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HFTs

A Few Notes On High Frequency Trading

Futures lead equities

Stock futures in the Chicago Mercantile Exchange tend to move a tiny fraction of a second before corresponding movements in the prices of the underlying stocks and ETFs in exchanges elsewhere.

Some points to note about this behaviour.

  1. Futures trading is highly leveraged, whereas leverage in the equities market is something to be negotiated with a prime broker. Perhaps this leads to more extreme price swings in the futures market.

  2. Liquidity is self-fulfilling. CME is the only futures market in the US. If market participants want to express a view on likely movements in the US stock market, they would naturally buy or sell futures in the CME's index futures market. This market has a reptuation for being very liquid and this reputation leads more market participants to take their trades there which makes it even more liquid.

  3. The slight lead in futures price movements ahead of the underlying equities still remains to this day despite this being public knowledge and HFTs strategies to exploit this behaviour.

Makers vs Takers

A market-maker places orders into an order book at prices that can’t immediately be traded away. The order 'sits' in an order book. This adds liquidity and is something exchanges encourage by offering rebates to market makers.

Taking is putting in orders that execute against orders that are already there.
This removes liquidity.

The strategy of market makers is to earn the 'spread', the difference between the bid-offer, while avoiding heavy losses by maintaining a minimal position.

The strategy of liquidity takers is to look for stale quotes- quotes that the market-maker has put into the order book and hasn’t cancelled fast enough when circumstances change.

Common Strategies

  1. Order book volumes. If there are more bids then asks, then prices are going to go up and vice versa. Same observation on the change in order book volumes. If the sizes of bids are decreasing, then price should move down. Another tool to use is the VWAP of up to 3 or 5 levels deep to avoid being faked by small token orders at the top of the book.

  2. Price arbitrage on different venues. The same equity can be traded on more than one venue. A move on one can precede the same move on another.

  3. Futures and equities. Movement of futures prices usually precede the movements of the underlying equities.

Cancel Everything

Market makers operate throughout the trading day with the fear of getting sniped. When market makers leave a quote in an order book for an extended time when market conditions have changed, that leaves a stale quote for liquidity takers to feast upon. Speaking from personal experience, the horror of getting picked off, seven times, on a mispriced off-the-run 10yr was a pain etched into this writer's memory.

For market makers, the ability to quickly modify and cancel orders on trading venues is absolutely critical. The market maker's engineers must ensure their modify and cancel order transmissions run on their system's 'hotpath'- meaning code that already runs frequently and is most likely already in cache. Furthermore, the hotpath has no unnecessary instructions that could add precious nanoseconds on its way the to its target venue. Even an extra if statement could wind up costly as a branch misprediction.

In options trading, this modify and cancel order low-latency requirement is further amplified a thousand times. To backtrack a bit, in the world of equities, one particular asset- the price of one share of Apple- could be mispriced. With options, there are puts and calls with a huge ranges of strike prices and expiries. There could be hundreds of actively quoted options on one stock. And if the stock of the underlying is wrong, the entire set of options prices built on the underlying price is wrong. If one mispriced equity order could be picked off, having a few hundred options orders picked off would be catastrophic.

To minimize the chances of this potential disaster, there are risk controls exchanges offer to market markers' toolbox. One is an instant alert whenever a pre-set number of options orders in the same family get executed within a pre-set timeframe. As soon as a market marker receives such alerts, it intuitively assume that there must've been some mispricing and it's safest to just pull all orders for options under that underlying. This is where the lowest latency to trading venues is of critical importance.

2025-04