can trade the component stocks of the S&P 500 against a future of the S&P 500 index itself.  Since one is literally made of the other, the price in one underlying symbol means that the other is worth a different amount.

Another good example is pricing options.  Most of the market prices options based on the Black-Scholes formula (roughly speaking).  This means that there’s a pretty standard way of figuring the prices that the market generally gravitates toward.  Those who can program a faster algorithm for computing this can price them faster, and have a pure arbitrage opportunity.  Options are also fun in another way.  You can “create” shares from options.  Wikipedia explains it better than I could, but basically you can buy and sell options in a certain way that lets you simulate having a share of stock.  Or better yet, simulate selling one or selling one short when you can’t really sell it short.

Correlation

This is basically taking advantage of similarities between companies.  If oil goes up, companies that use lots of oil tend to go down.  Or on a more practical example I like to give, if oil goes up, American car companies tend to go down.  Hand in hand with that, similar companies tend to follow each other also.  GM and Chrysler did for a while.  Big steel companies, when they existed.  Heck, weather futures against crop futures.  Think of a few on  your own, it’s fun!  Basically anything you can think of that may have an effect on something else can be priced.  It doesn’t have to be a 1:1 ratio either.  The companies aren’t priced the same, nor is the relationship between them perfect.

In practice – order types (list)

The market open and market close are where almost all of the fun in the markets happens.  Open especially.  You can saturate a 1GB connection to a market just with data feeds.  (Get a bigger connection).  For perspective, that line that is getting completely overrun with data is probably 500 to 1000 times faster than yours at home. You put your quotes and orders in before open or right at open and the insanity happens.  Now when the market moves on you, you need to change your quotes.  If the “value” is $10.00 and you’re at $9.95 and $10.05 and it inches higher, pretty soon your asking price is so low that you’re losing money on every trade.  So you update the price to move with the market.  You can have one order in at the beginning of the day and update it 100,000 times throughout the day.  These orders (market or limit) are normally “day” orders, and are valid until canceled.  So you can update it or do a cancel and replace.  The are liquidity *adding* orders.  The marketmaker uses them to get into the market and stay there until filled, at which point they’ll adjust their prices depending on whether they’re long or short and put in a new order.  Why is this *adding* liquidity?  Because it is giving others the opportunity to trade.  You you just out there saying “Here I am, I’ll trade with you if you want. Here are my prices.”

Immediate or cancel, fill or kill, whatever you want to call it – these are the market *taking* orders.  You see an opportunity for some quick profit that will remove liquidity from the market.  There’s a price mis-match somewhere, someone put in an order you think is “wrong”, there are plenty of reasons.  But you only only only want to get it at that price.  If it’s not immediately filled at that price, the order is canceled and nothing happened.  Why does this remove liquidity? Because unlike the day orders, you’re not actually giving an opportunity to someone else to trade, you’re trying to take it away from someone else.   It removes one open order from the market, takes the numbers a little lower from the exchange, and thus they charge you for the privilege.

Another interesting thing about the markets that one has to account for is what’s called an Iceberg.  Say you have a lot of stock you have to sell.  Putting a giant order out there will change the market – people will see you need to sell a lot and the price will got down accordingly.   Of course, you don’t want the price to go down as much – you want more money for your stock!  The markets let you put something called an iceberg order into the market.  It lets you specify how much the market sees of the order.  Instead of 10,000 or 100,000 maybe you want to show 1,000.  Eventually the market will figure out that there’s a lot of selling going on and price itself accordingly, but you haven’t thrown it for a loop with your giant numbers – it’s gradual.  So you can set  your order as an iceberg, and the people on the other side ordering against you can also place their order for *more* than it shows the offer is.  So you see an offer in the market for 500 shares @ $10.00, and you think that’s a great price – you can try an order larger than that, and if it’s an iceberg, you’ll trade for the larger quantity.  Neat stuff.

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