High frequency trading (HFT) is the use of

sophisticated technological tools to trade

securities like stocks or options, and is typically
characterized
by
several
distinguishing
features
In HFT, programs analyze market data to
capture trading opportunities that may open
up for only a fraction of a second to several
hours.
HFT uses computer programs & sometimes
specialized hardware to hold short-term
positions in equities, options, futures, ETFs,
currencies & other financial instruments that
possess electronic trading capability.

 High-frequency traders compete on a basis of speed

with other high frequency traders, not long-term
investors (who typically look for opportunities over a
period of weeks, months, or years) & compete with
each other for very small, consistent profits.
Aiming to capture just a fraction of a rupee per share
or currency unit on every trade, HF traders move in &
out of such short-term positions several times each
day.
Fractions of a penny accumulate fast to produce
significantly positive results at the end of every day.
High frequency trading firms do not employ
significant leverage, do not accumulate positions &
typically liquidate their entire portfolios on a daily
basis.

 Firms that engage in HFT include

proprietary trading desks at a small
number of major investment banks
(e.g. Goldman Sachs, Merrill Lynch),
hundreds of the most secretive
proprietary trading groups (like
Wolverine, Renaissance Technologies,
IMC & Getco) & less than 100 of the
most sophisticated hedge funds. As a
rule, they tend to be secretive,
stealthy, smart and relatively
unknown.

 HFT is characterized by a high turnover of capital.

The positions have very short holding times in
computer-driven responses to market situations.
Typically high frequency trading applies to multiple
trades each day, gaining small returns per trade,
with very limited, if any, positions carried overnight.
Overnight positions are not considered for high
speed trading because with the current volatility in
the markets, which extend most of the trading
activity over the to 24-hour, they are particularly
risky.
Moreover, overnight positions taken out on margin
have to be paid for at the interest rate referred to as
an overnight carry rate decreasing the profitability
of this type of operations.

High-Frequency Trading Strategies

HFT is quantitative trading, is characterized by
short portfolio holding periods.
All portfolio-allocation decisions are made by
computerized quantitative models.
Success of HFT strategies is largely driven by their
ability to simultaneously process volumes of
information, what ordinary human traders cannot
do.
Most HFT strategies fall within one of four groups
of trading strategies:
Market making
Ticker Tape Trading
Event Arbitrage
High-frequency Statistical Arbitrage

Market making
It is a set of HFT strategies that involve placing a limit
order to sell (or offer) or a buy limit order (or bid) in order
to earn the bid-ask spread.
By doing so, market makers provide counterpart to
incoming market orders.
Although role of market maker was traditionally fulfilled by
specialist firms, this class of strategy is now implemented
by a large range of investors, due to wide adoption of
direct market access.
This renewed competition among liquidity providers causes
reduced effective market spreads & therefore reduced
indirect costs for final investors.
Some HFT firms use market making as their primary
trading strategy. Building up market making strategies
typically involve precise modeling of target market
microstructure together with stochastic control techniques.

Ticker Tape Trading

Much information happens to be
unwittingly embedded in market data,
such as quotes & volumes.
By observing a flow of quotes, highfrequency trading machines are
capable of extracting information that
has not yet crossed the news screens.
Since all quote & volume information
is public, such strategies are fully
compliant with all the applicable laws.

Filter trading is one of the more primitive

HFT strategies involving monitoring large
amounts of stocks for significant or
unusual price changes or volume activity.
This includes trading on announcements,
news, or other event criteria. Software
would then generate a buy or sell order
depending on the nature of the event
being looked for.
Event Arbitrage
Certain recurring events generate
predictable short-term response in a
selected set of securities. HF traders take
advantage of such predictability to
generate short-term profits.

Statistical Arbitrage
Another set of HFT strategies are strategies that
exploit predictable temporary deviations from stable
statistical relationships among securities.
Statistical arbitrage at high-frequencies is actively
used in all liquid securities, including equities, bonds,
futures, foreign exchange, etc.
Such strategies may also involve classical arbitrage
strategies, such as covered interest rate parity in the
foreign exchange market, which gives a relation
between the prices of a domestic bond & a bond
denominated in a foreign currency, the spot price of
the currency, and the price of a forward contract on
the currency.
HFT allows similar arbitrages using models of greater
complexity involving many more than four securities.

Distinguishing features of HFT:

highly quantitative, employing computerized
algorithms to analyze incoming market data &
implement proprietary trading strategies;
usually implies a firm holds an investment
position only for very brief periods of time even just seconds - and rapidly trades into & out
of those positions, sometimes thousands or tens
of thousands of times a day;
firms typically end a trading day with no net
investment position in the securities they trade;
operations are usually found in proprietary firms
or on proprietary trading desks in larger,
diversified firms;

LOW LATENCY
HFT strategies are highly dependent on ultra-low
latency. To realize any real benefit from
implementing these strategies, a firm must have a
real-time, HFT platform where data is collected &
orders are created, routed & executed in submillisecond times.
ULLDMA
Ultra-Low Latency Direct Market Access. For HFT
strategies speed of execution is key.
DMA is means of executing trading flow on a
selected venue by almost by passing the brokers
discretionary methods.
For the lack of interaction with the broker this is
sometimes referred to as no-touch.

 DMA flow passes directly through the DMA

market gateway & onto the venue while
passing though strict risk checking & position
keeping algorithms.
It is at this point the brokers may monitor the
behaviour of their DMA clients. For the
purposes of HFT trading, the DMA must not
delay orders by more than a millisecond with
a few technology firms able to achieve round
trip times in the microseconds. With the
ability to co-locate the HFT traders
blackboxes with the DMA next to a venue's
matching engine, Ultra-low latency can be
achieved.

Multiple Asset Classes and Exchanges

Since many HFT trading strategies require transactions in
more than one asset class and across multiple exchanges,
appropriate infrastructure is required to facilitate long-haul
connectivity between different data centers.
Limited Shelf Life
Competitive advantage of a HFT strategy dilutes over time.
Although a firm's high-level trading strategy may remain
consistent over time, its micro-level strategies are constantly
altered for two important reasons. Firstly, because HFT
depends on extremely precise market interactions & security
correlations, traders need to regularly adjust code to reflect
subtle changes in the dynamic market. Secondly,
competitive intelligence is so good across rival trading firms
that each is exposed to the increasing susceptibility of their
strategies being reverse-engineered, turning their most
profitable ideas into their most risky.

Efficient frontier
It is a concept in Modern portfolio theory
introduced by Harry Markowitz and others.
A combination of assets, i.e. a portfolio, is referred
to as "efficient" if it has the best possible
expected level of return for its level of risk
usually shown by the standard deviation of the
portfolio's return.
Here, every possible combination of risky assets,
without including any holdings of the risk-free
asset, can be plotted in risk-expected return
space & collection of all such possible portfolios
defines a region in this space. The upward-sloped
part of the left boundary of this region, a
hyperbola, is called the "efficient frontier".

The optimal portfolios plotted along the

curve have the highest expected return
possible for the given amount of risk.

 Modern portfolio theory (MPT) is a

theory of investment which attempts to
maximize portfolio expected return for a
given amount of portfolio risk, or
equivalently minimize risk for a given
level of expected return, by carefully
choosing the proportions of various
assets.
MPT is mathematical formulation of the
concept of diversification in investing,
with the aim of selecting a collection of
investment assets that has collectively
lower risk than any individual asset.

 This is possible can be seen intuitively

because different types of assets often
change in value in opposite ways. For
example, as prices in the stock market
tend to move independently from prices
in the bond market, a collection of both
types of assets can therefore have lower
overall risk than either individually. But
diversification lowers risk even if assets'
returns are not negatively correlated
indeed, even if they are positively
correlated.

 Fundamental concept behind MPT - assets in investment

portfolio should not be selected individually, each on their
own merits. Important to consider how each asset changes in
price relative to how every other asset in the portfolio
changes in price.
Investing is a tradeoff between risk & expected return.
Generally assets with higher expected returns are riskier. For
a given amount of risk, MPT describes how to select a
portfolio with highest possible expected return or for given
expected return, how to select portfolio with lowest possible
risk
Targeted expected return cannot be more than highest
returning available security, unless negative holdings of
assets are possible.
MPT is a form of diversification.
Under certain assumptions & for specific quantitative
definitions of risk & return, MPT explains how to the best
possible diversification strategy.

 MPT assumes that investors are risk averse,

i.e., given two portfolios that offer same return,
investors will prefer less risky one.
Investor will take on increased risk only if there
are higher returns. If investor wants higher
returns must accept more risk.
Though trade-off be same for all investors,
different investors will evaluate trade-off
differently based on individual risk aversion
characteristics. Rational investor will not invest
in a portfolio if a other portfolio exists with
more favorable risk-return profile i.e., if for
that level of risk an alternative portfolio exists
which has better expected returns.