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Algorithmic and HFT have been the subject of much public debate since the U.S. Securities and Exchange Commission and the Commodity Futures Trading Commission said in reports that an algorithmic trade entered by
a mutual fund company triggered a wave of selling that
led to the 2010 Flash Crash.[14][15][16][17][18][19][20][21] The
same reports found HFT strategies may have contributed
to subsequent volatility. As a result of these events, the
Dow Jones Industrial Average suered its second largest
intraday point swing ever to that date, though prices
quickly recovered. (See List of largest daily changes in
the Dow Jones Industrial Average.) A July, 2011 report
by the International Organization of Securities Commissions (IOSCO), an international body of securities regulators, concluded that while algorithms and HFT technology have been used by market participants to manage their trading and risk, their usage was also clearly
a contributing factor in the ash crash event of May 6,
2010.[22][23] However, other researchers have reached a
dierent conclusion. One 2010 study found that HFT did
not signicantly alter trading inventory during the Flash
Crash.[24] Some algorithmic trading ahead of index fund
Algorithmic trading may be used in any investment strategy, including market making, inter-market spreading,
arbitrage, or pure speculation (including trend following).
The investment decision and implementation may be augmented at any stage with algorithmic support or may operate completely automatically. One of the main issues
regarding HFT is the diculty in determining how profitable it is. A report released in August 2009 by the
TABB Group, a nancial services industry research rm,
estimated that the 300 securities rms and hedge funds
that specialize in this type of trading took in a maximum
of US$21 billion in prots in 2008,[6] which the authors
called relatively small and surprisingly modest when
compared to the markets overall trading volume.
2
rebalancing transfers prots from investors.[25][26][27]
HISTORY
1 History
2.3
Pairs trading
bound determined by the speed of light; this corresponds 2.3 Pairs trading
to about 3.3 milliseconds per 1,000 kilometers of optical
bre. Any signal regenerating or routing equipment in- Pairs trading or pair trading is a long-short, ideally
troduces greater latency than this lightspeed baseline.
market-neutral strategy enabling traders to prot from
transient discrepancies in relative value of close substitutes. Unlike in the case of classic arbitrage, in case
of pairs trading, the law of one price cannot guarantee
convergence of prices. This is especially true when the
strategy is applied to individual stocks - these imperfect
2 Strategies
substitutes can in fact diverge indenitely. In theory the
long-short nature of the strategy should make it work re2.1 Trading ahead of index fund rebalanc- gardless of the stock market direction. In practice, execution risk, persistent and large divergences, as well as
ing
a decline in volatility can make this strategy unprotable
for long periods of time (e.g. 2004-7). It belongs to wider
Most retirement savings, such as private pension funds or categories of statistical arbitrage, convergence trading,
401(k) and individual retirement accounts in the US, are and relative value strategies.[37]
invested in mutual funds, the most popular of which are
index funds which must periodically rebalance or adjust their portfolio to match the new prices and market 2.4 Delta-neutral strategies
capitalization of the underlying securities in the stock or
other index that they track.[34][35] Prots are transferred In nance, delta-neutral describes a portfolio of related
from investors to algorithmic traders, estimated to be at nancial securities, in which the portfolio value remains
least 21 to 28 basis points annually for S&P 500 index unchanged due to small changes in the value of the unfunds, and at least 38 to 77 basis points per year for derlying security. Such a portfolio typically contains opRussell 2000 funds.[26] John Montgomery of Bridgeway tions and their corresponding underlying securities such
Capital Management says that the resulting poor in- that positive and negative delta components oset, resultvestor returns from trading ahead of mutual funds is the ing in the portfolios value being relatively insensitive to
elephant in the room that shockingly, people are not changes in the value of the underlying security.
talking about.[27]
2.5 Arbitrage
2.2
Trend following
STRATEGIES
2.6
Mean reversion
2.7
Scalping
5
dividual scalpers. A market maker has a sophisticated
trading system to monitor trading activity. However, a
market maker is bound by strict exchange rules while the
individual trader is not. For instance, NASDAQ requires
each market maker to post at least one bid and one ask
at some price level, so as to maintain a two-sided market
for each stock represented.
2.8
2.9
Strategies that only pertain to dark There are four key categories of HFT strategies: marketmaking based on order ow, market-making based on
pools
Recently, HFT, which comprises a broad set of buyside as well as market making sell side traders, has
become more prominent.[39] These algorithms or techniques are commonly given names such as Stealth (developed by the Deutsche Bank), Iceberg, Dagger,
tick data information, event arbitrage and statistical arbitrage. All portfolio-allocation decisions are made by
computerized quantitative models. The success of HFT
strategies is largely driven by their ability to simultaneously process volumes of information, something ordinary human traders cannot do.
5 STRATEGY IMPLEMENTATION
The spread between these two prices depends mainly on
the probability and the timing of the takeover being completed as well as the prevailing level of interest rates. The
bet in a merger arbitrage is that such a spread will eventually be zero, if and when the takeover is completed.
The risk is that the deal breaks and the spread massively
widens.
4 Low-latency trading
HFT is often confused with low-latency trading that uses
computers that execute trades within microseconds, or
with extremely low latency in the jargon of the trade.
Low-latency traders depend on ultra-low latency networks. They prot by providing information, such as
competing bids and oers, to their algorithms microseconds faster than their competitors.[8] The revolutionary
advance in speed has led to the need for rms to have
a real-time, colocated trading platform to benet from
implementing high-frequency strategies.[8] Strategies are
constantly altered to reect the subtle changes in the market as well as to combat the threat of the strategy being reverse engineered by competitors. There is also a
very strong pressure to continuously add features or improvements to a particular algorithm, such as client specic modications and various performance enhancing
changes (regarding benchmark trading performance, cost
reduction for the trading rm or a range of other implementations). This is due to the evolutionary nature of algorithmic trading strategies they must be able to adapt
and trade intelligently, regardless of market conditions,
which involves being exible enough to withstand a vast
array of market scenarios. As a result, a signicant proportion of net revenue from rms is spent on the R&D of
these autonomous trading systems.[8]
A subset of risk, merger, convertible, or distressed securities arbitrage that counts on a specic event, such as 5 Strategy implementation
a contract signing, regulatory approval, judicial decision,
etc., to change the price or rate relationship of two or Most of the algorithmic strategies are implemented usmore nancial instruments and permit the arbitrageur to ing modern programming languages, although some still
earn a prot.[49]
implement strategies designed in spreadsheets. IncreasMerger arbitrage also called risk arbitrage would be an ingly, the algorithms used by large brokerages and asexample of this. Merger arbitrage generally consists of set managers are written to the FIX Protocols Algorithbuying the stock of a company that is the target of a mic Trading Denition Language (FIXatdl), which altakeover while shorting the stock of the acquiring com- lows rms receiving orders to specify exactly how their
pany. Usually the market price of the target company electronic orders should be expressed. Orders built using
is less than the price oered by the acquiring company. FIXatdl can then be transmitted from traders systems via
6.2
Concerns
Algorithmic trading has been shown to substantially improve market liquidity[52] among other benets. However, improvements in productivity brought by algorithmic trading have been opposed by human brokers and
traders facing sti competition from computers.
Other issues include the technical problem of latency or
the delay in getting quotes to traders,[56] security and the
possibility of a complete system breakdown leading to a
6.1 Cyborg Finance
market crash.[57]
Technological advances in nance, particularly those
Goldman spends tens of millions of dolrelating to algorithmic trading, has increased nancial
lars on this stu. They have more people workspeed, connectivity, reach, and complexity while simultaing in their technology area than people on the
neously reducing its humanity. Computers running softtrading desk...The nature of the markets has
ware based on complex algorithms have replaced humans
changed dramatically. [58]
in many functions in the nancial industry. Finance is
essentially becoming an industry where machines and
On August 1, 2012 Knight Capital Group experienced
humans share the dominant roles transforming moda technology issue in their automated trading system,[59]
ern nance into what one scholar has called, cyborg
causing a loss of $440 million.
nance.[53]
6.2
Concerns
This issue was related to Knights installation of trading software and resulted in Knight
sending numerous erroneous orders in NYSElisted securities into the market. This software
has been removed from the companys systems.
[..] Clients were not negatively aected by the
erroneous orders, and the software issue was
limited to the routing of certain listed stocks
to NYSE. Knight has traded out of its entire
erroneous trade position, which has resulted in
a realized pre-tax loss of approximately $440
million.
Some have claimed that algorithmic trading and HFT
contributed to volatility during the May 6, 2010 Flash
Crash,[14][16] when the Dow Jones Industrial Average
plunged about 600 points only to recover those losses
within minutes. At the time, it was the second largest
point swing, 1,010.14 points, and the biggest one-day
point decline, 998.5 points, on an intraday basis in Dow
Jones Industrial Average history.[60]
7 TECHNICAL DESIGN
In late 2010, The UK Government Oce for Science initiated a Foresight project investigating the future of computer trading in the nancial markets,[64] led by Dame
Clara Furse, ex-CEO of the London Stock Exchange and
in September 2011 the project published its initial ndings in the form of a three-chapter working paper available in three languages, along with 16 additional papers
that provide supporting evidence.[65] All of these ndings are authored or co-authored by leading academics
and practitioners, and were subjected to anonymous peerreview. The Foresight projects nal report noted that
though HFT created the potential for periodic liquidity,
it found that HFT was benecial to liquidity and price formation and helped to lower transaction costs. [66][67]
In September 2011, RYBN has launched ADM8,[68] an
open source Trading Bot prototype, already active on the
nancial markets.
7 Technical design
The technical designs of such systems are not standardized. Conceptually, the design can be divided into logical
units:[69]
1. The data stream unit (the part of the systems that
receives data (e.g. quotes, news) from external
sources)
2. The decision or strategy unit
3. The execution unit
With the wide use of social networks, some systems implement scanning or screening technologies to read posts
9
of users extracting human sentiment and inuence the
trading strategies. [70]
Eects
Though its development may have been prompted by decreasing trade sizes caused by decimalization, algorithmic trading has reduced trade sizes further. Jobs once
done by human traders are being switched to computers. The speeds of computer connections, measured in
milliseconds and even microseconds, have become very
important.[71][72]
More fully automated markets such as NASDAQ, Direct Edge and BATS, in the US, have gained market
share from less automated markets such as the NYSE.
Economies of scale in electronic trading have contributed
to lowering commissions and trade processing fees, and
contributed to international mergers and consolidation of
nancial exchanges.
9 Communication standards
Algorithmic trades require communicating considerably
more parameters than traditional market and limit orders. A trader on one end (the extquotedblbuy side extquotedbl) must enable their trading system (often called
an extquotedblorder management system extquotedbl or
extquotedblexecution management system extquotedbl)
to understand a constantly proliferating ow of new algorithmic order types. The R&D and other costs to construct complex new algorithmic orders types, along with
the execution infrastructure, and marketing costs to distribute them, are fairly substantial. What was needed was
a way that marketers (the extquotedblsell side extquotedbl) could express algo orders electronically such that
buy-side traders could just drop the new order types into
their system and be ready to trade them without constant
coding custom new order entry screens each time.
FIX Protocol LTD http://www.fixprotocol.org is a trade
association that publishes free, open standards in the
securities trading area. The FIX language was originally created by Fidelity Investments, and the association Members include virtually all large and many midsized and smaller broker dealers, money center banks, institutional investors, mutual funds, etc. This institution
dominates standard setting in the pretrade and trade areas of security transactions. In 2006-2007 several members got together and published a draft XML standard
for expressing algorithmic order types. The standard
is called FIX Algorithmic Trading Denition Language
(FIXatdl).[75] The rst version of this standard, 1.0 was
not widely adopted due to limitations in the specication,
but the second version, 1.1 (released in March 2010) is
expected to achieve broad adoption and in the process
dramatically reduce time-to-market and costs associated
with distributing new algorithms.
10
10
4-Wheel Drive
Blotter
60-Step
Blue Bandsaw
The Abyss
Algo Mountains
Blue Blaster
Almost Human
Blue Blind
Apollo
Blue Blocker
Asimovs Nightmare
Blue Flicker
The Awakening
Blue Ice
Back to School
The Bagman
Blue Stubble
Bankers Ball
Blue Thicket
Bankers Blitz
Blue Wave
BAT Cave
Blue Zinger
BAT Code
Bluegrass
BAT Discovery
Boston Buck'r
BAT Dribble
Boston Shue
BAT Fence
Boston Zapper
BAT Hats
Bot Town
BAT Horizon
Bot Wars
BAT Lego
Botastic
Bat Pig
BOTvsBOT
Batastic
The Bridge
Batsicles
Bristles
BBOBomber
Broken BAT
The Beach
Broken Highway
Broken SKY
Bid Stuer
Broken Zanti
The Bird
Buckaroo Banzai
Blast This
The Bug
Blockhead
The Bunker
ALGORITHMS
11
CancelBot
Double Dip
CancelBot Jr.
Cancelled Check
The Drowning
Cannons
Early Discovery
Cannons 2
Early Riser
The Carnival
Enchanted Forest
Castle Wall
EPIC Zapper
Changing Tide
Eraser Head
Cherokee Nation
Faster Zapper
Flag Repeater
City Of BATS
The Flood
Flutter
The Click
Focus
Clockwork Orange
The Follower
Clogged Artery
Fred
Continental Crust
Frog Pond
Control Tower
From Above
Crazy Eyes
From Below
The Crown
Fuzzy Orange
Day Trippin
Gold Finger
Gone Fishing
The Deep
Depth Ping
Ground Strike
Detox
Hairline
Dinosaur Hunt
Heart Attack
Dirty Glaciers
High EQ
Don't Tread On Me
High Tide
12
10
Hummingbird
Orange Crush
I'm A PC
Orange Marmalade
Inner Chart
Jump Shot
Pacic Rim
Junior
The Palace
Just Ask
Penny Pincher
The Knife
Landmine
Periscopes
Petting Zoo
Lightning Strike
Pinger
Plate Shift
Local Dump
Platform Drilling
Low Tide
The Port
Made in America
Power Line
Mainframe
Power Tower
Puzzle Pieces
Marco Polo
The Quota
Market Share
Quota Catcher
Master Blaster
Quota Machine
Maxy-Zapper
The Raceway
Meteors
Racing Stripe
The Monster
Railway
Monster Mash
The Ramp
Morning Zanti
The Morphing
Red Tide
NARA Zapper
Redline
No Joy
Repeater Wars
No Reason
Robot Fight
Obstructus Maximus
Robot Hunting
Rock Star
ALGORITHMS
13
Rollerball
Tank Tracks
The Ron
Teslas Cathedral
Rougue Wave
Test Pattern
The Rover
Them
Runawa
S.O.S.
Scissors
Scoaw
Sea Level
Sea of BATS
Sea of BATS Star
The Search
tHigh EQ
The Thin Blue Line
Thin Blue Line
Things that make you go 'hmmmm'
The Tickler
To The Moon, Alice!
Trade Dominator
Search Bots
Twilight
The Seekers
Wading Pool
Wake Up Call
Seizure
Warp 15
Shades of Blue
Waste Pool
The Shredder
Simple BAT
Single Track
Social Buttery
Solar Flare
Soylent Blue
The Spartan
Spastic BAT
Street Lamps
Wild Thing
Wild Thing Edge
Yellow Picket Fence
Yellow Snow
You Don't Know Jack
Zanti Mahem
The Zanti Mist
Stubby Triangles
Zapata
Sunshowers
Zappa Street
T1 Killer
Zapper Clone
Take Two
Zero to Sixty
14
11 See also
FIXatdl
Alternative trading system
Articial intelligence
Complex event processing
Electronic trading platform
2010 Flash Crash
High-frequency trading
Mirror trading
Technical analysis
12 Notes
[1] As an arbitrage consists of at least two trades, the
metaphor is of putting on a pair of pants, one leg (trade)
at a time. The risk that one trade (leg) fails to execute is
thus 'leg risk'.
13 References
13
REFERENCES
[20] Younglai, Rachelle (5 Oct 2010). U.S. probes computer algorithms after ash crash extquotedbl extquotedbl. Reuters.
[21] Spicer, Jonathan (15 Oct 2010). Special report: Globally, the ash crash is no ash in the pan. Reuters.
[22] TECHNICAL COMMITTEE OF THE INTERNATIONAL ORGANIZATION OF SECURITIES COMMISSIONS (July 2011), Regulatory Issues Raised by the
Impact of Technological Changes on Market Integrity and
Eciency, IOSCO Technical Committee, retrieved July
12, 2011
[23] Huw Jones (July 7, 2011). Ultra fast trading needs curbs
-global regulators. Reuters. Retrieved July 12, 2011.
[24] Tuzun, Tugkan (May 5, 2014), The Flash Crash: The Impact of High Frequency Trading on an Electronic Market
(Social Science Research Network)
15
[25] Amery, Paul (November 11, 2010). Know Your Enemy. IndexUniverse.eu. Retrieved 26 March 2013.
[26] Petajisto, Antti (2011). The index premium and its hidden cost for index funds. Journal of Empirical Finance
18: 271288. doi:10.1016/j.jempn.2010.10.002. Retrieved 26 March 2013.
[27] Rekenthaler, John (FebruaryMarch 2011).
The
Weighting Game, and Other Puzzles of Indexing. Morningstar Advisor. pp. 5256 [56]. Retrieved 26 March
2013.
[28] Sornette (2003), Critical Market Crashes
[29] BOWLEY, GRAHAM (April 25, 2011). Preserving a
Market Symbol. The New York Times. Retrieved 7 August 2014.
[30] Agent-Human Interactions in the Continuous Double
Auction, IBM T.J.Watson Research Center, August 2001
[31] Price Formation in Double Auctions, Games and Economic Behavior, 22(1):1-29, S. Gjerstad and J. Dickhaut,
January 1998
[32] Minimal Intelligence Agents for Bargaining Behaviours
in Market-Based Environments, Hewlett-Packard Laboratories Technical Report 97-91 extquotedbl, D. Cli, August 1997
[33] Algo Arms Race Has a Leader For Now, NYU Stern
School of Business, December 18, 2006
[34] High-Frequency Firms Tripled Trades in Stock Rout,
Wedbush Says. Bloomberg/Financial Advisor. August
12, 2011. Retrieved 26 March 2013.
[35] Siedle, Ted (March 25, 2013). Americans Want More
Social Security, Not Less. Forbes. Retrieved 26 March
2013.
[36] Anatomy of a Trend Following Trade - The Short Exit
[37] The Application of Pairs Trading to Energy Futures Markets
[38] Jackie Shen (2013), A Pre-Trade Algorithmic Trading
Model under Given Volume Measures and Generic Price
Dynamics (GVM-GPD), available at SSRN or DOI.
[39] Wilmott, Paul (July 29, 2009). Hurrying into the Next
Panic. New York Times. p. A19. Retrieved July 29,
2009.
[40] Trading with the help of 'guerrillas and 'snipers extquotedbl, Financial Times, March 19, 2007
[41] Rob Curren, Watch Out for Sharks in Dark Pools, The
Wall Street Journal, August 19, 2008, p. c5. Available at
WSJ Blogs retrieved August 19, 2008
[42] Articial intelligence applied heavily to picking stocks by
Charles Duhigg, November 23, 2006
[43] Georey Rogow, Rise of the (Market) Machines, The
Wall Street Journal, June 19, 2009
[44] High-frequency nance and the hedge fund category of
the future
[45] Hendershott, Terrence, Charles M. Jones, and Albert J.
Menkveld. Does Algorithmic Trading Improve Liquidity? extquotedbl, Journal of Finance (forthcoming), 2010
[46] Jovanovic, Boyan, and Albert J. Menkveld. Middlemen
in Securities Markets, working paper, 2010
[47] James E. Hollis (Sep 2013). HFT: Boon? Or Impending
Disaster? extquotedbl. Cutter Associates. Retrieved July
1, 2014.
[48] Citigroup to expand electronic trading capabilities by
buying Automated Trading Desk, The Associated Press
(International Herald Tribune), July 2, 2007, retrieved
July 4, 2007
[49] Event Arb Denition Amex.com, September 4th 2010
[50] FIXatdl - An Emerging Standard, FIXGlobal, December
2009
[51] Preis, T.; Paul, W.; Schneider, J. J. (2008), Fluctuation
patterns in high-frequency nancial asset returns, EPL
(Europhysics Letters) 82 (6): 68005, doi:10.1209/02955075/82/68005
[52] HENDERSHOTT, TERRENCE, CHARLES M.
JONES, AND ALBERT J. MENKVELD. Does Algorithmic Trading Improve Liquidity? extquotedbl, Journal
of Finance, 2010
[53] Lin, Tom C.W., The New Investor, 60 UCLA 678 (2013),
available at: http://ssrn.com/abstract=2227498
[54] Black box traders are on the march The Telegraph, 27
August 2006
[55] Myners super-fast shares warning BBC News, Tuesday 3
November 2009.
[56] Enter algorithmic trading systems race or lose returns, report warns, Financial Times, October 2, 2006
[57] Cracking The Streets New Math, Algorithmic trades are
sweeping the stock market.
16
14
14 External links
Automated Trader Magazine: Algorithmic Trading
denition and reference
What is a Trading System?
Advanced Trading Magazine: Algorithmic Trading
Resource Center Advanced Trading Magazine
Motley Fool denition and references for Algorithmic Trading
BusinessWeek.com SEC Risks Harm With HighFrequency Trading Curbs, CME CEO Says
EXTERNAL LINKS
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