Tuesday, September 7, 2010

Durbin, All About High-Frequency Trading

The subtitle of Michael Durbin’s All About High-Frequency Trading (McGraw-Hill, 2010) is The Easy Way to Get Started. Added to the subtitle might have been “if you have wads of money, a team of sophisticated programmers, and clever trading strategies.” This is definitely not a DIY manual for the novice trader.

The book is, however, a first-rate description of how high-frequency trading (HFT) fits into general market structure. It also outlines some HFT strategies and presents a balanced account of the debate over HFT. And, as promised in the subtitle, Durbin gets down to the nuts and bolts of building an HFT system in chapters that even I, who spent almost two days over Labor Day weekend resurrecting a very sick computer, could easily understand and thoroughly enjoy.

Durbin has a spate of credentials. He worked at Ken Griffin’s Citadel Investment Group and at the Blue Capital Group, and he taught at the business schools of Duke and the University of North Carolina. He is also the author of All About Derivatives (McGraw-Hill, 2005).

Durbin writes with facility and wit. Although the book is marketed as a primer, which in many ways it is, it is not dumbed down. The reader learns about elephants and icebergs, volatility arbitrage, and penny jumping as well as about processing off the core, multicasting, and auto hedging.

Here I’ll briefly summarize one high-frequency trading strategy—jumping the delta. Options market-makers strive to keep their portfolios delta neutral, but they can rarely lay off the risk of an option trade with another option trade. Instead, they often hedge their trade with the underlying stock. “The market-maker in the underlying stock can use his knowledge of this procedure to his advantage by getting in front of these delta hedges. The basic idea is to watch for large option trades, figure out which side the market-maker is on, calculate the delta of the option trade about to hit the market, and then get in front of it. For example, the stock market-maker sees in the options market data feed a trade ‘print’ for 5,000 put options on stock XYZ. The strike price on those options is roughly the same as the current market price for XYZ stock, so he know this is an at-the-money option, which, by definition, has a delta of around 50. The option trade price was executed near the current offer price for that option, so the stock market-maker can deduce that the options market-maker sold (or wrote) the option.” The option market-maker will have to sell short 250,000 shares of XYZ to hedge the puts he wrote. “Because option market-makers are often willing to pay the market spread, the most common delta hedge order is a market order. The stock market-maker—if he acts very quickly, more quickly than the options market-maker—can whack the $25.50 bid and bid $25.49. When the option hedge order to sell at market arrives, it fills at $25.49 and our lightning-fast stock market-maker gets to buy for $25.49 what he just sold for $25.50.” (pp. 69-70) Whew! That, my friends, is what computers (and brilliant computer programmers) are for.

All About High-Frequency Trading should appeal to computer geeks who want to improve their algo trading software and hardware. But it’s a good read for the rest of us as well. I was flabbergasted to realize just how many components are necessary to have an effective HFT system. Without passing judgment on whether HFT is beneficial or detrimental to the markets, I can say unequivocally that it’s not a quick and easy way to get rich.

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