P1:SBT fm JWBT188-Aldridge October29,2009 16:50 Printer:Yettocome iv P1:SBT fm JWBT188-Aldridge October29,2009 16:50 Printer:Yettocome High-Frequency Trading A Practical Guide to Algorithmic Strategies and Trading Systems IRENE ALDRIDGE JohnWiley&Sons,Inc. i P1:SBT fm JWBT188-Aldridge October29,2009 16:50 Printer:Yettocome Copyright(cid:1)C 2010byIreneAldridge.Allrightsreserved. PublishedbyJohnWiley&Sons,Inc.,Hoboken,NewJersey. PublishedsimultaneouslyinCanada. 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HG4529.A432010 332.64–dc22 2009029276 PrintedintheUnitedStatesofAmerica 10 9 8 7 6 5 4 3 2 1 ii P1:SBT fm JWBT188-Aldridge October29,2009 16:50 Printer:Yettocome To my family iii P1:SBT fm JWBT188-Aldridge October29,2009 16:50 Printer:Yettocome iv P1:SBT fm JWBT188-Aldridge October29,2009 16:50 Printer:Yettocome Contents Acknowledgments xi CHAPTER 1 Introduction 1 CHAPTER 2 Evolution of High-Frequency Trading 7 FinancialMarketsandTechnologicalInnovation 7 EvolutionofTradingMethodology 13 CHAPTER 3 Overview of the Business of High-Frequency Trading 21 ComparisonwithTraditionalApproachestoTrading 22 MarketParticipants 24 OperatingModel 26 Economics 32 CapitalizingaHigh-FrequencyTradingBusiness 34 Conclusion 35 CHAPTER 4 Financial Markets Suitable for High-Frequency Trading 37 FinancialMarketsandTheirSuitability forHigh-FrequencyTrading 38 Conclusion 47 v P1:SBT fm JWBT188-Aldridge October29,2009 16:50 Printer:Yettocome vi CONTENTS CHAPTER 5 Evaluating Performance of High-Frequency Strategies 49 BasicReturnCharacteristics 49 ComparativeRatios 51 PerformanceAttribution 57 OtherConsiderationsinStrategyEvaluation 58 Conclusion 60 CHAPTER 6 Orders, Traders, and Their Applicability to High-Frequency Trading 61 OrderTypes 61 OrderDistributions 70 Conclusion 73 CHAPTER 7 Market Inefficiency and Profit Opportunities at Different Frequencies 75 PredictabilityofPriceMovesatHighFrequencies 78 Conclusion 89 CHAPTER 8 Searching for High-Frequency Trading Opportunities 91 StatisticalPropertiesofReturns 91 LinearEconometricModels 97 VolatilityModeling 102 NonlinearModels 108 Conclusion 114 CHAPTER 9 Working with Tick Data 115 PropertiesofTickData 116 QuantityandQualityofTickData 117 Bid-AskSpreads 118 P1:SBT fm JWBT188-Aldridge October29,2009 16:50 Printer:Yettocome Contents vii Bid-AskBounce 120 ModelingArrivalsofTickData 121 ApplyingTraditionalEconometricTechniques toTickData 123 Conclusion 125 CHAPTER 10 Trading on Market Microstructure: Inventory Models 127 OverviewofInventoryTradingStrategies 129 Orders,Traders,andLiquidity 130 ProfitableMarketMaking 134 DirectionalLiquidityProvision 139 Conclusion 143 CHAPTER 11 Trading on Market Microstructure: Information Models 145 MeasuresofAsymmetricInformation 146 Information-BasedTradingModels 149 Conclusion 164 CHAPTER 12 Event Arbitrage 165 DevelopingEventArbitrageTradingStrategies 165 WhatConstitutesanEvent? 167 ForecastingMethodologies 168 TradableNews 173 ApplicationofEventArbitrage 175 Conclusion 184 CHAPTER 13 Statistical Arbitrage in High-Frequency Settings 185 MathematicalFoundations 186 PracticalApplicationsofStatisticalArbitrage 188 Conclusion 199 P1:SBT fm JWBT188-Aldridge October29,2009 16:50 Printer:Yettocome viii CONTENTS CHAPTER 14 Creating and Managing Portfolios of High-Frequency Strategies 201 AnalyticalFoundationsofPortfolioOptimization 202 EffectivePortfolioManagementPractices 211 Conclusion 217 CHAPTER 15 Back-Testing Trading Models 219 EvaluatingPointForecasts 220 EvaluatingDirectionalForecasts 222 Conclusion 231 CHAPTER 16 Implementing High-Frequency Trading Systems 233 ModelDevelopmentLifeCycle 234 SystemImplementation 236 TestingTradingSystems 246 Conclusion 249 CHAPTER 17 Risk Management 251 DeterminingRiskManagementGoals 252 MeasuringRisk 253 ManagingRisk 266 Conclusion 271 CHAPTER 18 Executing and Monitoring High-Frequency Trading 273 ExecutingHigh-FrequencyTradingSystems 274 MonitoringHigh-FrequencyExecution 280 Conclusion 281