Inside the Black Box: A Simple Guide to Quantitative and High Frequency Trading, 2nd Edition

CHAPTER 15

High-Frequency Trading

If you have a mouse in your hand, you are too late!

—Blair Hull, December 2000

We have described the importance of, components of, and challenges to building a high-speed (low-latency) trading infrastructure. These components are used, primarily, for either high-frequency trading (HFT) applications or for implementing automated execution algorithms. In this chapter, we will focus on HFT, seeking to understand the kinds of strategies employed by these traders and how these techniques relate to the infrastructure we have outlined.

There is no widely accepted classification of HFT strategies. However, we can consider them to fall into one of four broad categories: contractual market making, noncontractual market making, arbitrage, and fast alpha. In this chapter, we will describe each of these kinds of strategies, as well as the risk management and portfolio construction considerations that apply to them.

CONTRACTUAL MARKET MAKING

A contractual market maker (CMM) is the class of HFT practitioner that has the closest analog to a traditional feature of the markets. First, we should understand the concept of market making.

The odds that two customers simultaneously want to do exactly opposite things (e.g., customer A wants to buy 2,000 shares of XYZ at $100.00, while customer B wants to sell 2,000 shares of XYZ at $100.00) are fairly small. Of course, it is reasonably likely that there is at least some portion of a customer's desired trade that could ...