High frequency FX trading

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                                                                                                                                                               Parry: I think that one of the
                                                                                                                                                               most important tools for any firm
                                                                                                                                                               looking to engage in high-
                                                                                                                                                               frequency trading is an integrated
                                                                                                                                                               development/trading application
                                                                                                                                                               to test, evaluate, and tune
                                                                                                                                                               potential strategies before rolling
                                                                                                                                                               them out to the production
                                                                                                                                                               environment and taking on
                                                                                                                                                               market risk. Although there are
                                                                                                                                                               any number of applications in the
                                                                                                                                Dr Richard Olsen               market that enable users to                        Thomas Parry
                                                                                                                           “Other things being equal,          perform some type of                      “Although superior technology
                                                                                                                           going to HFT enhances the           “backtesting” on the buy/sell logic      can be a significant competitive
                                                                                                                       return potential of an investment                                                  advantage in high-frequency

High frequency FX trading:                                                                                                strategy because a trader can
                                                                                                                             take advantage of many
                                                                                                                                more price spikes.”
                                                                                                                                                               of a particular trading system, very
                                                                                                                                                               few enable users to perform any
                                                                                                                                                               tests or simulations of the
                                                                                                                                                                                                            trading, technology alone
                                                                                                                                                                                                          without people possessing the
                                                                                                                                                                                                          “intellectual horsepower” to
                                                                                                                                                               performance of the pricing,               fully utilize it will not lead to

technology, techniques and data                                                                                      What trading metrics and tools
                                                                                                                     would you consider essential for
                                                                                                                                                               messaging, and order routing
                                                                                                                                                               components of the system.
                                                                                                                                                                                                             any sustainable form of
                                                                                                                                                                                                               alpha generation.”
                                                                                                                     any HFT operation?
                                      approximately 3,000 trades per day.    frequency trading, technology                                                     One of the primary reasons that        Why do you think FX is
                                                                                                                     Olsen: At Olsen we focus on a             Plimsoll recently chose to deploy
  The FX market has a number          The platform is computer-based,        alone without people possessing                                                                                          considered by some to be the
                                                                                                                     broad range of risk measures. One
  of features that make it            where humans oversee the trading       the “intellectual horsepower” to                                                  Athena Trader from Aegis               most advanced market for high
                                                                                                                     of the most important is the
  attractive for High Frequency       activity without actively              fully utilize it will not lead to any                                             Software was that their platform       frequency trading and what
                                                                                                                     Calmar Ratio, which compares
  Trading (HFT) and many              intervening. We human beings           sustainable form of alpha                                                         enabled us to perform a full range     advantages does it have?
                                                                                                                     annualized return with maximum
  believe we can expect to see        check that the processes are running   generation. Additionally, with the                                                of automated regression tests on       Olsen: In FX spreads are
                                                                                                                     draw down. The Calmar Ratio
  continuing interest and                                                                                                                                      each component of our trading          extremely low–approximately 0.01
                                      according to plan. In an emergency     increasing number of technology         focuses on the worst-case
  substantial future growth in                                                                                                                                 systems in parallel with complex       percent for EUR-USD. If a trader
                                      we will reactivate a process.          vendors and ISVs now offering           scenario–the relationship between
  this type of FX trading.                                                                                                                                     failover/recovery tests to assure      has perfect foresight, he can
                                                                             “off-the-shelf ” algorithmic trading    average return and extreme
  e-Forex invites Dr Richard                                                                                         loss–and is thus more relevant            that functional and performance        earn–without taking on any
                                      Our trading-model environment          applications, I believe that the vast
  Olsen, Chairman and CEO of                                                                                         than, say, the Sharpe Ratio.              capabilities are not adversely         leverage–approximately 2 percent
                                      comprises the following services:      majority of new entrants to the
  Olsen, Thomas Parry, Director                                                                                                                                affected at all by failures.           of return every day, or
                                      the core trading model taking          space would be wise to allocate
  of Algorithmic trading at                                                                                          Another risk metric we use is the                                                approximately 500 percent during
                                      trading decisions; a trading-          their resources to extending these
  Plimsoll Capital and Jonathan                                                                                      “ExposureFactor,” a term we coined        Additionally, by being able to         one year. This return potential
                                      support service for trade execution    existing applications to meet their                                               develop and test our strategies in
  Webb, Portfolio manager at                                                                                         to describe the relationship between                                             assumes that the trader can take
                                      (the actual trades); customer          needs as opposed to duplicating                                                   the same environment that they
  C-View Ltd to discuss some                                                                                         annualized return and maximum                                                    advantage of every small price
                                      reporting; and a host of               proven technology already widely                                                  will eventually be deployed in, we
  of the key issues involved.                                                                                        exposure. In financial markets,                                                  spike. If a trader cannot trade at
                                      monitoring tools. As is typical of     available in the marketplace.                                                     have been able to significantly
                                                                                                                     where uncertainty abounds, one                                                   high frequency (for example, only
                                      modern technology, the success of                                                                                        reduce the time needed to develop      once a day), then the annual
                                                                                                                     fact is sure: at low levels of
Is success in high frequency          our environment does not rely on       Webb: Not at all, HFT covers            exposure, risk increases in linear        new strategies. This allows us to      return potential is only 125
trading (HFT) in FX almost            one or two ideas, but builds on a      many types of trading. Whilst           increments; at higher levels of           deploy new strategies to the           percent. Other things being
entirely dependent upon having        complex system that has been well-     simple FX cross arbitrage models        exposure risk increases                   market faster, as well as explore      equal, going to HFT enhances the
superior technology?
                                      tuned at all levels of operation.      are undoubtedly a battle for the        exponentially, and so becomes very        more ideas.                            return potential of an investment
Olsen: Definitely, HFT is                                                    lowest latency, there are many          dangerous. It is therefore important                                             strategy because a trader can take
technology-driven. At Olsen we        Parry: Although superior               other ways to exploit HFT               to monitor exposure and to develop        Webb: Reliable, robust technology      advantage of many more price
have developed a systematic trading   technology can be a significant        opportunities rather than just          and pursue strategies that have           is the foundation for any high         spikes. For sophisticated
environment that executes             competitive advantage in high-         better technology.                      relatively small exposure at all times.   frequency trading.                     investment managers with the

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                                       more active management of FX                                                                                        successful trading. It is how you
                                       exposures. The other advantage is                                                                                   use the technology that will
                                       that there is large amount of price                                                                                 determine the profitability of the
                                       information available from banks,                                                                                   endeavour.
                                       EBS, CME etc which is essential
                                       to exploiting HFT ideas.                                                                                            Can you illustrate or describe
                                                                                                                                                           the type of new technologies
                                       Some commentators have                                                                                              that make HFT possible in FX?
                                       remarked that HFT is not an                                                                                         Olsen: Building an HFT strategy
                                       inherently better way to trade                                                                                      requires three basic tool sets:
                                       the market and indeed given the
           Jonathan Webb                                                                                                         Thomas Parry              - a data repository for tick data,                  Jonathan Webb
                                       transaction costs and the small                  Dr Richard Olsen
  “Whilst simple FX cross arbitrage                                            “Because an FX trader pays only        “What should be of a far greater       including data-cleansing                 “Systematic trading approaches,
                                       margins being captured, it is a
   models are undoubtedly a battle                                              the spread, he is not penalized       concern than data availability is      capabilities;                           in general, are well suited to risk
   for the lowest latency, there are   relatively expensive way to                                                    the cost of the high-frequency FX
                                                                              for making many small trades, so                                             - a trading-model environment to             management procedures as
  many other ways to exploit HFT       trade. Would you agree with that          HFT is not expensive at all.”        market data compared to similar                                                   optimal position-sizing can
                                                                                                                                                             develop and test the models
    opportunities rather than just     and how do you leverage                                                           market data in equity and                                                    be determined from combining
                                                                                                                                                             under real-world conditions; and
          better technology.”          technology to overcome this                                                             futures markets.”                                                              the p/l streams.”
                                                                             strategies are subject to the same                                            - a trade-execution service capable
                                       issue of costs?
                                                                             cost structure as lower-frequency                                               of faultless execution of the
appropriate computing power and        Olsen: FX is an over-the-counter                                              multiple liquidity pools to             trading signals.                      attract order flow and remain
                                                                             types of strategies. Typically, HFT
know-how this is a great               market with strong competitive                                                maximize the opportunity for                                                  competitive. Spread reduction has
                                                                             strategies are able to enjoy
enticement.                            pressure among market makers.                                                 price improvement. We have also       Without modern computers and            further fuelled the rise in HFT by
                                                                             significantly lower trading costs
                                       This has helped to bring down         due to the large amount of volume       created a series of FX-specific       advanced software tools it would        making many strategies which
Parry: I don’t know if I’d go as far   spreads and stopped banks from        they generate, allowing them to         trade execution algorithms based      be extremely expensive to build a       would have previously been
to say that the FX market is the       introducing ticket fees, as is        capture profits that have               on high-frequency analysis to         successful HFT trading                  unprofitable now viable. Finally,
most advanced market for high          customary for the futures and         previously been ‘overlooked’ by         improve our execution efficiency      environment. All three                  technology advances such as
frequency trading (yet), but I do      stock markets. Because an FX          more traditional types of               of both our medium-term and           domains–data collection, trading        complex-event processing and event-
feel strongly that it is evolving      trader pays only the spread, he is    strategies. Additionally, simply        high-frequency trading strategies     models, and trade execution–have        stream-processing, combined with
much faster than other markets         not penalized for making many         comparing the per trade return          by maximizing their opportunities     their specific complexities that        low latency market connectivity,
such as equities or futures, and it    small trades, so HFT is not           margins of different strategies         for price improvement and             must be overcome.                       have enabled traders to identify and
has several structural features that   expensive at all. HFT is all about    without taking into consideration       minimizing slippage and market                                                capture these inefficiencies as they
make it particularly attractive for    making many small trades at           the variance of those returns is a      impact.                               Parry: The introduction of              occur in real-time.
high-frequency trading. Unlike         relatively low risk.                  naïve analysis at best. Perhaps one                                           electronic order book trading
many equities and futures markets                                            of the best arguments for the           Webb: HFT covers many facets of       platforms or FX-ECNs (such as           Webb: The three key elements are
where algorithmic trading was          HFT infrastructure is not that        efficiency of HFT is that although      trading, but in terms of trading      Hotspot, Currenex and                   price discovery via FX pricing
developed as a response to a lack      costly–at least when compared to      high-frequency trading strategies       simply on a proprietary basis,        FXMarketSpace) coupled with the         feeds, auto-trading interfaces and
of liquidity, the high levels of       the lofty salaries of top traders.    generally attempt to capture            rather than as an aid to execution,   ability to easily aggregate these
liquidity in FX allow participants     The hardware and software             smaller margins than more               some of the initial opportunities     new liquidity pools through
to focus on alpha generation.          infrastructure of HFT is relatively   traditional types of trading            such as exploiting latency of bank    standardized interfaces (i.e. FIX)
                                                                                                                                                                                                   The quality and availability of
                                       durable and not lost when an          strategies, they are often able to do   FX feeds were never a sustainable     have significantly increased the
                                                                                                                                                                                                   relevant historical FX spot data
Webb: Many of the ideas and            employee leaves, which is what        so with a much higher probability       business model. In addition the       levels of pre-trade transparency in
                                                                                                                                                                                                   is a challenge for those building
much of the technology are from        happens when a top trader walks       of success (profitability) and with     costs of maintaining the              the market and have highlighted
                                                                                                                     infrastructure, settling deals etc                                            HFT models. How much of a
the equity markets so I am not         out the door.                         a lower risk per trade.                                                       the existence of previously hidden
                                                                                                                     was probably underestimated and       but profitable trading                  concern for you is availability of
sure that is true. However in FX,
                                       Parry: I think that some of these                                             like all trading ideas not everyone   opportunities. Another key effect       relevant spot data and how do
HFT can be used, for example, to                                             At Plimsoll, we have been able to
hide large orders which is             commentators may have come to         utilize advances in technology to       will make money out of HFT.           of this liquidity aggregation is that   you address the problem?
increasingly important given the       this conclusion by possibly           improve the execution efficiency        Good technology is a necessary        liquidity providers have had to         Olsen: At Olsen we started to
size of cross border flows and         assuming that high-frequency          of our strategies by aggregating        but not a sufficient condition for    tighten their spreads in order to       collect tick data in 1986; we have

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a lot of experience in storing,          granularity. Reducing these costs      go for the carry trade and there is
filtering, and using data for real-      to levels comparable with other        exuberance in one direction.
time applications. In addition, we       markets will increase market
have established a company, Olsen        participants’ understanding of the     Parry: Plimsoll utilizes a number
Financial Technologies (OFT),            high-frequency aspects of the FX       of risk measures such as VaR,
dedicated solely to gathering,           market, enabling them to build         Conditional VaR, Monte Carlo
cleansing, and formatting data.          more models, resulting in more         simulations, and maximum
OFT sells tick data in any shape         trades, more liquidity, and more       drawdown analysis to identify
or form. Also available are all the      efficient market. The greater the      potential losses under extreme
tools required for storing, filtering    quality and granularity of the data    market conditions. This analysis
and processing that data. Today,         available, the more trading            is used in our portfolio
the availability of spot data is not     strategies will be built around that   construction process to determine
the challenge for HFT; it is more        data.                                  trading limits, position sizing, and
an issue of project                                                             optimal leverage to meet our
implementation–the sort of task          Webb: This is not such a large         investment objectives.
that any software engineer               issue. In the high frequency           Furthermore, we employ a multi-
experienced in executing larger          arena, because of the large number     level diversification scheme that
projects is used to.                     of trades, it does not take many       includes diversification by
                                         weeks of data before you can have      instrument, trading model, and
Parry: I don’t really think that         statistically significant results.     trade duration.
there is a significant problem           More importantly is ensuring that
concerning the availability of           the simulations accurately reflect     Finally, our high-frequency
historical FX tick data. Although        the real world environment when        portfolio utilizes an adaptive risk
it is difficult to obtain tick-by-tick   they are replayed.                     model that dynamically allocates
market data for most currency                                                   risk to each of the underlying
pairs before 2003, several               Risk management is another key         strategies in the portfolio based on
structural changes have taken            consideration. Do you mainly           a mean-variance optimization
place over the last few years and        tackle this by diversification and     technique that continually re-
using data from before this period                                              optimizes the risk allocated to
                                         position size management or do
could very likely introduce                                                     each strategy to maximize the
                                         you employ other additional
unwanted estimation biases into                                                 expected growth rates under the
your models. Fortunately, in most                                               constraints that a CVaR or
cases, one to two years of high-         Olsen: Yes, agreed–risk                maximum drawdown objective
quality high-frequency market            management is a key issue. We          will be satisfied with a 99%
data is more than sufficient to          tackle this by diversification and     probability level.
generate statistically significant       position-size management. More
high-frequency models.                   important, we have introduced a        Webb: Systematic trading
                                         multi-layered approach to risk         approaches, in general, are well
What should be of a far greater          management. In our software we         suited to risk management
concern than data availability is        manage risk trade by trade; then,      procedures as optimal position-
the cost of the high-frequency FX        on a more aggregate level, per         sizing can be determined from
market data compared to similar          exchange rate; at a higher level,      combining the p/l streams. In
market data in equity and futures        per currency; and, finally, at the     addition, C-View’s approach to
markets. In some instances, the          global level. By managing risk         risk management is to use trading
cost of FX tick data can be              across multiple horizons we can        experience to determine when
upwards of 1,000 times more              get a better handle on                 trading conditions are no longer
expensive than futures or equities       concentration risk–for example,        conducive to any particular
data with similar levels of              when all the players in the market     trading approach.

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                     High frequency FX trading:
                technology, techniques and data

Why do you think we have seen recent substantial
growth and interest in HFT in FX trading and do you
expect this to continue in the future?
Olsen: HFT offers a lot of return potential. As I have
outlined, building a solid HFT environment is an
extremely challenging exercise; but once this has been
accomplished the platform runs smoothly and operates
at far lower risk than a traditional setup with human
traders. Incremental improvements are relatively easy;
it is the start-up where you have to get things right
without major hiccups– that’s the hard part.
Nevertheless, I expect the substantial interest and
growth in HFT to continue.

HFT–at least as practiced by Olsen–is counter-trend
and thus not subject to the typical capacity constraints.
In the hedge-fund industry there is a shortage of
highly liquid and outperforming investment strategies,
so I believe investors will automatically gravitate
towards HFT. Finally, HFT in FX is extremely
attractive from a funding point of view. Institutional
investors can invest in HFT without putting up equity,
purely on credit. So HFT is ideally suited to enhance
returns in the context of another investment strategy.
This investment story has yet to be picked up; once it
is, we think we’ll see unprecedented growth in HFT.

Parry: The FX market’s unique combination of high
liquidity and low volatility make it an ideal
environment for deploying high-frequency trading
strategies. These factors along with tight bid-ask
spreads and low transaction costs enable HFT
strategies to be much more scalable in FX than other
asset classes. This scalability could be the single most
important factor for the future growth of FX high-
frequency trading because it allows for the creation of
the economies of scale necessary to offset the high
developments costs associated with the development
of HFT strategies such as of highly-skilled
traders/quants/programmers, long development cycles
and technology investments.

Webb: HFT covers three distinct areas: banks using
algorithms to auto price FX, as a way of hiding and
reducing slippage of large flows in the marketplace
and as a proprietary trading tool. The time that a
position is held also varies from under a second to a
number of minutes. As trading technology continues
to become more ubiquitous there is no reason why all
theses areas will not increasingly use HFT ideas and