P1: SBT fm JWBT188-Aldridge October 29, 2009 16:50 Printer: Yet to come iv P1: SBT fm JWBT188-Aldridge October 29, 2009 16:50 Printer: Yet to come High-Frequency Trading A Practical Guide to Algorithmic Strategies and Trading Systems IRENE ALDRIDGE John Wiley & Sons, Inc. i P1: SBT fm JWBT188-Aldridge October 29, 2009 16:50 Printer: Yet to come Copyright ⃝C 2010 by Irene Aldridge. All rights reserved. Published by John Wiley & Sons, Inc., Hoboken, New Jersey. Published simultaneously in Canada. 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HG4529.A43 2010 332.64–dc22 2009029276 Printed in the United States of America 10 9 8 7 6 5 4 3 2 1 ii P1: SBT fm JWBT188-Aldridge October 29, 2009 16:50 Printer: Yet to come To my family iii P1: SBT fm JWBT188-Aldridge October 29, 2009 16:50 Printer: Yet to come iv P1: SBT fm JWBT188-Aldridge October 29, 2009 16:50 Printer: Yet to come Contents Acknowledgments xi CHAPTER 1 Introduction 1 CHAPTER 2 Evolution of High-Frequency Trading 7 Financial Markets and Technological Innovation 7 Evolution of Trading Methodology 13 CHAPTER 3 Overview of the Business of High-Frequency Trading 21 Comparison with Traditional Approaches to Trading 22 Market Participants 24 Operating Model 26 Economics 32 Capitalizing a High-Frequency Trading Business 34 Conclusion 35 CHAPTER 4 Financial Markets Suitable for High-Frequency Trading 37 Financial Markets and Their Suitability for High-Frequency Trading 38 Conclusion 47 v P1: SBT fm JWBT188-Aldridge October 29, 2009 16:50 Printer: Yet to come vi CONTENTS CHAPTER 5 Evaluating Performance of High-Frequency Strategies 49 Basic Return Characteristics 49 Comparative Ratios 51 Performance Attribution 57 Other Considerations in Strategy Evaluation 58 Conclusion 60 CHAPTER 6 Orders, Traders, and Their Applicability to High-Frequency Trading 61 Order Types 61 Order Distributions 70 Conclusion 73 CHAPTER 7 Market Inefficiency and Profit Opportunities at Different Frequencies 75 Predictability of Price Moves at High Frequencies 78 Conclusion 89 CHAPTER 8 Searching for High-Frequency Trading Opportunities 91 Statistical Properties of Returns 91 Linear Econometric Models 97 Volatility Modeling 102 Nonlinear Models 108 Conclusion 114 CHAPTER 9 Working with Tick Data 115 Properties of Tick Data 116 Quantity and Quality of Tick Data 117 Bid-Ask Spreads 118 P1: SBT fm JWBT188-Aldridge October 29, 2009 16:50 Printer: Yet to come Contents vii Bid-Ask Bounce 120 Modeling Arrivals of Tick Data 121 Applying Traditional Econometric Techniques to Tick Data 123 Conclusion 125 CHAPTER 10 Trading on Market Microstructure: Inventory Models 127 Overview of Inventory Trading Strategies 129 Orders, Traders, and Liquidity 130 Profitable Market Making 134 Directional Liquidity Provision 139 Conclusion 143 CHAPTER 11 Trading on Market Microstructure: Information Models 145 Measures of Asymmetric Information 146 Information-Based Trading Models 149 Conclusion 164 CHAPTER 12 Event Arbitrage 165 Developing Event Arbitrage Trading Strategies 165 What Constitutes an Event? 167 Forecasting Methodologies 168 Tradable News 173 Application of Event Arbitrage 175 Conclusion 184 CHAPTER 13 Statistical Arbitrage in High-Frequency Settings 185 Mathematical Foundations 186 Practical Applications of Statistical Arbitrage 188 Conclusion 199 P1: SBT fm JWBT188-Aldridge October 29, 2009 16:50 Printer: Yet to come viii CONTENTS CHAPTER 14 Creating and Managing Portfolios of High-Frequency Strategies 201 Analytical Foundations of Portfolio Optimization 202 Effective Portfolio Management Practices 211 Conclusion 217 CHAPTER 15 Back-Testing Trading Models 219 Evaluating Point Forecasts 220 Evaluating Directional Forecasts 222 Conclusion 231 CHAPTER 16 Implementing High-Frequency Trading Systems 233 Model Development Life Cycle 234 System Implementation 236 Testing Trading Systems 246 Conclusion 249 CHAPTER 17 Risk Management 251 Determining Risk Management Goals 252 Measuring Risk 253 Managing Risk 266 Conclusion 271 CHAPTER 18 Executing and Monitoring High-Frequency Trading 273 Executing High-Frequency Trading Systems 274 Monitoring High-Frequency Execution 280 Conclusion 281