Understanding High-Frequency Trading Terminology

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Understanding High-Frequency Trading Terminology

The spike in investor interest in high-frequency trading (HFT) necessitates that industry experts get acquainted with HFT terminology. Many HFT words have their roots in the computer networking/systems business, which is understandable considering that HFT is built on tremendously fast computer architecture and cutting-edge software. Below, we will go through 10 major HFT words that we feel are vital for understanding the topic.

Co-Location

Putting computers owned by HFT businesses and private traders in the same building as an exchange’s computer systems. This allows HFT businesses to get stock prices a fraction of a second before the rest of the investing public. Exchanges have turned co-location into a profitable industry, charging HFT businesses millions of dollars for the right of “low latency access.”

As Michael Lewis argues in his book Flash Boys, the high demand for co-location is one of the main reasons why certain stock exchanges have significantly enlarged their data centers. The former New York Stock Exchange building was 46,000 square feet in size, while the NYSE data center in Mahwah, New Jersey, is over nine times bigger, at 400,000 square feet.

Flash Trading

A sort of HFT trading in which an exchange “flashes” information regarding buy and sell orders from market participants to HFT companies for a few fractions of a second before making the information public. Flash trading is contentious because HFT companies might use this knowledge advantage to trade ahead of incoming orders, a practice known as front running.

In July 2009, U.S. Senator Charles Schumer urged the Securities and Exchange Commission to prohibit flash trading, claiming that it created a two-tiered system in which a privileged group received preferential treatment while retail and institutional investors were put at an unfair disadvantage and denied a fair price for their transactions.

Latency

The period between when a signal is delivered and when it is received. Because lower latency implies quicker speed, high-frequency traders spend a lot of money to have the quickest computer hardware, software, and data connections in order to execute orders as quickly as possible and acquire a competitive advantage in trading.

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The length of the physical connection (typically fiber-optic) that transports data from one location to another is the most important driver of delay. Because light travels at 186,000 miles per second in a vacuum, or 186 miles per millisecond, an HFT business with its computers co-located immediately inside an exchange would have significantly lower latency—and hence a trading advantage—than a competing firm placed miles away.

To guarantee the same latency, an exchange’s co-location customers get the same amount of cable length regardless of where they are situated inside the exchange premises.

Liquidity Rebates

For supporting the supply of stock liquidity, most exchanges have used a “maker-taker model.” In this approach, limit order investors and traders generally earn a modest rebate from the exchange upon order execution since they are viewed as having contributed to liquidity in the stock, i.e. they are liquidity “makers.”

Those who place market orders, on the other hand, are considered “takers” of liquidity and are paid a small fee by the exchange for their transactions. While the rebates are generally fractions of a penny per share, they may quickly build up over the millions of shares exchanged daily by high-frequency traders. Many HFT businesses use trading techniques geared particularly to obtain as much of the liquidity rebates as feasible.

Matching Engine

The software program that serves as the foundation of an exchange’s trading system and continually matches buy and sell orders, a service traditionally done by trading floor professionals. Because the matching engine connects buyers and sellers for all equities, it is critical to the proper operation of an exchange. The matching engine is housed on the exchange’s computers and is the main reason why HFT businesses strive to get as near to the exchange servers as possible.

Pinging

The practice of placing tiny marketable orders (often for 100 shares) in order to discover about huge concealed orders in dark pools or exchanges. While pinging might be thought of as a ship or submarine sending out sonar signals to identify oncoming obstacles or hostile boats, in the context of HFT, pinging is used to discover concealed “prey.”

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Here’s how it’s done: To lessen the market effect of huge orders, buy-side businesses utilize algorithmic trading tools to divide them up into many smaller ones and feed them slowly into the market. HFT companies post bids and offers in 100-share lots for each listed stock in order to identify the existence of such huge orders.

Once a firm receives a “ping” (i.e., the HFT’s small order is executed) or series of pings alerting the HFT to the presence of a large buy-side order, it may engage in predatory trading activity that ensures it a nearly risk-free profit at the expense of the buy-sider, who will receive an unfavorable price for its large order. Some significant market participants have compared pinging to “baiting” since its main objective is to entice institutions with huge orders to expose their hand.

Point of Presence

The connection point for traders to the market exchange. HFT businesses want to reach as near to the point of presence as feasible in order to decrease latency. See also “Co-location.”

Predatory Trading

Some high-frequency traders use trading tactics to create almost risk-free gains at the cost of investors. In Lewis’ book, the IEX exchange, which aims to counteract some of the most shady HFT methods, identifies three predatory trading activities:

  • “Slow market arbitrage” or “latency arbitrage” is the practice of a high-frequency trader arbitraging minute price disparities across stock exchanges.
  • “Electronic front running” refers to an HFT firm racing ahead of a large client order on an exchange, scooping up all the shares on offer at various other exchanges (if it is a buy order) or hitting all the bids (if it is a sell order), and then selling to (or buying from) the client and pocketing the difference.
  • “Rebate arbitrage” refers to HFT behavior that tries to exploit liquidity rebates provided by exchanges while not really contributing to liquidity. See also “Liquidity Rebates.”
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Securities Information Processor

The system that collects quotes and trade data from several exchanges, collates and consolidates that data, and continually distributes real-time price quotations and transactions for all equities. The SIP computes the National Best Bid and Offer (NBBO) for all equities, but it has a limited delay time because to the enormous amount of data it must manage.

The latency of a SIP in calculating the NBBO is often greater than that of HFT companies (due to the latter’s quicker computers and co-location), and it is this latency difference—estimated by Lewis to sometimes reach as much as 25 milliseconds—that lies at the heart of predatory HFT behavior. The SIP for NYSE equities is overseen by the Consolidated Tape Association, whereas the UTP Plan regulates Nasdaq stocks.

Smart Routers

The technology used to identify which exchanges orders or transactions are delivered to. To provide cost-effective trade execution, smart routers may be configured to send out portions of huge orders (after they have been broken up by a trading algorithm). A smart router, such as a sequential cost-effective router, may route an order to a dark pool and subsequently to a market exchange (if it is not executed in the former), or to an exchange where a liquidity rebate is more probable.

The Bottom Line

In recent years, HFT has made waves and ruffled feathers (to use a mixed metaphor). Regardless of your feelings regarding high-frequency trading, familiarizing yourself with these HFT words should help you better comprehend this contentious subject.

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