1.0 High Frequency Trading
1.1 What is High Frequency Trading
High frequency trading is a form of automated trading that uses super computers to transact or process mega transaction orders at super fast speed, which are mostly measured in microsecond or milliseconds. ( Investopedia, n.d) with the aim to identify and arbitrage temporary market inefficiencies that are created by the competing interests of market participants (Aldridge,2013)
Algorithms, low latency technology, high message rates and high speed connections are the 4 main characteristics in the performance of a High Frequency Trading.
Algorithms is a set of instructions for accomplishing a given task. So a trading algorithm is just a computerized model with steps to trade an order in a specific way (Johnson, 2010) The algorithms in HFT are for the purpose of decision making, order initiation, generation, routing or execution for each individual transaction without a human execution. (Aldridge, 2013)
The low latency technology infrastructure on the other hand is a must for high frequency trading. This infrastructure is designed to minimize response times, including its proximity and co-location services which thus improves the execution speed (Cisco, 2014) Therefore, computers play an very important role in replacing slow humans in the trading decisions.
Next on is the high message rates and speed connections in HFT which relates to the response speed for market order entry , orders quotation and speed for cancellation.
1.2 High Frequency Trader’s Strategies
High Frequency Traders uses various strategy when performing HFT in the market. Such as for arbitrage strategies, directional event based strategies, automated market trading and liquidity detection strategies.
First of all, the arbitrage purpose. There are various arbitrage strategies in the equity market, such as statistical arbitrage, liquidity arbitrage, risk arbitrage and arbitraging different equity classes of the same issuer One of the commonly used arbitrage strategies for HFT traders in the equity market is the pair trading method in statistical arbitrage. Where HFT traders hedge away their unsystematic risk, by pairing stock with market-based similarities, and short the better performing stock and long poorer performing stock ( Perez ,2011)
Secondly, directional event based strategies which refers to market reactions to events. This event may be economic announcements, eg. Interest rates movement. The goal of event based strategies is to identify portfolios that makes positive profit over the time surrounding this event. Which in the case for high frequency traders, the speed of response towards event determines their trade gain. The faster the response, the higher the probability that their strategies will profit from the ride of momentum wave to the post announcement on equilibrium price level.
Thirdly, automated market trading. Most HFT systems are deployed to provide automated market...