High–Frequency Trading: A Practical Guide to Algorithmic Strategies and Trading Systems

Praise for High–Frequency Trading, Second Edition

"High–Frequency Trading, Second Edition tells the fascinating story of how computers came to dominate modern financial markets. Irene Aldridge guides the reader through the intellectual ideas that have allowed this revolution to occur, from the economic, technological, and regulatory points of view."
Sasha Stoikov, Senior Research Associate, ORIE, Cornell University

"High–frequency trading is a complex subject at the nexus of advances in market microstructure, computer science, and financial data analysis. This book handles the topic in a comprehensive manner, making it accessible to a lay reader, yet providing enough detail for sophisticated industry practitioners and scientists."
Charles S. Tapiero, Topfer Distinguished Professor of Financial Engineering and Technology Management; Chair, Department of Finance and Risk Engineering, New York University Polytechnic Institute; and Coeditor in Chief, Risk and Decision Analysis

While interest in high–frequency trading (HFT) continues to grow, there is still very little meaningful information available to help investors understand and implement HFT systems. That′s why industry expert Irene Aldridge has returned with the Second Edition of High–Frequency Trading.

Incorporating the latest research and questions that have come to light since the publication of the first edition, this reliable resource has everything you need to gain a firm grip on how HFT works and what it takes to apply this proven approach to your trading endeavors. Covering various aspects of HFT from trading strategies to risk management and regulation this book will put you in a better position to excel in today′s turbulent markets.

Website includes:

Customizable teaching slides Basic C/C++ code for estimating regression coefficients A sample of tick data Continuously updated resources, including research papers and news

Preface xi

Acknowledgments xiii

Chapter 1 How Modern Markets Differ from Those Past 1

Media, Modern Markets, and HFT 6

HFT as Evolution of Trading Methodology 7

What Is High–Frequency Trading? 13

What Do High–Frequency Traders Do? 15

How Many High–Frequency Traders Are There? 17

Major Players in the HFT Space 17

Organization of This Book 18

Summary 18

End–of–Chapter Questions 19

Chapter 2 Technological Innovations, Systems, and HFT 21

A Brief History of Hardware 21

Messaging 25

Software 33

Summary 35

End–of–Chapter Questions 35

Chapter 3 Market Microstructure, Orders, and Limit Order Books 37

Types of Markets 37

Limit Order Books 39

Aggressive versus Passive Execution 43

Complex Orders 44

Trading Hours 45

Modern Microstructure: Market Convergence and Divergence 46

Fragmentation in Equities 46

Fragmentation in Futures 50

Fragmentation in Options 51

Fragmentation in Forex 51

Fragmentation in Fixed Income 51

Fragmentation in Swaps 51

Summary 52

End–of–Chapter Questions 52

Chapter 4 High–Frequency Data 53

What Is High–Frequency Data? 53

How Is High–Frequency Data Recorded? 54

Properties of High–Frequency Data 56

High–Frequency Data Are Voluminous 57

High–Frequency Data Are Subject to the Bid–Ask Bounce 59

High–Frequency Data Are Not Normal or Lognormal 62

High–Frequency Data Are Irregularly Spaced in Time 62

Most High–Frequency Data Do Not Contain Buy–and–Sell Identifiers 70

Summary 73

End–of–Chapter Questions 74

Chapter 5 Trading Costs 75

Overview of Execution Costs 75

Transparent Execution Costs 76

Implicit Execution Costs 78

Background and Definitions 82

Estimation of Market Impact 85

Empirical Estimation of Permanent Market Impact 88

Summary 96

End–of–Chapter Questions 96

Chapter 6 Performance and Capacity of High–Frequency Trading Strategies 97

Principles of Performance Measurement 97

Basic Performance Measures 98

Comparative Ratios 106

Performance Attribution 110

Capacity Evaluation 112

Alpha Decay 116

Summary 116

End–of–Chapter Questions 116

Chapter 7 The Business of High–Frequency Trading 117

Key Processes of HFT 117

Financial Markets Suitable for HFT 121

Economics of HFT 122

Market Participants 129

Summary 130

End–of–Chapter Questions 130

Chapter 8 Statistical Arbitrage Strategies 131

Practical Applications of Statistical Arbitrage 133

Summary 144

End–of–Chapter Questions 144

Chapter 9 Directional Trading Around Events 147

Developing Directional Event–Based Strategies 148

What Constitutes an Event? 149

Forecasting Methodologies 150

Tradable News 153

Application of Event Arbitrage 155

Summary 163

End–of–Chapter Questions 163

Chapter 10 Automated Market Making Naïve Inventory Models 165

Introduction 165

Market Making: Key Principles 167

Simulating a Market–Making Strategy 167

Naïve Market–Making Strategies 168

Market Making as a Service 173

Profitable Market Making 176

Summary 178

End–of–Chapter Questions 178

Chapter 11 Automated Market Making II 179

What s in the Data? 179

Modeling Information in Order Flow 182

Summary 193

End–of–Chapter Questions 193

Chapter 12 Additional HFT Strategies, Market Manipulation, and Market Crashes 195

Latency Arbitrage 196

Spread Scalping 197

Rebate Capture 198

Quote Matching 199

Layering 200

Ignition 201

Pinging/Sniping/Sniffing/Phishing 201

Quote Stuffing 201

Spoofing 202

Pump–and–Dump 202

Machine Learning 207

Summary 208

End–of–Chapter Questions 208

Chapter 13 Regulation 209

Key Initiatives of Regulators Worldwide 209

Summary 222

End–of–Chapter Questions 223

Chapter 14 Risk Management of HFT225

Measuring HFT Risk 225

Summary 244

End–of–Chapter Questions 244

Chapter 15 Minimizing Market Impact 245

Why Execution Algorithms? 245

Order–Routing Algorithms 247

Issues with Basic Models 258

Advanced Models 262

Practical Implementation of Optimal Execution Strategies 269

Summary 269

End–of–Chapter Questions 270

Chapter 16 Implementation of HFT Systems 271

Model Development Life Cycle 271

System Implementation 273

Testing Trading Systems 283

Summary 286

End–of–Chapter Questions 287

About the Author 288

About the Web Site 290

References 291

Index 303

IRENE ALDRIDGE is an investment consultant, portfolio manager, a recognized expert on the subjects of quantitative investing and high–frequency trading, and a seasoned educator. She is currently Industry Professor at New York University, Department of Finance and Risk Engineering, Polytechnic Institute, as well as Managing Partner and Quantitative Portfolio Manager at Able Alpha Trading Ltd., an investment consulting firm and a proprietary trading vehicle specializing in quantitative and high–frequency trading strategies. Aldridge is also a founder of AbleMarkets.com, an online resource making the latest high–frequency research for institutional investors and broker–dealers. Aldridge holds an MBA from INSEAD, an MS in financial engineering from Columbia University, a BE in electric engineering from the Cooper Union in New York, and is in the process of completing her PhD at New York University. She is a frequent speaker at top industry events and a contributor to academic, practitioner, and mainstream media publications, including the Journal of Trading, Futures magazine, Reuters HedgeWorld, Advanced Trading, FX Week, FINalternatives, Dealing With Technology, and Huffington Post.