Abstract: Detailed interpretation of the logic and pros and cons of high-frequency trading strategies
Introduction:
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High-frequency trading is a programmatic trading method that uses complex computer systems to place orders, enjoys direct data channels with the exchange, and has high turnover and low latency characteristics. High-frequency trading has played an important role in US stocks, futures, , foreign exchange and other markets. At its peak, its trading volume accounted for 50% of the three markets. In recent years, profit levels have declined due to the decline in overall market trading volume and liquidity, changes in regulatory policies and intensified competition in the track.
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The high-frequency trading strategy capacity of the digital currency market is relatively small. The single team size is generally between dozens and hundreds of BTCs, and the yield ratio is relatively high. The usage scenarios are mainly market making and self-operated trading, and the scale effect of lack of funds . However, combining high-frequency strategy logic with other strategies to effectively prevent market and exchange risks in extreme market conditions will help quantitative strategies optimize combinations to create excess returns.
1. The definition, scale and current
high-frequency trading refers to the use of high-performance computers to conduct programmatic order trading, and capture the slight price difference between buying and selling of a trading target through large batches of order cancellations, and make profits in an extremely short period of time. In the United States, where finance is highly developed, its Securities and Exchange Commission (SEC) gave five summary of the characteristics of high-frequency trading in an official document in 2010:
1. Using a complex computer system with ultra-high speed
is different from traditional Internet companies that use scenarios for computer networks to handle high load and high concurrency. High-frequency trading systems have extremely high requirements for the low-latency characteristics of the network, that is, they can capture the information on the order book faster and analyze it, which will largely determine the profit level of this high-frequency trading system. In terms of program implementation, in order to improve the algorithm running speed, some instructions will be integrated into the computer system (the instruction interval is usually the order of milliseconds, and even microseconds can be reached). In the development of high-frequency systems, the underlying language C++, which runs faster, is mainly based on the fastest running language; in terms of hardware,
can use overclocking CPU, FPGA hardware acceleration, GPU parallel computing and other methods to improve overall performance.
In terms of communication networks, because the propagation rate of electromagnetic waves in quartz is only two-thirds of the propagation rate in the air, and the congestion of fiber optic networks will increase the delay, high-frequency trading will even abandon traditional fiber optic communications and instead use microwave and millimeter wave dedicated communication lines. As shown in the figure below, the green line in the figure represents the microwave circuits set up between urban clusters with dense fiber distribution (London and Frankfurt, Chicago and New York). Quincy data has been able to transmit the Aurora-based Chicago Mercantile Exchange trading data to Carterlett and Scox in New Jersey at a low latency of about 4 milliseconds.
Figure 1 Microwave communication network directly connected to the exchange with high-frequency trading Source: Quincy data
2. Data channel using co-location and direct connection to the exchange
The so-called co-location means that the servers and other hardware facilities of high-frequency companies need to be placed very close to the exchange host. Some exchanges even provide server hosting services for market makers near their server cluster . In this way, trading instructions do not need to be transferred through brokerage companies, and high-frequency trading companies will also see the information on the order book earlier than other market participants.
3. On average, each time holds positions is very short
In addition to low latency, another major feature of high-frequency trading is high turnover, which means that trading behaviors will occur very frequently and the position time is short to reduce risk exposure.
4, send and cancel entrusted orders in large quantities
High-frequency traders will process and judge every piece of information that appears on the order book, and set up corresponding positions in a targeted large number of orders. In some high-frequency strategies, traders will issue some order orders to explore other orders (such as iceberg strategies), or guide short-term price trend changes through large-scale order withdrawal operations to promote price discovery.
5. Basically, close the position at the close
Generally, high-frequency trading will close all positions (except for holding the bottom position) before the end of a trading day. On the one hand, holding positions overnight will increase the risk; on the other hand, it can greatly reduce the cost of holding positions (mainly overnight interest paid except margin positions).
Looking at the history of the development of high-frequency trading, it is not difficult to see that it is due to the policy adjustments of the regulatory authorities and the wide application of Internet technology in the financial industry. At first, New York Stock Exchange adopted manual matching order placing method, while Nasdaq market was mainly handled by its market makers. With the gradual rise of electronic automatic trading platforms, the number of customers participating in day trading has gradually increased, laying the foundation for the rise of high-frequency trading. With the improvement of several regulations issued by the SEC, the high-frequency trading market is becoming increasingly shape. The "Alternative Trading System Regulations" issued in 1998 has gradually become accepted by the market.
After that, through many ECN platforms, people did not need to place orders through market makers, and order information that could reflect the real market situation also entered the investors' horizons - this is undoubtedly a shocking change for high-frequency teams who like to study the microstructure of transactions. At that time, even the New York Stock Exchange and Nasdaq had to follow the torrent of history and devote themselves to the wave of electronic trading platform business. After entering 2000, the SEC stipulated that the minimum price change unit was changed from US$0.0625 to US$0.01. The increase in the price range gave more room for batch orders between selling one and buying one.
With the development of high-frequency trading, many traditional financial industry giants such as Goldman Sachs, JP Morgan, Merrill Lynch have entered this field, and the industry has a group of competitive legendary companies and hedge funds that support it - Renaissance Technologies, led by the father of quantitative Simmons , Virtu Financial, which is famous for its speed (only one day in the 1,485 trading days from 2009 to 2014), Citadel Securities, Two sigma, Jump Trade Co, GETCO, etc.
Since then, high-frequency trading ushered in a golden decade of rapid development in the US stock market. As shown in the blue histogram in the figure below, its trading volume, which accounted for only about 10% of the US stock market in 2005, gradually developed to account for 61% in 2009. In the futures and foreign exchange markets, according to data released by the Chicago Mercantile Exchange (CME) and Electronic Broking System in 2009, high-frequency trading also contributed at least 50% of the trading volume. The orange histogram in the picture represents the European market situation. Similar to the United States, high-frequency trading accounted for only 1% at the beginning, and 38% accounted for in 2010.
Figure 2 The transaction proportion of high-frequency trading in the United States and Europe between 2005 and 2014
However, since the peak of the trading volume in major markets in 2009, its trading volume proportion and profit level have a downward trend. According to the above figure, the proportion of high-frequency trading in the US market has dropped to 54% and 56% in 2010 and 2011; the European market has slightly delayed, and the scale of its high-frequency trading dropped to about 35% in 2012. According to Tabb Group data, the high-frequency team's full-year profit in 2016 has fallen sharply from the peak of US$7.2 billion in 2009 to US$1.1 billion.In addition to the decline in the average daily volatility of the market, the author speculates that the decline is mainly caused by the following reasons: the profit level of
-
high-frequency trading attracts a large number of financial technology teams into this field, making the track increasingly crowded and profits gradually divided; some high-frequency strategies of
-
threaten traditional asset management companies and hedge funds that believe in value investment or fundamental analysis. In addition, due to the introduction of domestic policies in the United States, it further suppresses them;
-
has caused overall market liquidity and trading volume to decline due to deleveraging.
high-frequency team has been exploring the European and American trading markets so far, and is gradually turning their attention to the "undeveloped" Chinese market. However, the trading rules and structures of the two markets are quite different. my country's A-share market implements a trading system of T+1 (different from the T+0 of the US stock market), making it impossible to complete the opening and closing position within the day. However, with the first trading open-end index fund (SSE 50 ETF) logged into the Shanghai Stock Exchange and the 2010 CICC opening stock index futures trading, the high-frequency team began to trade in ETF, commodity futures and stock index futures markets . It is not difficult to see from the previous development history that this type of trading strategy is deeply influenced by the trading structure and system of the market, and its domestic development will be restricted by the following conditions:
-
is different from foreign high-frequency companies that can set up data dedicated lines to directly connect to the exchange. Each order withdrawal of domestic traders must be transferred through securities companies, which will greatly reduce the low latency performance and lose the speed advantage.
-
transaction data is not granular enough. Domestic exchanges will only give TICK-level data and cannot obtain more detailed information on each order and order sheet.
-
Domestic regulatory policies are unclear, and trading behaviors that are suspected of guiding price trends such as large-scale orders and withdrawals are strictly controlled.
At present, there is still a long way to go for the development of high-frequency trading in the Chinese market.
2. High-frequency strategy classification and profit model
The reason why high-frequency trading can achieve profitability is the law of large numbers, that is, when we repeat a certain experiment in large quantities, the distribution of the results tends to a certain fixed value. In high-frequency trading, when the probability of each profit is greater than 50% (the winning rate of passive market making strategy will even reach 80%), even if the profit per transaction is meager, the expected return is positive after a large number of transactions are closed loop (buyed and sold again, and the total position remains unchanged) is completed. The profit methods of different high-frequency strategies are also different. The following will introduce several mainstream high-frequency strategies and their specific profit models.
1, passive market making strategy
The core idea of this strategy is that according to the principle of reverse selection, market makers insert both the buy order and the sell order at the front of the buy order sequence and the sell order sequence to become the new buy and sell order. Assuming that these two orders can be traded within a certain period of time, profits will be achieved without changing positions. The following figure in
is a schematic diagram of the order book. The real situation is often more complicated than here. The market making strategy will determine the price at which price is determined by combining the information of ten levels of buying and selling on the order book. Only 5 levels are left for schematic diagrams. In the market without a passive market making strategy, as shown in Figure 1, the bid-ask price difference is 100.2-99.5 = 0.7 yuan. At this time, if the market is determined to be a central oscillation, the high-frequency strategy will open a position and insert the order in Sell and Buy, as shown in the red order in Figure 2. High-frequency trading has huge advantages over manual traders in terms of speed. Therefore, if the manual trader cancels the order placed at the buy 2, 3/sell 2 and 3 and then cuts the line to the front of the commission sequence, the passive market making strategy will also withdraw the orders accordingly, and from the reverse selection principle, lower the price and place orders again, keeping the market making orders closest to the direction of price formation at all times, that is, being at the forefront of the commission sequence.
passive market making strategy is more suitable for central oscillating markets without obvious breakthrough trends. However, once the market breaks through unilaterally, it will cause market makers to deviate their positions. Either the bottom position is sold at a low price and cannot be taken back, or the price continues to fall after the purchase order is completed. At this time, the strategy must stop losses in time. As shown in the figure below, when we completed the 15-order orders under 100.1 in Figure 2, the price still rose and directly dropped the first to third and third levels. After rejudging the market information, it was learned that there was no hope of receiving 15 buy orders at 99.7 yuan. Removing the red four orders in Figure 3, and directly eating 15 orders sold for 100.45 yuan to complete the recoup, which is considered a stop loss trigger. Generally speaking, the winning rate of passive market making strategies can reach 80%, and the probability of stop loss is 20%.
passive market making is one of the main applications of high-frequency trading. When the price fluctuates within a range (no obvious trend), the high-frequency market maker will insert quotations that are more favorable to the buyer and seller between the markets of buying and selling, thereby promoting the transaction, that is, injecting liquidity into a certain securities by narrowing the market price difference. Although the profits of the market share are small, the winning rate is high, and considerable returns can be achieved under high frequency transactions; in more cases, the profits of the market making strategy come from the liquidity compensation provided by the exchange for the promotion of the transaction - returning a part of the handling fee as a commission.
2, directional strategy
is relatively stable in the market environment of passive market making strategy. Trend strategy is used in price reversal or breakout market trends. When high-frequency strategies detect external market information and learn that the event-driven market is coming, combined with the market data, a position will be established in advance, and the profit-taking and closing position will be completed when the market responds to the event and reflects the price. As shown in the figure below, suppose we judge that a downward trend is coming (it can be seen that the amount of selling orders on the market is large and dense), so we sell 100 lots first and then knock out all the buy ones and buy twos in Figure 4, and the remaining 1 lot is placed at the selling position at a price of 99.85. Because the market response is slow, we set up short positions in advance and wait for the price to fall. At this time, when other traders see that the downward trend has become, they will follow the reduction of positions. When the price falls to the position of buying four in Figure 5, the high-frequency strategy will take back the 100 lots sold at the high level at 99.4 yuan and close the position with profit. Of course, if you make a mistake in judging the market, you also need to stop the loss in time, that is, quickly buy back the short position and use the above sell orders to cover it.
In addition to the directional strategies triggered by event-driven, there are also two strategies for trend hiring to issue and instructions to take the lead. The instruction-leading strategy has another name in the academic community - predatory algorithm trading , that is, the high-frequency strategy will send small orders continuously before opening a position to test whether there are icebergs in the market to establish positions. If you find that there are continuous large-scale buy/sell orders at a certain price, you will use technical means to complete the position before the large order is completed, and wait until the price rises before distributing the chips to large orders that have not been successfully placed before. trend-induced strategy is also called fraudulent trading , which is easy to connect with market manipulation and becomes the target of supervision’s focus on investigation and punishment. The specific method is to place huge sell orders/buy orders and place small buy orders/sell orders at lows/highs. When other traders in the market see the information about the order thin, they will be affected by fear or greed to make trading behaviors of scrambling to sell/buy. In this way, small orders that have been ambushed in advance can be traded, and they can make profits and close positions after the trend returns to normal. The core idea of
directional strategy is basically to determine the direction of short-term high-probability price fluctuation after judging the order flow information or specific events, build positions in advance with the advantage of speed, and close the positions after the price fluctuates to the expected point. The reason why this strategy can make profit is that the research on the microstructure of the trading market (order thin information), event grasp and execution speed far overwhelm other participants. At the same time, due to order orders, emotions are not easily affected by fluctuations.
3. Structural strategy
is similar to the trend strategy to take the lead and cheat trading. Structural strategy is also about making a fuss about trading mechanisms, seizing the initiative, and more or less suspected of destroying the fairness of the trading market. As mentioned above, some high-frequency companies will place servers and other hardware facilities very close to the exchange host, and some exchanges even provide server hosting services for market makers near their server clusters. In this way, trading instructions not only do not need to be transferred through brokerage firms, but also high-frequency trading companies will also see the information on the order book earlier than other market participants. In addition, there were structural strategies such as "no audit path" and "lightning directives", but because it was too damaging market fairness, it was banned by by the US Securities Regulatory Commission around 2010.
4, arbitrage strategy
arbitrage can be roughly divided into cross-market arbitrage and cross-asset category arbitrage. In the US stock trading market, the same stock can be traded on different exchanges. When the price of the same asset on different exchanges occurs slight deviation, it will be quickly captured by the high-frequency team and complete arbitrage. What is more common are ETF arbitrage and stock index futures arbitrage, which also have very high requirements for speed, and the instructions are conveyed in the order of microseconds or even nanoseconds.
3. Advantages of high-frequency trading and risk
1. Advantages of high-frequency strategy
For funds that allocate high-frequency strategies to some assets, the profits generated are an important part of excess returns and will not conflict with other investment strategies, which plays a role in hedging risks. From the micro level of trading, high-frequency trading pays attention to the research on order thin information flow to an unrefined degree, so that high-frequency strategies can guide the price trend in the short term, make correct judgments and make profits; combined with its own hardware's speed advantages, they can often take the initiative and complete the action of building or closing positions before market participants.
For the overall market, the contribution of high-frequency strategies mainly includes the following aspects:
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stimulates trading desire by narrowing the price spread and increasing the real trading volume of the market to a certain extent.
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provides short-term impetus for price fluctuations in the trading market and can fill the gap so that the price will not deviate too far from the normal range in an instant.
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improves the overall trading efficiency of the market, catalyzes the iteration of computer software and hardware technology and feeds back to the financial industry.
2. Risks brought to the market by high-frequency trading
At around 11 a.m. on August 16, 2013, Everbright Securities issued more than 26,000 purchase orders, actively purchased ETF constituent stocks worth 23.4 billion yuan, with an actual transaction of 7.27 billion yuan; then converted 1.85 billion yuan into ETFs and sold them and issued more than 7,000 short orders for stock index futures. After this series of operations, the Shanghai Composite Index changed dramatically by 6% that day, triggering investigations from regulators and investors' attention, which is called the "Everbright Wrong Index Incident" in the industry. According to the self-inspection report of Everbright Securities, the reason is that the order generation module of its high-frequency arbitrage system mistakenly submitted more than 26,000 orders other than the actual order funds available to the order module, and there was no risk control alarm, which caused a subsequent shock. At that time, this incident not only unveiled the mystery of high-frequency arbitrage, but also brought high-frequency trading and the hidden risks it brought to Chinese regulators and market participants.
A misunderstanding incident that occurred in the United States in 2012 caused huge losses to Cavaliers Capital, a former industry leader. Due to the fact that during the upgrade of the high-frequency trading system, technicians did not upgrade a certain server, which caused them to send millions of abnormal orders to the market after the opening of the market on August 1, involving more than 150 stocks and triggering a circuit breaker mechanism. Some stocks were temporarily suspended and terminated trading. Afterwards, the New York Stock Exchange only canceled the day's trading of 6 stocks, and the remaining more than 140 stocks failed to be cancelled, which eventually led to a loss of 460 million US dollars in Cavaliers Capital, which was transferred to operating difficulties and was acquired by GETCO. To this day,
high-frequency trading seems to have been arousing people's reflection and criticism of the systemic risks it may bring.Berkshire Hathaway's head Buffett and Munger once publicly stated that high-frequency trading is like "rats in the barn", criticizing it for not bringing liquidity to the market, but only bringing trading volume. The rest of this chapter will discuss the risks brought to the market by high-frequency trading, the relationship between trading volume and liquidity, and other issues.
brings us back to May 6, 2010. Several major indexes such as the Dow Jones, S&P, etc. in the US stock market plummeted by more than 9% in a short period of time. Although the price gradually recovered in the rest of the trading day, and it closed down only about 3% from the previous day, this incident shocked the whole of the United States, known as the "Flash Crash" in history.
Figure 3 May 6, 2010 US Dow Jones Index K-line chart Source: Futu Securities
The US Securities and Exchange Commission conducted a comprehensive investigation of the flash crash afterwards. The conclusions drawn can better help us understand what contributions high-frequency trading has in providing liquidity. As shown in the left figure below, the red curve represents the change in the trading volume of the S&P 500 futures on the day, the blue curve represents the change in the futures price, and the right figure represents the change curve of the number of pending orders. We can clearly see at 14:45 when the flash crash occurred, the trading volume surged but the market depth dropped sharply, and the order for the commission even dropped to 0. With the support of the market making strategy, why did the market quota draw to a vacuum and there was no liquidity in an instant?
Figure 4 S&P 500 futures trading volume and price trend chart Source: Bloomberg
Figure 5 S&P 500 futures trading orders trend chart Source: Bloomberg
In May of that year, under the negative sentiment of the European debt crisis, the capital market was tight and sensitive. When an institution trader decided to place a short order of 75,000 lots for hedging, an unexpected flash crash occurred. As usual, due to the existence of high-frequency market makers, such "small" positions will definitely be accepted as the orders. After judging the order book information and market sentiment on the spot, the high-frequency strategy can decide to adopt the "quotation without transaction intention" plan, or to avoid the stock price falling sharply, the market-making position will be trapped and directly adopt the "not making market" strategy. The exit of market makers has led to the instantaneous depletion of liquidity in the market, and the depth of the market has deteriorated. A small number of sell orders can also smash several levels of the buy orders, and the stock price fell sharply in an instant. At this point, we can see that targets with large trading volume do not necessarily have greater liquidity and real trading demand. The role of high-frequency trading in the market is to provide trading convenience such as smaller price spreads for real demand, rather than the fundamental reason for price declines. As for whether high-frequency trading can boost the large fluctuations in price, there has been controversy in the academic community.
is similar to Buffett and Munger's view on high-frequency trading. Some scholars believe that high-frequency teams influence price changes through fraudulent transactions and other means, thus depriving other traders on the market of profits. Jonathan Brogaard said in an academic paper published in 2018 that high-frequency trading truly provides liquidity to the market and narrows the bid and offer price difference; high-frequency trading is not the price, but quantity, so there is no voice in the academic community about high-frequency strategies - targeted harvesting of fundamental investors through price competition.
Brogaard selected the order-blank data of 279 large-cap stocks from Canada's second largest trading platform, Alpha Exchange, from 2008 to 2012 as the research object. At the same time, in order to more accurately characterize the market situation, similar data from the Canadian TSX Exchange was selected as a reference. The following two pictures show the situation where high-frequency market makers have entered the platform one after another in the past three years. The picture on the left shows the number of merchants that provide market-making for each stock during the sampling time, and the picture on the right shows the date distribution chart of high-frequency traders entering the Alpha platform.
Figure 6 2008-2012 provides the number of merchants for each stock
Figure 7 Date distribution map of high-frequency traders entering the Alpha platform
then uses the double-scoring method (difference-in-difference, DID) to process the data, and analyze the liquidity changes before and after the entry of high-frequency market makers. As shown in the figure below, as the number of market makers entering increased, the bid and offer price spreads on the same stock of the two exchanges gradually narrowed but eventually remained basically the same. This process also led to the intensification of competition among market makers.
Abstract: Detailed interpretation of the logic and pros and cons of high-frequency trading strategies
Introduction:
-
High-frequency trading is a programmatic trading method that uses complex computer systems to place orders, enjoys direct data channels with the exchange, and has high turnover and low latency characteristics. High-frequency trading has played an important role in US stocks, futures, , foreign exchange and other markets. At its peak, its trading volume accounted for 50% of the three markets. In recent years, profit levels have declined due to the decline in overall market trading volume and liquidity, changes in regulatory policies and intensified competition in the track.
-
The high-frequency trading strategy capacity of the digital currency market is relatively small. The single team size is generally between dozens and hundreds of BTCs, and the yield ratio is relatively high. The usage scenarios are mainly market making and self-operated trading, and the scale effect of lack of funds . However, combining high-frequency strategy logic with other strategies to effectively prevent market and exchange risks in extreme market conditions will help quantitative strategies optimize combinations to create excess returns.
1. The definition, scale and current
high-frequency trading refers to the use of high-performance computers to conduct programmatic order trading, and capture the slight price difference between buying and selling of a trading target through large batches of order cancellations, and make profits in an extremely short period of time. In the United States, where finance is highly developed, its Securities and Exchange Commission (SEC) gave five summary of the characteristics of high-frequency trading in an official document in 2010:
1. Using a complex computer system with ultra-high speed
is different from traditional Internet companies that use scenarios for computer networks to handle high load and high concurrency. High-frequency trading systems have extremely high requirements for the low-latency characteristics of the network, that is, they can capture the information on the order book faster and analyze it, which will largely determine the profit level of this high-frequency trading system. In terms of program implementation, in order to improve the algorithm running speed, some instructions will be integrated into the computer system (the instruction interval is usually the order of milliseconds, and even microseconds can be reached). In the development of high-frequency systems, the underlying language C++, which runs faster, is mainly based on the fastest running language; in terms of hardware,
can use overclocking CPU, FPGA hardware acceleration, GPU parallel computing and other methods to improve overall performance.
In terms of communication networks, because the propagation rate of electromagnetic waves in quartz is only two-thirds of the propagation rate in the air, and the congestion of fiber optic networks will increase the delay, high-frequency trading will even abandon traditional fiber optic communications and instead use microwave and millimeter wave dedicated communication lines. As shown in the figure below, the green line in the figure represents the microwave circuits set up between urban clusters with dense fiber distribution (London and Frankfurt, Chicago and New York). Quincy data has been able to transmit the Aurora-based Chicago Mercantile Exchange trading data to Carterlett and Scox in New Jersey at a low latency of about 4 milliseconds.
Figure 1 Microwave communication network directly connected to the exchange with high-frequency trading Source: Quincy data
2. Data channel using co-location and direct connection to the exchange
The so-called co-location means that the servers and other hardware facilities of high-frequency companies need to be placed very close to the exchange host. Some exchanges even provide server hosting services for market makers near their server cluster . In this way, trading instructions do not need to be transferred through brokerage companies, and high-frequency trading companies will also see the information on the order book earlier than other market participants.
3. On average, each time holds positions is very short
In addition to low latency, another major feature of high-frequency trading is high turnover, which means that trading behaviors will occur very frequently and the position time is short to reduce risk exposure.
4, send and cancel entrusted orders in large quantities
High-frequency traders will process and judge every piece of information that appears on the order book, and set up corresponding positions in a targeted large number of orders. In some high-frequency strategies, traders will issue some order orders to explore other orders (such as iceberg strategies), or guide short-term price trend changes through large-scale order withdrawal operations to promote price discovery.
5. Basically, close the position at the close
Generally, high-frequency trading will close all positions (except for holding the bottom position) before the end of a trading day. On the one hand, holding positions overnight will increase the risk; on the other hand, it can greatly reduce the cost of holding positions (mainly overnight interest paid except margin positions).
Looking at the history of the development of high-frequency trading, it is not difficult to see that it is due to the policy adjustments of the regulatory authorities and the wide application of Internet technology in the financial industry. At first, New York Stock Exchange adopted manual matching order placing method, while Nasdaq market was mainly handled by its market makers. With the gradual rise of electronic automatic trading platforms, the number of customers participating in day trading has gradually increased, laying the foundation for the rise of high-frequency trading. With the improvement of several regulations issued by the SEC, the high-frequency trading market is becoming increasingly shape. The "Alternative Trading System Regulations" issued in 1998 has gradually become accepted by the market.
After that, through many ECN platforms, people did not need to place orders through market makers, and order information that could reflect the real market situation also entered the investors' horizons - this is undoubtedly a shocking change for high-frequency teams who like to study the microstructure of transactions. At that time, even the New York Stock Exchange and Nasdaq had to follow the torrent of history and devote themselves to the wave of electronic trading platform business. After entering 2000, the SEC stipulated that the minimum price change unit was changed from US$0.0625 to US$0.01. The increase in the price range gave more room for batch orders between selling one and buying one.
With the development of high-frequency trading, many traditional financial industry giants such as Goldman Sachs, JP Morgan, Merrill Lynch have entered this field, and the industry has a group of competitive legendary companies and hedge funds that support it - Renaissance Technologies, led by the father of quantitative Simmons , Virtu Financial, which is famous for its speed (only one day in the 1,485 trading days from 2009 to 2014), Citadel Securities, Two sigma, Jump Trade Co, GETCO, etc.
Since then, high-frequency trading ushered in a golden decade of rapid development in the US stock market. As shown in the blue histogram in the figure below, its trading volume, which accounted for only about 10% of the US stock market in 2005, gradually developed to account for 61% in 2009. In the futures and foreign exchange markets, according to data released by the Chicago Mercantile Exchange (CME) and Electronic Broking System in 2009, high-frequency trading also contributed at least 50% of the trading volume. The orange histogram in the picture represents the European market situation. Similar to the United States, high-frequency trading accounted for only 1% at the beginning, and 38% accounted for in 2010.
Figure 2 The transaction proportion of high-frequency trading in the United States and Europe between 2005 and 2014
However, since the peak of the trading volume in major markets in 2009, its trading volume proportion and profit level have a downward trend. According to the above figure, the proportion of high-frequency trading in the US market has dropped to 54% and 56% in 2010 and 2011; the European market has slightly delayed, and the scale of its high-frequency trading dropped to about 35% in 2012. According to Tabb Group data, the high-frequency team's full-year profit in 2016 has fallen sharply from the peak of US$7.2 billion in 2009 to US$1.1 billion.In addition to the decline in the average daily volatility of the market, the author speculates that the decline is mainly caused by the following reasons: the profit level of
-
high-frequency trading attracts a large number of financial technology teams into this field, making the track increasingly crowded and profits gradually divided; some high-frequency strategies of
-
threaten traditional asset management companies and hedge funds that believe in value investment or fundamental analysis. In addition, due to the introduction of domestic policies in the United States, it further suppresses them;
-
has caused overall market liquidity and trading volume to decline due to deleveraging.
high-frequency team has been exploring the European and American trading markets so far, and is gradually turning their attention to the "undeveloped" Chinese market. However, the trading rules and structures of the two markets are quite different. my country's A-share market implements a trading system of T+1 (different from the T+0 of the US stock market), making it impossible to complete the opening and closing position within the day. However, with the first trading open-end index fund (SSE 50 ETF) logged into the Shanghai Stock Exchange and the 2010 CICC opening stock index futures trading, the high-frequency team began to trade in ETF, commodity futures and stock index futures markets . It is not difficult to see from the previous development history that this type of trading strategy is deeply influenced by the trading structure and system of the market, and its domestic development will be restricted by the following conditions:
-
is different from foreign high-frequency companies that can set up data dedicated lines to directly connect to the exchange. Each order withdrawal of domestic traders must be transferred through securities companies, which will greatly reduce the low latency performance and lose the speed advantage.
-
transaction data is not granular enough. Domestic exchanges will only give TICK-level data and cannot obtain more detailed information on each order and order sheet.
-
Domestic regulatory policies are unclear, and trading behaviors that are suspected of guiding price trends such as large-scale orders and withdrawals are strictly controlled.
At present, there is still a long way to go for the development of high-frequency trading in the Chinese market.
2. High-frequency strategy classification and profit model
The reason why high-frequency trading can achieve profitability is the law of large numbers, that is, when we repeat a certain experiment in large quantities, the distribution of the results tends to a certain fixed value. In high-frequency trading, when the probability of each profit is greater than 50% (the winning rate of passive market making strategy will even reach 80%), even if the profit per transaction is meager, the expected return is positive after a large number of transactions are closed loop (buyed and sold again, and the total position remains unchanged) is completed. The profit methods of different high-frequency strategies are also different. The following will introduce several mainstream high-frequency strategies and their specific profit models.
1, passive market making strategy
The core idea of this strategy is that according to the principle of reverse selection, market makers insert both the buy order and the sell order at the front of the buy order sequence and the sell order sequence to become the new buy and sell order. Assuming that these two orders can be traded within a certain period of time, profits will be achieved without changing positions. The following figure in
is a schematic diagram of the order book. The real situation is often more complicated than here. The market making strategy will determine the price at which price is determined by combining the information of ten levels of buying and selling on the order book. Only 5 levels are left for schematic diagrams. In the market without a passive market making strategy, as shown in Figure 1, the bid-ask price difference is 100.2-99.5 = 0.7 yuan. At this time, if the market is determined to be a central oscillation, the high-frequency strategy will open a position and insert the order in Sell and Buy, as shown in the red order in Figure 2. High-frequency trading has huge advantages over manual traders in terms of speed. Therefore, if the manual trader cancels the order placed at the buy 2, 3/sell 2 and 3 and then cuts the line to the front of the commission sequence, the passive market making strategy will also withdraw the orders accordingly, and from the reverse selection principle, lower the price and place orders again, keeping the market making orders closest to the direction of price formation at all times, that is, being at the forefront of the commission sequence.
passive market making strategy is more suitable for central oscillating markets without obvious breakthrough trends. However, once the market breaks through unilaterally, it will cause market makers to deviate their positions. Either the bottom position is sold at a low price and cannot be taken back, or the price continues to fall after the purchase order is completed. At this time, the strategy must stop losses in time. As shown in the figure below, when we completed the 15-order orders under 100.1 in Figure 2, the price still rose and directly dropped the first to third and third levels. After rejudging the market information, it was learned that there was no hope of receiving 15 buy orders at 99.7 yuan. Removing the red four orders in Figure 3, and directly eating 15 orders sold for 100.45 yuan to complete the recoup, which is considered a stop loss trigger. Generally speaking, the winning rate of passive market making strategies can reach 80%, and the probability of stop loss is 20%.
passive market making is one of the main applications of high-frequency trading. When the price fluctuates within a range (no obvious trend), the high-frequency market maker will insert quotations that are more favorable to the buyer and seller between the markets of buying and selling, thereby promoting the transaction, that is, injecting liquidity into a certain securities by narrowing the market price difference. Although the profits of the market share are small, the winning rate is high, and considerable returns can be achieved under high frequency transactions; in more cases, the profits of the market making strategy come from the liquidity compensation provided by the exchange for the promotion of the transaction - returning a part of the handling fee as a commission.
2, directional strategy
is relatively stable in the market environment of passive market making strategy. Trend strategy is used in price reversal or breakout market trends. When high-frequency strategies detect external market information and learn that the event-driven market is coming, combined with the market data, a position will be established in advance, and the profit-taking and closing position will be completed when the market responds to the event and reflects the price. As shown in the figure below, suppose we judge that a downward trend is coming (it can be seen that the amount of selling orders on the market is large and dense), so we sell 100 lots first and then knock out all the buy ones and buy twos in Figure 4, and the remaining 1 lot is placed at the selling position at a price of 99.85. Because the market response is slow, we set up short positions in advance and wait for the price to fall. At this time, when other traders see that the downward trend has become, they will follow the reduction of positions. When the price falls to the position of buying four in Figure 5, the high-frequency strategy will take back the 100 lots sold at the high level at 99.4 yuan and close the position with profit. Of course, if you make a mistake in judging the market, you also need to stop the loss in time, that is, quickly buy back the short position and use the above sell orders to cover it.
In addition to the directional strategies triggered by event-driven, there are also two strategies for trend hiring to issue and instructions to take the lead. The instruction-leading strategy has another name in the academic community - predatory algorithm trading , that is, the high-frequency strategy will send small orders continuously before opening a position to test whether there are icebergs in the market to establish positions. If you find that there are continuous large-scale buy/sell orders at a certain price, you will use technical means to complete the position before the large order is completed, and wait until the price rises before distributing the chips to large orders that have not been successfully placed before. trend-induced strategy is also called fraudulent trading , which is easy to connect with market manipulation and becomes the target of supervision’s focus on investigation and punishment. The specific method is to place huge sell orders/buy orders and place small buy orders/sell orders at lows/highs. When other traders in the market see the information about the order thin, they will be affected by fear or greed to make trading behaviors of scrambling to sell/buy. In this way, small orders that have been ambushed in advance can be traded, and they can make profits and close positions after the trend returns to normal. The core idea of
directional strategy is basically to determine the direction of short-term high-probability price fluctuation after judging the order flow information or specific events, build positions in advance with the advantage of speed, and close the positions after the price fluctuates to the expected point. The reason why this strategy can make profit is that the research on the microstructure of the trading market (order thin information), event grasp and execution speed far overwhelm other participants. At the same time, due to order orders, emotions are not easily affected by fluctuations.
3. Structural strategy
is similar to the trend strategy to take the lead and cheat trading. Structural strategy is also about making a fuss about trading mechanisms, seizing the initiative, and more or less suspected of destroying the fairness of the trading market. As mentioned above, some high-frequency companies will place servers and other hardware facilities very close to the exchange host, and some exchanges even provide server hosting services for market makers near their server clusters. In this way, trading instructions not only do not need to be transferred through brokerage firms, but also high-frequency trading companies will also see the information on the order book earlier than other market participants. In addition, there were structural strategies such as "no audit path" and "lightning directives", but because it was too damaging market fairness, it was banned by by the US Securities Regulatory Commission around 2010.
4, arbitrage strategy
arbitrage can be roughly divided into cross-market arbitrage and cross-asset category arbitrage. In the US stock trading market, the same stock can be traded on different exchanges. When the price of the same asset on different exchanges occurs slight deviation, it will be quickly captured by the high-frequency team and complete arbitrage. What is more common are ETF arbitrage and stock index futures arbitrage, which also have very high requirements for speed, and the instructions are conveyed in the order of microseconds or even nanoseconds.
3. Advantages of high-frequency trading and risk
1. Advantages of high-frequency strategy
For funds that allocate high-frequency strategies to some assets, the profits generated are an important part of excess returns and will not conflict with other investment strategies, which plays a role in hedging risks. From the micro level of trading, high-frequency trading pays attention to the research on order thin information flow to an unrefined degree, so that high-frequency strategies can guide the price trend in the short term, make correct judgments and make profits; combined with its own hardware's speed advantages, they can often take the initiative and complete the action of building or closing positions before market participants.
For the overall market, the contribution of high-frequency strategies mainly includes the following aspects:
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stimulates trading desire by narrowing the price spread and increasing the real trading volume of the market to a certain extent.
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provides short-term impetus for price fluctuations in the trading market and can fill the gap so that the price will not deviate too far from the normal range in an instant.
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improves the overall trading efficiency of the market, catalyzes the iteration of computer software and hardware technology and feeds back to the financial industry.
2. Risks brought to the market by high-frequency trading
At around 11 a.m. on August 16, 2013, Everbright Securities issued more than 26,000 purchase orders, actively purchased ETF constituent stocks worth 23.4 billion yuan, with an actual transaction of 7.27 billion yuan; then converted 1.85 billion yuan into ETFs and sold them and issued more than 7,000 short orders for stock index futures. After this series of operations, the Shanghai Composite Index changed dramatically by 6% that day, triggering investigations from regulators and investors' attention, which is called the "Everbright Wrong Index Incident" in the industry. According to the self-inspection report of Everbright Securities, the reason is that the order generation module of its high-frequency arbitrage system mistakenly submitted more than 26,000 orders other than the actual order funds available to the order module, and there was no risk control alarm, which caused a subsequent shock. At that time, this incident not only unveiled the mystery of high-frequency arbitrage, but also brought high-frequency trading and the hidden risks it brought to Chinese regulators and market participants.
A misunderstanding incident that occurred in the United States in 2012 caused huge losses to Cavaliers Capital, a former industry leader. Due to the fact that during the upgrade of the high-frequency trading system, technicians did not upgrade a certain server, which caused them to send millions of abnormal orders to the market after the opening of the market on August 1, involving more than 150 stocks and triggering a circuit breaker mechanism. Some stocks were temporarily suspended and terminated trading. Afterwards, the New York Stock Exchange only canceled the day's trading of 6 stocks, and the remaining more than 140 stocks failed to be cancelled, which eventually led to a loss of 460 million US dollars in Cavaliers Capital, which was transferred to operating difficulties and was acquired by GETCO. To this day,
high-frequency trading seems to have been arousing people's reflection and criticism of the systemic risks it may bring.Berkshire Hathaway's head Buffett and Munger once publicly stated that high-frequency trading is like "rats in the barn", criticizing it for not bringing liquidity to the market, but only bringing trading volume. The rest of this chapter will discuss the risks brought to the market by high-frequency trading, the relationship between trading volume and liquidity, and other issues.
brings us back to May 6, 2010. Several major indexes such as the Dow Jones, S&P, etc. in the US stock market plummeted by more than 9% in a short period of time. Although the price gradually recovered in the rest of the trading day, and it closed down only about 3% from the previous day, this incident shocked the whole of the United States, known as the "Flash Crash" in history.
Figure 3 May 6, 2010 US Dow Jones Index K-line chart Source: Futu Securities
The US Securities and Exchange Commission conducted a comprehensive investigation of the flash crash afterwards. The conclusions drawn can better help us understand what contributions high-frequency trading has in providing liquidity. As shown in the left figure below, the red curve represents the change in the trading volume of the S&P 500 futures on the day, the blue curve represents the change in the futures price, and the right figure represents the change curve of the number of pending orders. We can clearly see at 14:45 when the flash crash occurred, the trading volume surged but the market depth dropped sharply, and the order for the commission even dropped to 0. With the support of the market making strategy, why did the market quota draw to a vacuum and there was no liquidity in an instant?
Figure 4 S&P 500 futures trading volume and price trend chart Source: Bloomberg
Figure 5 S&P 500 futures trading orders trend chart Source: Bloomberg
In May of that year, under the negative sentiment of the European debt crisis, the capital market was tight and sensitive. When an institution trader decided to place a short order of 75,000 lots for hedging, an unexpected flash crash occurred. As usual, due to the existence of high-frequency market makers, such "small" positions will definitely be accepted as the orders. After judging the order book information and market sentiment on the spot, the high-frequency strategy can decide to adopt the "quotation without transaction intention" plan, or to avoid the stock price falling sharply, the market-making position will be trapped and directly adopt the "not making market" strategy. The exit of market makers has led to the instantaneous depletion of liquidity in the market, and the depth of the market has deteriorated. A small number of sell orders can also smash several levels of the buy orders, and the stock price fell sharply in an instant. At this point, we can see that targets with large trading volume do not necessarily have greater liquidity and real trading demand. The role of high-frequency trading in the market is to provide trading convenience such as smaller price spreads for real demand, rather than the fundamental reason for price declines. As for whether high-frequency trading can boost the large fluctuations in price, there has been controversy in the academic community.
is similar to Buffett and Munger's view on high-frequency trading. Some scholars believe that high-frequency teams influence price changes through fraudulent transactions and other means, thus depriving other traders on the market of profits. Jonathan Brogaard said in an academic paper published in 2018 that high-frequency trading truly provides liquidity to the market and narrows the bid and offer price difference; high-frequency trading is not the price, but quantity, so there is no voice in the academic community about high-frequency strategies - targeted harvesting of fundamental investors through price competition.
Brogaard selected the order-blank data of 279 large-cap stocks from Canada's second largest trading platform, Alpha Exchange, from 2008 to 2012 as the research object. At the same time, in order to more accurately characterize the market situation, similar data from the Canadian TSX Exchange was selected as a reference. The following two pictures show the situation where high-frequency market makers have entered the platform one after another in the past three years. The picture on the left shows the number of merchants that provide market-making for each stock during the sampling time, and the picture on the right shows the date distribution chart of high-frequency traders entering the Alpha platform.
Figure 6 2008-2012 provides the number of merchants for each stock
Figure 7 Date distribution map of high-frequency traders entering the Alpha platform
then uses the double-scoring method (difference-in-difference, DID) to process the data, and analyze the liquidity changes before and after the entry of high-frequency market makers. As shown in the figure below, as the number of market makers entering increased, the bid and offer price spreads on the same stock of the two exchanges gradually narrowed but eventually remained basically the same. This process also led to the intensification of competition among market makers. finally concluded that high-frequency trading can effectively improve market liquidity and reduce price volatility at the same time.
Figure 8 The bid and offer price difference between the same target of the two exchanges
Until now, the outside world's attitude towards high-frequency trading is still mixed. People are surprised by its investment scale and profitability, and are also afraid of the "black swan event" it may bring to the system again. Although every instruction and every algorithm of high-frequency trading are completed by machines, how to improve risk control capabilities, reduce system loopholes or think about changes in trading systems and transaction structures is what people should do.
4. High-frequency trading in the crypto asset market
various strategy types of high-frequency trading can be applied in the digital currency market, and its strategy logic and profit model are basically the same as those of the traditional trading market. Moreover, for high-frequency strategies, the digital currency market has fewer trading restrictions, stronger market invalidity, and the difficulty of making profits for high-frequency trading strategies is also lower, and the return level is higher.
In order to improve liquidity level and trading volume, digital currency exchanges usually provide a variety of subsidies and preferential convenience policies to high-frequency trading teams, such as extremely low handling fees and even negative handling fees, as well as providing co-location and lifting API trading frequency restrictions for high-frequency market makers under the exchange server cluster. For smaller exchanges, you also need to pay to hire a high-frequency market maker team to provide liquidity services to the exchange. However, for teams oriented towards high-frequency strategy profitability, general trading venues will also choose large trading platforms with better liquidity and accumulated retail traders to deploy their strategies.
Figure 9 Digital currency exchange handling fees and delivery rates list
Figure 10 Digital currency exchange high-frequency market maker handling fees discount
Due to the small overall market value of crypto assets, the capacity of high-frequency trading strategies in the crypto asset market is mostly small, mainly based on market making strategies and cross-platform liquidity arbitrage strategies, and the strategy capacity is generally between dozens and hundreds of BTC. Due to the exchange's few transaction restrictions on high-frequency quantization and the various conveniences provided by the high-frequency quantization team to meet the exchange's own liquidity needs, the high-frequency quantization strategy has a much higher yield and Sharpe ratio in the crypto asset market than other quantitative strategies. , however, due to the limitation of high-frequency strategy capacity, the quantitative team is generally self-operated and does not accept external investment, so the scale effect of funds is difficult to achieve.
In addition to this, exchange failures in the case of market fluctuations are also a major hidden danger to high-frequency quantitative strategies. When extreme market conditions occur, high-frequency strategies generally take measures to withdraw orders to avoid position deviation due to excessive price fluctuations and ensure position balance. Due to the withdrawal of high-frequency market makers and arbitrage teams, the liquidity of the exchange market will be instantly taken to cause greater price fluctuations, and other traders' trading slippage will be higher, further aggravating price changes. The emergence of a large number of trading instructions and liquidation of positions will also cause the exchange server to be overloaded or downtime, resulting in delays in API query, trading and other instructions. The impact of small delays on low-frequency quantization strategies may be small, but the impact of API delays on high-frequency strategies will be huge, which will lead to the high-frequency strategies incorrectly executing a large number of loss-making orders in a short period of time. Sometimes API failures can lead to the inability to place orders, withdraw orders and close transactions in trading strategies. Position uneven among multiple exchanges creates risks, and the sharing of positions across positions further reduces the profits of the strategy, which may eventually lead to huge losses in the strategy.
Figure 11 The sharp fluctuations in the market on March 12 resulted in a major slippage. Source: skew
Conclusion
High-frequency trading strategy, as an important part of the secondary market, plays an important role in stocks, futures, foreign exchange and other markets. It is also because of the increase in high-frequency trading participants in traditional financial markets and the regulatory restrictions that have caused some high-frequency teams to be squeezed out, thus entering the digital currency market. For high-frequency strategies, the digital currency market is relatively small and the possibility of extreme risks is high. Pure high-frequency strategies are more suitable for small capital and self-operated management. The increase in high-frequency track traders further lead to strategic congestion, making it more difficult to form a scale effect.However, combining high-frequency strategy logic with other strategies to effectively prevent market and exchange risks in extreme market conditions will help quantitative strategies optimize combinations to create excess returns.
Reference materials:
. Will high-frequency trading practices transform the financial markets in the Asia Pacific Region? Kauffman, Hu and Ma. High-Frequency Trading Competition, Jonathan Brogaard, Corey Garriott February 16, 2018 Introduction to BlockVC
BlockVC is affiliated with the global digital asset management group BVC Group is the world's leading blockchain venture capital institution, covering early-stage seed investment, venture capital, private equity investment, project incubation acceleration and global compliance.
BlockVC is committed to "bringing blockchain into the mainstream", actively deploying infrastructure construction including basic public chains, application protocols and financial services, and actively promoting crypto asset compliance and regulatory services around the world, thus establishing an investment matrix and ecological layout with full industrial chain and global influence. The core team of
BlockVC is distributed in many countries and regions such as North America, Singapore, Beijing, Hong Kong and Japan. The members are from Credit Suisse, Morgan Stanley, CIT Group, Tiger Securities, Stanford, MIT, Peking University and Tsinghua University, etc., and have professional experience in finance, the Internet, blockchain and other fields.
(1. The content comes from the open platform of Liandede content "Dedeha". The content of the manuscript only represents the author's views and does not represent the official position of Liandede. 2. For any article "Dedeha", the originality and authenticity of the content are guaranteed by the contributor. If the legal consequences of the manuscript caused by plagiarism, fraud and other behaviors, the contributor himself shall be responsible. 3. If the article is published by the Dedeha platform, if there is any infringement, violation or other improper remarks, please supervise the readers. Once confirmed, the platform will be offline immediately. If there is any problem with the article content, please send it to the email address: [email protected])
However, combining high-frequency strategy logic with other strategies to effectively prevent market and exchange risks in extreme market conditions will help quantitative strategies optimize combinations to create excess returns.Reference materials:
. Will high-frequency trading practices transform the financial markets in the Asia Pacific Region? Kauffman, Hu and Ma. High-Frequency Trading Competition, Jonathan Brogaard, Corey Garriott February 16, 2018 Introduction to BlockVC
BlockVC is affiliated with the global digital asset management group BVC Group is the world's leading blockchain venture capital institution, covering early-stage seed investment, venture capital, private equity investment, project incubation acceleration and global compliance.
BlockVC is committed to "bringing blockchain into the mainstream", actively deploying infrastructure construction including basic public chains, application protocols and financial services, and actively promoting crypto asset compliance and regulatory services around the world, thus establishing an investment matrix and ecological layout with full industrial chain and global influence. The core team of
BlockVC is distributed in many countries and regions such as North America, Singapore, Beijing, Hong Kong and Japan. The members are from Credit Suisse, Morgan Stanley, CIT Group, Tiger Securities, Stanford, MIT, Peking University and Tsinghua University, etc., and have professional experience in finance, the Internet, blockchain and other fields.
(1. The content comes from the open platform of Liandede content "Dedeha". The content of the manuscript only represents the author's views and does not represent the official position of Liandede. 2. For any article "Dedeha", the originality and authenticity of the content are guaranteed by the contributor. If the legal consequences of the manuscript caused by plagiarism, fraud and other behaviors, the contributor himself shall be responsible. 3. If the article is published by the Dedeha platform, if there is any infringement, violation or other improper remarks, please supervise the readers. Once confirmed, the platform will be offline immediately. If there is any problem with the article content, please send it to the email address: [email protected])
