Inside the Black Box: The Simple Truth About Quantitative Trading

7.2. HIGH-FREQUENCY TRADING: BLURRING THE LINE BETWEEN ALPHA AND EXECUTION

Some quants attempt to make extremely near-term bets (e.g., seconds or less into the future) about markets. The alphas that drive these strategies are typically called microstructure alphas and focus on liquidity patterns in the order book for both the target instrument and related securities. Larger quants also use these microstructure forecasts to guide their execution models, thereby improving their costs of entering trades that their portfolio construction model has deemed necessary. For example, if two trades are equally appealing over the expected life of the trade, but one is significantly more appealing in the extremely short term, this can lead to greater aggressiveness in the more appealing name and more passivity in the less appealing one.

This kind of nuance can make a small difference in a given trade, but in the long run, these savings can add up to a significant improvement in long-term performance. Some quants actually trade these microstructure alphas as independent high-frequency strategies, which are characterized by very small, short-term, high-probability bets. To do so, they must be prepared to invest rather substantially in infrastructure and research while only being able to manage small sums due to the problems presented by market impact. In other words, if a high-frequency strategy is too large, it will begin to move the market so much that the prices at which it finally executes ...