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100% found this document useful (1 vote)
287 views20 pages

Risk HFT Flyer

hft risk

Uploaded by

Yongho Shin
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PDF, TXT or read online on Scribd
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High-Frequency Trading
New Realities for Traders, Markets and Regulators

Edited by David Easley, Marcos López de Prado and


Maureen O’Hara

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Published by Risk Books, a Division of Incisive Media Investments Ltd

Incisive Media
32–34 Broadwick Street
London W1A 2HG
Tel: +44(0) 20 7316 9000
E-mail: [email protected]
Sites: www.riskbooks.com
www.incisivemedia.com

© 2013 Incisive Media Investments Limited


ISBN 978-1-78272-009-6
British Library Cataloguing in Publication Data
A catalogue record for this book is available from the British Library

Publisher: Nick Carver


Commissioning Editor: Sarah Hastings
Managing Editor: Lewis O’Sullivan
Editorial Development: Sarah Hastings
Designer: Lisa Ling
Copy-edited and typeset by T&T Productions Ltd, London
Printed and bound in the UK by Berforts Group

Conditions of sale
All rights reserved. No part of this publication may be reproduced in any material form whether
by photocopying or storing in any medium by electronic means whether or not transiently
or incidentally to some other use for this publication without the prior written consent of
the copyright owner except in accordance with the provisions of the Copyright, Designs and
Patents Act 1988 or under the terms of a licence issued by the Copyright Licensing Agency
Limited of Saffron House, 6–10 Kirby Street, London EC1N 8TS, UK.
Warning: the doing of any unauthorised act in relation to this work may result in both civil
and criminal liability.
Every effort has been made to ensure the accuracy of the text at the time of publication, this
includes efforts to contact each author to ensure the accuracy of their details at publication
is correct. However, no responsibility for loss occasioned to any person acting or refraining
from acting as a result of the material contained in this publication will be accepted by the
copyright owner, the editor, the authors or Incisive Media.
Many of the product names contained in this publication are registered trade marks, and Risk
Books has made every effort to print them with the capitalisation and punctuation used by the
trademark owner. For reasons of textual clarity, it is not our house style to use symbols such
as TM, ®, etc. However, the absence of such symbols should not be taken to indicate absence
of trademark protection; anyone wishing to use product names in the public domain should
first clear such use with the product owner.
While best efforts have been intended for the preparation of this book, neither the publisher,
the editor nor any of the potentially implicitly affiliated organisations accept responsibility
for any errors, mistakes and or omissions it may provide or for any losses howsoever arising
from or in reliance upon its information, meanings and interpretations by any parties.

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Contents

About the Editors vii

About the Authors ix

Preface xv

1 The Volume Clock: Insights into the High-Frequency Paradigm 1


David Easley; Marcos López de Prado; Maureen O’Hara
Cornell University; RCC at Harvard University;
Cornell University

2 Execution Strategies in Equity Markets 21


Michael G. Sotiropoulos
Bank of America Merrill Lynch

3 Execution Strategies in Fixed Income Markets 43


Robert Almgren
Quantitative Brokers LLC; New York University Courant
Institute of Mathematical Sciences

4 High-Frequency Trading in FX Markets 65


Anton Golub, Alexandre Dupuis, Richard B. Olsen
Olsen Ltd

5 Machine Learning for Market Microstructure and


High-Frequency Trading 91
Michael Kearns and Yuriy Nevmyvaka
University of Pennsylvania

6 A “Big Data” Study of Microstructural Volatility in


Futures Markets 125
Kesheng Wu, E. Wes Bethel, Ming Gu, David Leinweber, Oliver Rübel
Lawrence Berkeley National Laboratory

7 Liquidity and Toxicity Contagion 143


David Easley; Marcos López de Prado; Maureen O’Hara
Cornell University; RCC at Harvard University;
Cornell University

8 Do Algorithmic Executions Leak Information? 159


George Sofianos, JuanJuan Xiang
Goldman Sachs Equity Execution Strats

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9 Implementation Shortfall with Transitory Price Effects 185


Terrence Hendershott; Charles M. Jones; Albert J. Menkveld
University of California, Berkeley; Columbia Business School;
VU University Amsterdam

10 The Regulatory Challenge of High-Frequency Markets 207


Oliver Linton; Maureen O’Hara; J. P. Zigrand
University of Cambridge; Cornell University; London School of
Economics and Political Science
Index 231

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About the Editors

David Easley is the Henry Scarborough professor of social science,


professor of economics and professor of information science at Cor-
nell University. He served as chair of the Cornell economics depart-
ment from 1987 to 1993 and 2010 to 2012. He is a fellow of the Econo-
metric Society and has served as an associate editor of numerous
economics journals. David recently co-authored the book Networks,
Crowds and Markets: Reasoning About a Highly Connected World, which
combines scientific perspectives from economics, computing and
information science, sociology and applied mathematics to describe
the emerging field of network science.
Marcos López de Prado is head of quantitative trading and research
at HETCO, the trading arm of Hess Corporation, a Fortune 100 com-
pany. Previously, Marcos was head of global quantitative research
at Tudor Investment Corporation, where he also led high-frequency
futures trading. In addition to more than 15 years of investment man-
agement experience, Marcos has received several academic appoint-
ments, including postdoctoral research fellow of RCC at Harvard
University, visiting scholar at Cornell University, and research affil-
iate at Lawrence Berkeley National Laboratory (US Department of
Energy’s Office of Science). Marcos holds two doctorate degrees from
Complutense University, is a recipient of the National Award for
Excellence in Academic Performance (Government of Spain), and
was admitted into American Mensa with a perfect test score.
Maureen O’Hara is the Robert W. Purcell professor of finance at the
Johnson Graduate School of Management, Cornell University. Her
research focuses on market microstructure, and she is the author of
numerous journal articles as well as the book Market Microstructure
Theory. Maureen serves on several corporate boards, and is chairman
of the board of ITG, a global agency brokerage firm. She is a mem-
ber of the CFTC-SEC Emerging Regulatory Issues Task Force (the
“flash crash” committee), the Global Advisory Board of the Securi-
ties Exchange Board of India (SEBI) and the Advisory Board of the
Office of Financial Research, US Treasury.

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About the Authors

Robert Almgren is a co-founder of Quantitative Brokers, which pro-


vides agency algorithmic execution and cost measurement in interest
rate markets. He is a Fellow in the mathematics in finance program
at New York University. Until 2008, Robert was a managing director
and head of quantitative strategies in the electronic trading services
group of Banc of America Securities. From 2000 to 2005 he was a
tenured associate professor of mathematics and computer science at
the University of Toronto, and director of its Master of Mathemati-
cal Finance program. He has an extensive research record in applied
mathematics, including papers on optimal trading, transaction cost
measurement and portfolio construction.

E. Wes Bethel is a senior computer scientist at Lawrence Berkeley


National Laboratory, where he conducts and manages research in
the area of high performance visualisation and analysis. He is a
member of IEEE and a Distinguished Scientist of the Association
for Computing Machinery. He has a PhD in computer science from
the University of California, Davis.

Alexandre Dupuis has worked at OLSEN since 2006 and is head of


the quantitative research unit Romandy. His focus lies in researching
and developing trading models as well as creating risk-management
tools. Alex is a member of the risk-management team where he
controls a third of the investment portfolio. In collaboration with
universities, he supervises PhD students in the field of quantitative
finance. Alex holds a PhD in computer science from the University
of Geneva and has gained further research experience by working
at the University of Oxford and at ETH.

Anton Golub has worked at OLSEN since the summer of 2012 as


a member of the research team. He performs research in the field
of market micro-structure, leveraging the methodology developed
at OLSEN. Anton previously worked at the Manchester Business
School as a researcher on high-frequency trading, market micro-
structure and flash crashes. In 2012, he was invited to participate
in an international project on computerised trading funded by the

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UK Treasury. He holds a MSc degree in Financial and Business


Mathematics from the University of Zagreb.
Ming Gu is a professor of applied mathematics at the University
of California at Berkeley, a position he has held since 2006. Prior
to joining Berkeley, he was a professor of applied mathematics at
University of California Los Angeles. Ming holds a PhD in computer
science from Yale University and a BS in mathematics from Nanjing
University in China.
Terrence Hendershott completed his PhD at the graduate school
of business at Stanford University and is the Cheryl and Christian
Valentine Chair as an associate professor at the Haas School of Busi-
ness at the University of California at Berkeley. His research interests
include information technology’s impact and role in financial mar-
kets and the structure and regulation of financial markets. His writ-
ing has appeared in national newspapers and magazines, and his
academic work has been published in numerous scholarly journals.
He has consulted for various financial markets and investment firms.
Charles M. Jones is the Robert W. Lear professor of finance and
economics and the director of the program for financial studies at
Columbia Business School, where he has been on the faculty since
1997. Charles studies the structure of securities markets, and he is
particularly noted for his research on short sales, algorithmic trad-
ing, liquidity and trading costs. His published articles have won a
number of best paper awards. He received an undergraduate degree
in mathematics from MIT in 1987, and he completed his PhD in
finance at the University of Michigan in 1994.
Michael Kearns is professor of computer and information science at
the University of Pennsylvania, where he holds secondary appoint-
ments in the statistics and operations and information management
departments of the Wharton School. His research interests include
machine learning, algorithmic game theory, quantitative finance and
theoretical computer science. Michael also has extensive experience
working with quantitative trading and statistical arbitrage groups,
including at Lehman Brothers, Bank of America and SAC Capital.
David Leinweber was a co-founder of the Center for Innovative
Financial Technology at Lawrence Berkeley National Laboratory.
Previously, he was visiting fellow at the Hass School of Business and

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ABOUT THE AUTHORS

at Caltech. He was the founder of Integrated Analytics Corporation,


with was acquired by Jefferies Group and spun off as Investment
Technology Group (NYSE: ITG). At First Quadrant, he was manag-
ing director, responsible for quantitative management of over US$6
billion in global equities. In 2011, he was named one of the top 10
innovators of the decade by Advanced Trading magazine. David holds
undergraduate degrees in computer science and physics from MIT
and a PhD in applied mathematics from Harvard University.

Oliver Linton holds the chair of political economy at Cambridge


University and is a fellow of Trinity College. He is a Fellow of the
Econometric Society, of the Institute of Mathematical Statistics and
of the British Academy. His research has mostly been about econo-
metric methodology applied to financial data. He served as an expert
witness for the Financial Services Authority on a market abuse case
in 2012. He was a member of the Lead Expert Group for the Govern-
ment Office for Science project “The Future of Computer Trading in
Financial Markets”, published in November 2012.

Albert J. Menkveld is professor of finance at VU University Amster-


dam, and research fellow at the Tinbergen Institute and the Duisen-
berg School of Finance. In 2002, he received his PhD from Erasmus
University Rotterdam. He visited the Wharton School of the Univer-
sity of Pennsylvania in 2000, Stanford University in 2001 and New
York University in 2004/5 and 2008–11. Albert’s research focuses
on securities trading, liquidity, asset pricing and financial econo-
metrics. He has published in the Journal of Finance, Journal of Business
and Economic Statistics and Journal of Financial and Quantitative Analy-
sis, among others. He has been a member of the Group of Economic
Advisors of the European Securities and Market Authority (ESMA)
since 2011.

Yuriy Nevmyvaka has extensive experience in quantitative trad-


ing and statistical arbitrage, including roles as portfolio manager
and head of groups at SAC Capital, Bank of America and Lehman
Brothers. He has also published extensively on topics in algorithmic
trading and market microstructure, and is a visiting scientist in the
computer and information science department at the University of
Pennsylvania. Yuriy holds a PhD in computer science from Carnegie
Mellon University.

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Richard B. Olsen founded OLSEN in 1985 and is chief executive offi-


cer. He oversees all portfolio investments as part of a comprehensive
risk-management process and is involved in the ongoing develop-
ment of trading models. Richard has written and co-authored many
scientific papers and published a book, numerous articles and opin-
ion pieces on a variety of topics. Richard’s unorthodox but com-
pelling ideas have made him a very welcome speaker at conferences
around the world. His goal is “to create tools of finance that are
as slick and elegant as the most sophisticated tools of technology”.
Richard holds a Licentiate in Law from the University of Zurich, a
Masters in economics from Oxford University and a PhD from the
University of Zurich. He worked as researcher and foreign exchange
dealer before founding OLSEN.
Oliver Rübel is a member of the Lawrence Berkeley National Lab-
oratory Visualization Group and a member of the NERSC Analytics
team. He received his PhD in computer science in 2009 from the
University of Kaiserslautern, Germany. His research has focused on
high-performance data analysis and visualisation, machine learn-
ing and query-driven visualisation of multi-dimensional scientific
data. During his career, Oliver has worked closely with applica-
tions including high-energy physics, climate science and biological
sciences.
George Sofianos joined Goldman Sachs in 2001 and is a vice pres-
ident in the firm’s Equity Execution Strats group. Prior to joining
Goldman Sachs, he was head of research at the New York Stock
Exchange. George also worked at the Federal Reserve Bank of New
York, in the financial studies department and at the open markets
desk. He began his career teaching finance at the Stern Graduate
School of Business, New York University. George has published
research on execution strategies, trading costs, market structure,
the cross-listing and trading of non-US stocks, market-maker trad-
ing behaviour, stock-price behaviour on expirations, the impact of
program trading on intraday stock-price volatility and index arbi-
trage. He holds BSc and MSc degrees from the London School
of Economics, and received his PhD in economics from Harvard
University. He is an associate editor of the Journal of Trading.
Michael G. Sotiropoulos is the global head of algorithmic trading
quantitative research at Bank of America Merrill Lynch. His group

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ABOUT THE AUTHORS

supports the global execution services business, and focuses on mar-


ket microstructure and electronic trading research and development.
Michael joined Bank of America in 2004 as an equity derivatives
quant, after spending three years at Bear Stearns in the same role.
He was head of equities quantitative research for year 2008 before
moving to algorithmic trading. He has a PhD in theoretical physics
from SUNY Stony Brook. Prior to joining the finance industry he
taught and worked in quantum field theory and particle physics at
the University of Southampton and at the University of Michigan.
Kesheng (John) Wu is director of CIFT (Computational Infra-
structure for Financial Technology) at Lawrence Berkeley National
Laboratory, where he works on applying high-performance comput-
ing techniques to the analysis of high-frequency trading data. He
also works on a range of topics in scientific data management, data
analysis and distributed computing. Examples of his work include
bitmap-indexing techniques for searching large datasets, restarting
strategies for computing extreme eigenvalues, and connected com-
ponent labelling algorithms for image analysis. Many of these algo-
rithms are available in open-source software packages, including
FastBit indexing tool and TRLan eigenvalue tool. John earned a
PhD from University of Minnesota. He is a senior member of the
IEEE and a Distinguished Scientist of the Association for Computing
Machinery.
JuanJuan Xiang joined Goldman Sachs in 2010 and is a vice president
in the firm’s Equity Execution Strats group. Prior to joining Goldman
Sachs, she was a digital signal processing engineer at Starkey Labo-
ratory. She holds BSc and MSc degrees from Huazhong University of
Science and Technology, and received her PhD in electrical and com-
puter engineering from the University of Maryland–College Park.
Jean-Pierre Zigrand is director of the ESRC-funded Systemic Risk
Centre at the London School of Economics and Political Science
(LSE). He is also an associate professor of finance at the LSE, a pro-
gramme director at the financial markets group and the director of
the executive MSc finance programme at LSE. Jean-Pierre has been
a lead expert for the Foresight Project on The Future of Computer
Trading in Financial Markets. He holds a PhD in economics from
the University of Chicago and a BSc and MSc in economics from the
Université Catholique de Louvain.

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Preface

High-frequency trading (HFT) is now the norm for trading finan-


cial assets in electronic markets around the world. Be it in equities,
foreign exchange, futures or commodities, high-frequency traders
provide not only the bulk of volume in these markets, but also
most liquidity provision. In so doing, high-frequency trading has
changed how individual markets operate and how markets dynam-
ically interact. In this book, we give a comprehensive overview of
high-frequency trading, and its implications for investors, market
designers, researchers and regulators.
Our view is that HFT is not technology run amok, but rather a
natural evolution of markets towards greater technological sophis-
tication. Because markets have changed, so, too, must the way that
traders behave, and the way that regulators operate. Low-frequency
traders (shorthand for everyone who does not have their own high-
performance computers and co-located servers) need to understand
how high-speed markets work in order to get effective execution,
minimise trade slippage and manage risk. Regulators, who face
the daunting task of crafting new rules and regulations for high-
frequency environments, need to understand better how and why
high-frequency markets falter. Perhaps most importantly, individual
investors need to understand that high-frequency markets need not
be the milieu of Terminator-like adversaries, but rather, with care-
ful design and regulation, can be venues in which they can trade at
lower costs and better prices than ever before.
The chapters in this book take on many facets of high-frequency
trading, but for any of them to make sense it is important for our
readers to understand some basic features of high-frequency trading.
First, HFT is microstructure based, and it operates to exploit the inef-
ficiencies in how markets operate. A market’s microstructure refers
to the rules and design of the trading platform. All microstructures
have inefficiencies arising, for example, from tick size specifications,
matching engine protocols or latency issues in sending orders both
within and across markets.1 By exploiting these inefficiencies, at its
best HFT lowers transaction costs and enhances market efficiency; at
its worst, HFT takes advantage of resting orders, “simple-minded”

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trading algorithms and pricing conventions to transfer profits from


low-frequency traders to high-frequency traders. The latter outcome
arises because HFT is also strategy based: it is designed to take
advantage of predictable behaviours in markets. Thus, momentum
ignition strategies or attempts to move quote midpoints artificially
are all designed to fool and exploit “uninformed” traders, who rely
on simple trading rules and strategies.
A third feature of HFT is that it uses a new type of information.
Traditionally, informed traders in markets were those who had bet-
ter information on asset fundamentals, but HFT information relates
to the trading process and not to the asset itself. At longer time hori-
zons, fundamental information predominates in determining asset
prices, but in the very short run it is trading information that mat-
ters. Thus, information on order flows, the structure of the book
or the “toxicity” of the market can all help a high-frequency trader
predict where market prices are going both in a single market and
across markets. This trading information is useful because of the
millisecond speed at which HFT algorithms operate. Consequently,
to shave a few milliseconds off order transmission, it becomes opti-
mal to spend hundreds of millions of US dollars to lay a new cable
underneath the Atlantic Ocean (as was done in Project Hibernia)
or to build towers between New Jersey and Chicago (as is being
done in a joint project between Nasdaq and the CME) to send
orders via microwaves, thereby improving transmission speed rela-
tive to ground-based fibre-optic cables. It is only natural to question
whether such expenditures are socially optimal.
It would be a mistake, however, to believe that HFT is only about
speed. There have been, and always will be, some traders who
are faster than others. In today’s markets, distinctions are being
drawn between algorithmic traders (machines that are programmed
to follow specific trading instructions), high-frequency traders (also
machines but typically faster than algorithmic traders and may have
more complex trading behaviours) and ultra-high-frequency traders
(machines that use the fastest supercomputers, lowest latency link-
ages, etc). Indeed, it is safe to say that the latencies of the larger
broker/dealer firms are now at the levels HFT firms were at just one
or two years ago. The speed differentials between different trader
groups will continue to decrease, but the strategic nature of HFT will
remain as an important differentiator in markets.

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It would also be a mistake to assume that all HFT strategies


are the same. Just as markets, and their microstructures, differ, so
too do the behaviours of high-frequency traders. Strategies that
are optimal in short-term interest rate futures, for example, are
very different from strategies that are successfully deployed in
equity markets. Moreover, these strategies are constantly evolving as
high-frequency traders employ more complex and technologically
advanced approaches to trade within and across markets.
These two points are the subject of the first four chapters of the
book. David Easley, Marcos López de Prado and Maureen O’Hara
argue in Chapter 1 that HFT is not simply faster trading, but
instead represents a new paradigm for trading financial assets. This
paradigm is volume-based, reflecting that machines operate not on
a time basis but rather on an event basis. Recognising this new
paradigm is crucial for understanding why high-frequency mar-
kets are not just the same old markets “on steroids”. These authors
explain how, acting strategically, high-frequency algorithms interact
with exchange-matching engines to exploit inefficiencies in markets
and predictabilities in other traders’ behaviours. This chapter sets
the stage for understanding how high-frequency trading affects low-
frequency traders, and it suggests strategies that LFTs should adopt
to thrive in this environment.
Chapters 2–4 then discuss in detail how high-frequency trad-
ing “works” in equity markets, fixed-income futures markets and
foreign exchange markets. Their authors discuss the particular
strategies used and how these strategies have evolved over time.
In Chapter 2, Michael G. Sotiropoulos describes how equity trading
algorithms work and how they can be structured to meet the needs of
a wide variety of market participants. He discusses how trading has
evolved from simple deterministic trade algorithms, such as volume
weighed average price (VWAP), to new adaptive algorithms that
adjust trading speeds to a variety of high-frequency indicators such
as queuing time and order book imbalance. Sotiropoulos also dis-
cusses how incorporating order protection strategies into adaptive
algorithms can minimise transaction costs for low-frequency traders.
In Chapter 3 Robert Almgren examines the distinctive features
of trading futures on interest rate products. Fixed-income trading
algorithms must have special defensive features built in to protect
the trader from the shocks arising from public information events

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such as Treasury auction results or scheduled government data


releases. Moreover, fixed-income futures are cointegrated, meaning
that individual contracts are not independent of other contracts due
to linkages with the term structure, varying maturities, and the like.
Thus, algorithmic strategies must take account of the inherent ten-
dency for prices to move congruently. Almgren describes analytical
approaches to characterising cointegration and how this can be used
for price prediction. He also highlights the role played by priority
rules in affecting trading strategies.
In Chapter 4, Anton Golub, Alexandre Dupuis and Richard B.
Olsen describe the unique market structure of foreign exchange (FX)
trading and the main algorithms used in the industry. FX markets
feature a spectrum of traders from manual traders (ie, humans using
a graphical user interface) to ultra-high-frequency traders submit-
ting (and cancelling) thousands of orders over millisecond ranges.
This chapter highlights the different roles played by these traders,
and in particular draws attention to the changing composition of
trading during periods of market instability. Olsen et al also sug-
gest a new priority rule to enhance market liquidity production and
stability.
Having established the basic frameworks used in high-frequency
trading, we then turn in Chapters 5 and 6 to the foundations of
high-frequency trading by examining the roles of machine learning
and “big data”. In Chapter 5, Michael Kearns and Yuriy Nevmy-
vaka discuss the role that machine learning plays in developing
predictive algorithms for high-frequency trading. Machine learning
is an area of computer science that draws on research in statistics,
computational complexity, artificial intelligence and related fields to
build predictive models from large data sets. Kearns and Nevmy-
vaka demonstrate how techniques such as reinforcement learning
can determine optimal dynamic state-based policies from data; for
example, such an approach could be used to determine an optimal
execution algorithm that decides whether to slow down or speed
up trading depending upon current microstructure data. They also
show how machine learning can use order book data to predict
future price movements. This chapter, while showcasing the exten-
sive technological sophistication underlying high-frequency trad-
ing, also makes clear the role that “human inputs” have in designing
such analytical tools.

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In Chapter 6, Kesheng Wu, E. Wes Bethel, Ming Gu, David


Leinweber and Oliver Rübel look at another dimension of high-
frequency trading: the role of “big data”. Algorithmic and high-
frequency trading generate massive amounts of hard-to-process
data. Some of this comes from trade executions, but a much greater
amount arises from the placement and cancellation of orders both
within and across markets. Handling, let alone analysing, such mas-
sive databases (which can be of the order of a petabyte) is almost
impossible using standard data management techniques. Wu et al
discuss how new file formatting and computational techniques can
be applied to high-frequency trading data. They use these techniques
to test the predictive ability of VPIN, a measure of order toxicity, for
future volatility.2 Their results illustrate how “big data” can play a
critical role in testing new risk-management tools for high-frequency
markets.
The remaining four chapters focus on the implications of high-
frequency trading for markets, traders and regulators. In Chapter 7,
David Easley, Marcos López de Prado and Maureen O’Hara exam-
ine how volatility contagion can take place across markets. High-
frequency market makers often engage in inter-market arbitrage, a
strategy in which market makers “lift” liquidity by placing bids in
one market and asks in another. Easley et al show how this results
in order toxicity spreading across markets, which in turn results in
volatility contagion. Using data from energy futures, they demon-
strate that these contagion effects can be sizeable. These results show
that the volatility process in high-frequency markets is now interde-
pendent across markets, a result of interest to both researchers and
regulators.
George Sofianos and JuanJuan Xiang consider in Chapter 8 the
challenges facing low-frequency traders in markets with high-
frequency traders. Trading algorithms are designed to minimise a
trade’s execution cost, and they generally do so by splitting orders
into many smaller pieces that then have to be traded over time in
the market. If high-frequency traders can detect in market data the
early trades in the sequence (known as the algorithm’s “footprint”),
then they can front-run the subsequent trades and profit at the low-
frequency trader’s expense. Sofianos and Xiang discuss how feasi-
ble this is, and present an extensive empirical study to determine
how easy it is to find these patterns in the data. The analysis here

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HIGH-FREQUENCY TRADING

demonstrates how important it is for low-frequency traders to use


sophisticated trading techniques in high-frequency settings.
This issue of new trading tools and techniques is also the focus
of Chapter 9. Terrence Hendershott, Charles M. Jones and Albert J.
Menkveld develop a new approach for measuring the effect of tran-
sitory trading costs for transaction cost analysis. The ability to mea-
sure trading costs is crucial for institutional traders, and is greatly
complicated when algorithms chop orders into sequences of trades.
Hendershott et al construct an efficient price estimator that allows
an enhanced ability to compute the execution cost of a large trade.
Their analysis shows the importance of temporary price effects on
trading costs, and it illustrates the need to develop new analytical
tools designed for high-frequency settings.
Our final chapter turns to the challenges of regulation in a high-
frequency world. In Chapter 10, Oliver Linton, Maureen O’Hara and
J. P. Zigrand argue that, while HFT has increased market quality on
average, it has made markets more vulnerable to episodic instability.
This is due, in part, to the changing nature of liquidity provision in
high-frequency markets, but this vulnerability also arises because
HFT has opened the door to both new forms of manipulation and
market failures arising from errant technology. Linton et al argue for
a new ex ante regulatory approach that relies on technology to moni-
tor markets in real time, pre-specifies regulatory actions in the event
of faltering markets and applies across, and not merely within, mar-
ket settings. They also examine a variety of existing and proposed
regulatory reforms in the US and Europe.
We hope this book makes the high-frequency world more acces-
sible to our readers.

ACKNOWLEDGEMENTS
We thank our outstanding co-authors and the editors at Risk Books
(particularly, Sarah Hastings) for making this book possible.

1 Latency is a measure of time delay in a system. In the context of trading financial assets, it
refers to the time it takes to get orders from a trader’s computer to the trading venue (and,
depending on context, it may also include the time to confirm trades back to the trader).
Latencies in high-frequency markets are often measured in milliseconds (thousandths of a
second), or even microseconds (millionths of a second).
2 Volume-synchronised probability of informed trading (VPIN) is a measure of order imbalance
and it signals when the order flow is likely to be disadvantageous, or “toxic”, to market
makers. High toxicity can cause market makers to withdraw from the market, and this can
lead to disruptions in liquidity provision. Because of this linkage, VPIN can signal future
toxicity-related volatility in markets: an issue of importance to both regulators and traders.

xx

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Special offer: free post and
packaging with this order form

High-Frequency
Trading
New Realities for Traders,
Markets and Regulators
Edited By
David Easley, Marcos López de Prado, and Maureen O’Hara
A Survival Guide to High-Frequency Trading

Equip yourself with this book to gain a full execution algorithms and how markets inter-
understanding of high-frequency trading. What connect in new ways that affect volatility and
opportunities are available for you to take market stability. Contributors also discuss the
advantage of? Do new regulations affect you? new regulatory challenges that arise in the high-
How might your competitors be using high- frequency world.
frequency trading? Can you compete in the high-
frequency world? Chapters include:
• High-Frequency Trading Strategies in FX
High-frequency trading now predominates in Markets (Anton Golub, Alexandre Dupuis,
markets, with upwards of 60% of trading in Richard B. Olsen)
equities and futures, and 40% in foreign • Execution Strategies in Fixed Income Markets
exchange. It is the subject of extensive debate, (Robert Almgren)
particularly as to whether it is beneficial for • The Regulatory Challenge of High-Frequency
traders and markets or instead allows some Markets (Oliver Linton, Maureen O’Hara and
traders to benefit at others expense. This book J.P. Zigrand)
provides you with an important overview and • Machine Learning for Market Microstructure
perspective on this area, with a particular focus and High-Frequency Trading (Michael Kearns
on how low-frequency traders can survive in the and Yuriy Nevmyvaka)
high frequency world.
Price
£85
This book is essential reading for anybody who
With chapters written by the leading practitioners wants or needs to learn about this changing
Format:
Paperback
and academics in the area the book will show subject area, including institutional traders,
ISBN: you how issues such as big data come into play, exchanges and trading system operators,
978-1-782720-09-6 how high-frequency should affect optimal regulators and academics.

More information at: riskbooks.com/hifreq


What this Book Covers
1. The Volume Clock: Insights into the High-Frequency Paradigm
David Easley, Marcos Lopez de Prado, Maureen O’Hara What the industry is saying:
“The concept of high-frequency trading too often evinces irrational
2. High-Frequency Trading Strategies in FX Markets fears and opposition.  This book, by experts in the field, unveils the
Anton Golub, Alexandre Dupuis, Richard B. Olsen mysteries, records the facts and sets out the real pros and cons of
such mechanisms.”
3. Execution Strategies in Equity Markets Charles Goodhart, Fellow of the British Academy, and Emeritus
Michael G. Sotiropoulos Professor at the London School of Economics.

4. Execution Strategies in Fixed Income Markets


“High-Frequency Trading offers a much-needed collection of
Robert Almgren complementary perspectives on this hottest of topics. The combined
academic credentials and first-hand market knowledge of the editors
5. Machine Learning for Market Microstructure and High-Frequency Trading is probably unparalleled, and their style of writing precise and
Michael Kearns and Yuriy Nevmyvaka engaging. The book is thoughtfully organized, tightly focussed in its
coverage and comprehensive in its scope. Practitioners, academics
and regulators will greatly benefit from this work.”
6. A “Big Data” Study of Microstructural Volatility in Futures Markets
Kesheng Wu, E. Wes Bethel, Ming Gu, David Leinweber, Oliver Rübel Riccardo Rebonato, Global Head of Rates and FX Analytics, PIMCO,
and Visiting Lecturer, Mathematical Finance, University of Oxford.

7. Liquidity and Toxicity Contagion


David Easley, Marcos Lopez de Prado, Maureen O’Hara “This book is a must read for anyone with any interest in high-
frequency trading. The authors of this book are a who’s who of
thought leaders and academics who literally did the fundamental
8. Do Algo Executions Leak Information? research in the innovation, development, and oversight of modern
George Sofianos and JuanJuan Xiang electronic trading mechanics and strategies.”
Larry Tabb, Founder & CEO, TABB Group, and Member of the CFTC
9. Implementation Shortfall with Transitory Price Effects Subcommittee on Automated and High-Frequency Trading.
Terrence Hendershott, Charles M. Jones, Albert J. Menkveld
“Easley, Lopez de Prado, and O’Hara have produced a classic that
10. The Regulatory Challenge of High-Frequency Markets
everyone should have on their shelves.”
Oliver Linton, Maureen O’Hara, J.P. Zigrand
Attilio Meucci, Chief Risk Officer at KKR, and Founder of SYMMYS

More information at: riskbooks.com/hifreq


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