I came across this superb 5-minute YouTube video that explains what is high frequency trading. I summarized the points made below. The presenter headed quantitative research at Tudor and UBS, and was a portfolio manager at Citadel, so he knows what he’s talking about. More information can be found on the presenter’s website here.
- The goal is to obtain razor thin margins (a few cents or dollars per trade) on a massive number of trades per day.
- Following the “Fundamental Law of Active Management”, a small forecasting edge on a large number of independent bets delivers a high Sharpe Ratio.
- HFT strategies profit from imperfections in the microstructure of the double auction order book.
- They are generally unrelated to valuation.
- Microstructure imperfections arise due to rigidities (regulatory, psyche, IT), idiosyncracy, and asymmetric information.
- Such imperfections would apply across a wide variety of products.
- HFT strategies hold positions from a fraction of a second to a few hours.
- Small amount of capital that is tactically deployed intraday.
- Liquid markets to minimize transaction costs.
- Accurate estimation of order flow toxicity (e.g. using VPIN Flow Toxicity metric)
- Nuts and bolts
- High performance software
- Ultra-low latency lines
- Fast processors