All About High-Frequency Trading (All About Series) - Softcover

Durbin, Michael

Softcover

ISBN 10: 0071743448 ISBN 13: 9780071743440

Publisher: McGraw-Hill, 2010

Synopsis

A DETAILED PRIMER ON TODAY'S MOST SOPHISTICATEDAND CONTROVERSIAL TRADING TECHNIQUE

Unfair . . . brilliant . . . illegal . . . inevitable. High-frequency trading has been described in many different ways, but one thing is for sure--it has transformed investing as we know it.

All About High-Frequency Trading examines the practice of deploying advanced computer algorithms to read and interpret market activity, make trades, and pull in huge profi ts―all within milliseconds. Whatever your level of investing expertise, you'll gain valuable insightfrom All About High-Frequency Trading's sober, objective explanations of:

• The markets in which high-frequency traders operate
• How high-frequency traders profi t from mispriced securities
• Statistical and algorithmic strategies used by high-frequency traders
• Technology and techniques for building a high-frequency trading system
• The ongoing debate over the benefi ts, risks, and ever-evolving future of high-frequency trading

About this title

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Excerpt. © Reprinted by permission. All rights reserved.

All About HIGH-FREQUENCY TRADING

By MICHAEL DURBIN

The McGraw-Hill Companies, Inc.

Copyright © 2010 The McGraw-Hill Companies, Inc.
All rights reserved.

ISBN: 978-0-07-174344-0

Contents

Preface
Acknowledgments
Chapter 1 Busted
Chapter 2 Trading 101
Chapter 3 Trading Strategies
Chapter 4 Achieving Speed
Chapter 5 Under the Hood
Chapter 6 The High-Frequency Trading Debate
Now What?
Glossary
Bibliography
Index

Excerpt

CHAPTER 1

Busted

I always wondered when word would get out. I got my own look in 2003. That'swhen I went to work for the Citadel Investment Group, Ken Griffin's stealthyChicago hedge fund, to help them build a high-frequency trading system for theU.S. equity options market. There was only one fully automated options exchangein the United States at that time, the International Securities Exchange (ISE)in New York. Before the ISE opened for business in 2000, no options exchangewould allow market-makers (a type of trader we'll learn about presently) tosubmit their all-important quotations—bids to buy and offers tosell—electronically. For the most part, those were still communicatedverbally by human traders with loud voices and sharp elbows, standing all day inopen outcry trading pits wearing sensible shoes. ISE founders David Krell andGary Katz knew it was time to change that, and the success of their enterpriseproved to any remaining doubters how absolutely right they were. The ISE was thequintessential game changer. Their explosive success forced the traditional,floor-based options exchanges to make their own plans for electronic quoting.And Ken Griffin wanted Citadel to be all over it.

I had been managing financial systems development for several years by thistime, mostly for the pricing of derivative securities. The Citadel system,though, would not only calculate hundreds of thousands of option pricessimultaneously— an impressive feat in its own right—but also injectstreams of bids and offers into the markets at literally superhuman speed. Thecustom-built quoting engines would tirelessly inject many millions of quotesinto the markets every day, each of them a binding commitment to buy or sell alisted option contract at some specified price, each one the result of asoftware program running on a computer. And while the quoters were busy doingthat, "electronic eyes" would scan everyone else's quotations andorders—hundreds of millions per day—all in real time. It would belike standing at the end of an open fire hose and examining each drop of waterbefore it hit the ground. When the electronic eye (or EE) found someone offeringto buy an option for more than it was worth, or to sell it for less, it wouldimmediately submit an order to take the other side of the trade for a tinyprofit.

It was a dazzling sight, watching these machines pick the markets clean of itsinefficiencies. I would have loved to talk about it back then, to tell friendsand family what was going on in the gleaming glass tower at the intersection ofDearborn and Adams. But the confidentiality agreements one has to sign foremployers like Citadel are very, very effective. In this business, everyoneknows that loose lips get pink slips. So like everyone else, I kept my mouthshut and talked only with my small group of colleagues on the 37th floor.

By the time I left Citadel in 2005, their options market-making system—thework of a team not much larger than the Chicago Cubs' starting lineup—wasresponsible for more than 10 percent of all options trading in the UnitedStates, or more than a million contracts a day. Within three years, its marketshare had reportedly grown to a commanding 30 percent. The U.S. options markethad become dominated by the extraordinary machines of just a handful ofsecretive firms like Citadel. Still, nobody on the outside seemed to have aclue—or a care—that trading was no longer done by traders.

That all changed in 2009. As people licked their wounds in the aftermath of the2008 market meltdown, wondering where all the money went, word got out thatsomething like $20 billion of it went to these folks known as high-frequencytraders. The term was well known inside firms like Citadel but not so muchoutside. Now, it was bad enough that anyone made out like bandits in thehorrible year that was 2008, but a far more frightening contemplation causedmore than a few people to go grab a pitchfork from the shed: Was high-frequencytrading (HFT) somehow culpable? Did it cause the mother of all crashes oraccelerate it once it began? After all, the 1987 market crash was widelyattributed to automated trading, then known as program trading. Did thecomputers do it again?

Word went around that 50 percent of all stock trading— maybe 60 percent oreven 70 percent—was attributable to HFT computers trading with each other,supposedly just to collect tiny kickbacks, known as rebates, from the exchange.The HFT firms weren't even holding on to their stock. Once bought, they'dimmediately turn around and sell it, sometimes buying and selling the same stockhundreds or thousands of times a day. What was up with that? All this trading atungodly speeds, it was said, was creating massive price volatility thatotherwise wouldn't exist. Could this be good? Nerves were not settled when aformer Goldman Sachs employee was arrested for allegedly stealing proprietarycomputer code for high-frequency trading, with the bank asserting ominously,"There is a danger that somebody who (knows) how to use this program could useit to manipulate markets in unfair ways." Computer code to manipulate markets?What the heck was going on here?

Anyone following the HFT stories in 2009 learned a handful of new terms from themodern trading lexicon— none of them particularly comforting. The HFTfirms were supposedly using something called "flash orders" to get advance looksat customer trade orders before the rest of the market, then using those peeksto make their own trades at a profit. Wasn't that front-running and wasn't itillegal? The flash order robbers supposedly had only 30 milliseconds to do theirdirty work, but this was plenty of time because they "colocated" their computerservers in the same data centers as the exchange computers, at great expense.This also let them get their own orders in before any investor possibly could.Uneven playing field, anybody?

Unsatisfied with flash order thievery, the HFT smarties supposedly submittedsomething called immediate-or-cancel (IOC) orders with no intention oftrading, but only to force investors to reveal the true prices at which theywere willing to trade, information the HFT guys would use to move market pricesagainst the investor. Whoa. Were the HFT firms even qualified to be so close tothe exchange and trade at lightning speeds? Nobody could say, because it wasnearly impossible to know even the identities of high-frequency traders. Theydidn't need to make the infrastructure investments themselves. They could usedirect market access (DMA) or naked access, using their broker'sexchange connection to get in anonymously, then perform their lightning-fastderring-do as if wearing a mask.

"Dude," you could almost hear people asking, fatigued and more than a littleticked off, "What happened to our stock market?" Was it no longer what it usedto be, a place to simply invest in companies with the idea of holding on to thatstock for a while? Were we all foolishly naive to still think like that? Maybewe had all been reduced to easy marks for sharpies with fast computers and mathskills far better than our own, like dummies on the boardwalk, sized up andtaken by the hucksters. Do the markets still work? Or have they been hijacked bycutthroat information technology and runaway greed?

It can sure seem that way.

The year 2008 was indeed the year of wonders for high-frequency traders,especially options traders, and this struck plenty of folks as somehow wrong. Aheadhunter told me that his client, a high-frequency options market-making firm,had made over $800 million in 2008. Another well-known firm was said to havecleared $1.3 billion of net profit—and that was just trading options. Whoknows what the stock HFT desk pulled in.

Having worked in this business and performed mind-numbing P&L calculationsmyself, I found those rumored numbers entirely plausible. Three billion optioncontracts were traded in 2008 with a net profit to the market-maker of, let'ssay, $2.00 each. That's $6 billion in profits across the entire market. Even ifmy estimate is high and the marketwide profit was more like $5 or even $4billion, with so few market-makers having forks in that pie, it's entirelyplausible that some of the slices were around $1 billion. Now, just because somepeople made out like kings in 2008 when most people suffered, however, does notmean all those gains were ill-gotten. When technology revolutionizes anindustry, be it personal computing or automobile manufacturing or oil refining,it's not unheard-of for a small number of pioneers (Gates, Ford, Rockefeller) tomake bazillions from their investments.

There's more mileage to be had from the automobile analogy, this time relatingto safety. When horseless buggies first hit the streets in the early twentiethcentury, top speeds were on the order of 10 or 15 miles per hour, and thereweren't all that many of these novelties on the road. As technology, demand, andfree-market enterprise found their confluence, however, those top speeds climbedsteadily and the roads started filling. Cars crashed, people died, and thelethality of these contraptions became frightfully obvious. Government andindustry began addressing safety in the design and regulation of automobiles.Speed limits were posted, seat belts were invented, laws were written, and copsstarted writing tickets. It's not unreasonable to say that high-frequencytrading requires that same sort of rethinking to keep people safe in light ofthe new capabilities brought on by technology.

And there is yet one more obvious parallel between the automotive revolution andHFT. Some folks in the early years of the automobile saw cars not asconveniences but as tools to help commit crime. Would John Dillinger have faredso well were his getaway vehicle a trolley? Bank robbers used cars to get awaywith crimes they might not have otherwise. In turn, the cops themselves wereequipped with better and better cars and laws were expanded and revisedaccordingly. Can people use the tools of high-frequency trading to get away withthings they might not have, say, ten years ago? It's not inconceivable. Is ittime to reconsider regulations and law enforcement in the securities markets?Probably.

It must be said that pulling off the high-frequency part of high-frequencytrading is no stroll through the mall. It's exceedingly difficult setting up anHFT system that actually works, and there is no one thing to be done, no singletask to master, any more than there is only one thing to ensure the successfulconstruction of an ocean liner. High-frequency traders leave no stone unturnedin pursuit of their wispy profits, starting with the hiring of just the rightnumber of rock stars from the fields of trading, mathematics, and softwaresystem development. They write their own software rather than license packagedproducts from third parties, investing the time and money required for a systemcatered to their exact needs, one they can fix and modify on their own schedule.Oh, and for the building and maintaining of these systematic goliaths, theyspend sums of money that would make even Warren Buffett raise his eyebrows.

HFT firms apply softare engineering practices that facilitate the development ofsoftware designed for change— because it must change continuously to keepup with the equally well-heeled and motivated Joneses—and they writeexquisitely efficient code. Their systems are perfect examples of so-calleddistributed, real-time systems, borrowing patterns from the field of complexevent processing, with thousands of individual programs running on just theright number of computers in just the right number of data centers. They buckthe decades-long trend of packing more and more processing onto a computer's CPU(central processing unit), favoring the seemingly backward approach ofdelegating some computing tasks to specialized hardware. They even take over themassively parallel processing capability of graphical processingunits—game cards, in essence—for financial computations.

An HFT firm would not dream of receiving market data—the crucial flow of"ticks"—or submitting trade orders by way of third parties and theirlatency-consuming connections. They insist on direct connections to the exchangefor these purposes. Wherever they can, they forego the use of the industrystandard FIX protocol for communicating with the exchange, favoring the writingof software that talks directly to the native application programminginterfaces, or APIs, of each exchange. They also know where the exchanges housetheir computers, or matching engines, and they lease space in the very same datacenters to colocate their own servers, thus getting their work done just a fewmillionths of a second sooner than the next guy.

Exhausting? Expensive? You betcha. But with the prospect of rolling a billionsimoleons a year off of one these money-making machines, it's no wonder morethan one firm is willing to pay whatever it takes to have one.

CHAPTER 2

Trading 101

First things first: Before we address high-frequency trading, let's review a fewthings about plain old trading. Once we orient ourselves with respect to theequity-related securities traded on U.S. markets and the essence of what happensat a securities exchange—who does what and why, and some of the naturaldynamics among various parties—we'll be in a better position to appreciatewhat happens when we step on the gas.

EQUITY SECURITIES

Many discussions of high-frequency trading pertain to listed cash equitysecurities, or stocks. But HFT also takes place in two securities closelyrelated to stocks: equity options (stock options) and equity index futures. TheU.S. markets for stocks, options, and futures are so deeply interconnected theyact as one giant market in equity-based securities, and high-frequency tradingis practiced extensively across that "supermarket." Indeed, more than beingsomething that just happens to be practiced in each of those markets, it isarguably the very reason those markets are connected as tightly as they are.

In this book, we'll focus primarily on HFT in the stock markets, but we willalso delve into options and futures HFT should you want to expand your view abit, although that's certainly not necessary for a basic understanding of HFT.Moreover, and as we'll see later on, some of the strategies employed in thestock market are driven by what goes on in the futures and options markets,giving yet another reason you may want to be at least familiar with what goes onthere. HFT is certainly not confined to the U.S. equity supermarket. It'sbecoming more and more prevalent in markets outside the United States and innonequity markets such as those for commodities, interest rates, and currencies(aka, foreign exchange or FX). Although we won't discuss those directlyin this book, many of the concepts we discuss pertain to those markets as well.

Stocks

A stock, of course, represents a sliver of ownership of a corporation. On atypical day, roughly 9 billion shares of stock are traded across the U.S.markets. These stocks include not only the 5,000 or so listed equity securitiesissued by individual companies—Google (symbol GOOG), Alcoa (AA), Motorola(MOT), and so on—but also exchange-traded funds, or ETFs, whichtrade very much like traditional stock but whose value is based on an index.These have become extremely popular in recent years with some ETFs trading asheavily as the most actively traded stocks.

ETFs are sometimes known as index tracking stocks. For example, thevalue of the ETF known as the Spider (symbol SPDR) is by definition equal toapproximately one-tenth that of the S&P 500 stock index. Another extremelypopular ETF tracks the NASDAQ-100 index (QQQQ, also known as "the Qs"). ETFs arelisted right alongside single-name stocks and even pay cumulative dividends fromthe underlying stocks. There are dozens of traditional ETFs available, althougha very small number tend to dominate the market. There are also new breeds ofso-called leveraged ETFs whose daily returns are amplified by some factor (twoor three, typically) versus a traditional ETF.

Options

Equity options are a type of derivative security that give their buyers theright to buy (in the case of call options) or sell (put options)an underlying stock or ETF at a specified strike price in a specified timeframe, in return for payment of a premium. A popular variation of these is theindex option, whose underlier is not an individual stock or ETF but an index(you can think of it as a basket of stocks), such as the S&P 500. For a givenstock or index, there may be hundreds of listed option contracts, each with adifferent strike price, expiration date, and type (call versus put). As aresult, there are actually more listed option contracts than there arestocks—far more.

This fact is indeed one reason why HFT is well suited for options trading; thereare simply so many contracts to keep track of, a computer can manage them muchmore effectively than can a human trader. The other reason options and HFT gotogether so well is the relationship between a stock price and a correspondingoption price (or index level, in the case of index options). The price of anoption depends on several factors, but the most obvious of these is the currentprice of the underlying stock. When a stock price moves, the value of an optionon it changes simultaneously; the price of an option is said to be derived(hence the term derivative) from the price of the stock. Only computerscan recalculate option prices quickly enough for option prices to keep up withstock prices. (Sometimes even computers don't keep up. Later, we'll see how alag in the process presents a nice opportunity known as arbitrage.)

Equity and equity index options have become extraordinarily popular securitiesover the past several years, with daily trading volumes in 2009 hovering around14 million contracts. Most contracts grant trading rights to 100 shares of theunderlying stock. As such, options on roughly 1.4 billion shares of stock tradeeach day.

Futures

Equity index futures are another type of derivative security that allow you toeffectively buy or sell the basket of stocks underlying an index, on a specifieddate in the future at a specified delivery price. As with index options, youdon't actually buy or sell the basket (they are cash-settled contracts)but you gain or lose money as if you could and you realize those gains or lossesdaily. As such, to take a position in one of these futures is very much to makea bet on the market.

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Excerpted from All About HIGH-FREQUENCY TRADING by MICHAEL DURBIN. Copyright © 2010 by The McGraw-Hill Companies, Inc.. Excerpted by permission of The McGraw-Hill Companies, Inc..
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Edition details

• Publisher: McGraw-Hill
• Publication date: 2010
• Language: English
• ISBN 10: 0071743448
• ISBN 13: 9780071743440
• Binding: Paperback
• Number of pages: 226