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I lHE EASY WAY lO GEl STARTEO I Everything You Need lo Know, Including: • The internal configuration of a high-frequency trading systelll • COlllparisons of benefits and drawbacks, as we" as analyscs of inhcrcnt risks • Who profits frOIll high-frcqucncy trading and how they do it MICHAEL DURBIN

All About HIGH-FREQUENCY TRADING MICHAEL DURBIN New York Chicago San Francisco Lisbon London Madrid Mexico City Milan New Delhi San Juan Seoul Singapore Sydney Toronto

Copyright © 2010 by The McGraw-Hill Companies, Inc. All rights reserved. Except as permitted under the United States Copyright Act of 1976, no part of this publication may be reproduced or distributed in any form or by any means, or stored in a database or re- trieval system, without the prior written permission of the publisher. ISBN: 978-0-07-174345-7 MHID: 0-07-174345-6 The material in this eBook also appears in the print version of this title: ISBN: 978-0-07-174344-0, MHID: 0-07-174344-8. All trademarks are trademarks of their respective owners. Rather than put a trademark symbol after every occurrence of a trademarked name, we use names in an editorial fashion only, and to the beneﬁ t of the trademark owner, with no intention of infringement of the trademark. Where such designations appear in this book, they have been printed with initial caps. McGraw-Hill eBooks are available at special quantity discounts to use as premiums and sales promotions, or for use in corporate training programs. To contact a representative please e-mail us at bulksales@mcgraw-hill.com. Trademarks: McGraw-Hill, the McGraw-Hill Publishing logo, All About, and related trade dress are trademarks or registered trademarks of The McGraw-Hill Companies and/or its afﬁ liates in the United States and other countries and may not be used without written permission. All other trademarks are the property of their respective owners. The McGraw- Hill Companies is not associated with any product or vendor mentioned in this book. This publication is designed to provide accurate and authoritative information in regard to the subject matter covered. It is sold with the understanding that neither the author nor the publisher is engaged in rendering legal, accounting, securities trading, or other professional services. If legal advice or other expert assistance is required, the services of a competent professional person should be sought. — From a Declaration of Principles Jointly Adopted by a Committee of the American Bar Association and a Committee of Publishers and Associations TERMS OF USE This is a copyrighted work and The McGraw-Hill Companies, Inc. (“McGrawHill”) and its licensors reserve all rights in and to the work. Use of this work is subject to these terms. Except as permitted under the Copyright Act of 1976 and the right to store and retrieve one copy of the work, you may not decompile, disassemble, reverse engineer, reproduce, modify, create derivative works based upon, transmit, distribute, disseminate, sell, publish or sublicense the work or any part of it without McGraw-Hill’s prior consent. You may use the work for your own noncommercial and personal use; any other use of the work is strictly prohibited. Your right to use the work may be terminated if you fail to comply with these terms. THE WORK IS PROVIDED “AS IS.” McGRAW-HILL AND ITS LICENSORS MAKE NO GUARANTEES OR WARRANTIES AS TO THE ACCURACY, ADEQUACY OR COMPLETENESS OF OR RESULTS TO BE OBTAINED FROM USING THE WORK, INCLUDING ANY INFORMATION THAT CAN BE ACCESSED THROUGH THE WORK VIA HYPERLINK OR OTHERWISE, AND EXPRESSLY DISCLAIM ANY WARRANTY, EXPRESS OR IMPLIED, INCLUDING BUT NOT LIMITED TO IMPLIED WARRANTIES OF MERCHANTABILITY OR FITNESS FOR A PARTIC- ULAR PURPOSE. McGraw-Hill and its licensors do not warrant or guarantee that the functions contained in the work will meet your requirements or that its operation will be unin- terrupted or error free. Neither McGraw-Hill nor its licensors shall be liable to you or anyone else for any inaccuracy, error or omission, regardless of cause, in the work or for any damages resulting therefrom. McGraw-Hill has no responsibility for the content of any information accessed through the work. Under no circumstances shall McGraw-Hill and/or its licensors be liable for any indirect, incidental, special, punitive, consequential or similar damages that result from the use of or inability to use the work, even if any of them has been advised of the possibility of such damages. This limitation of liability shall apply to any claim or cause whatsoever whether such claim or cause arises in contract, tort or otherwise.

C O N T E N T S Preface v Acknowledgments xiii Chapter 1 Busted 1 Chapter 2 Trading 101 9 Chapter 3 Trading Strategies 43 Chapter 4 Achieving Speed 95 Chapter 5 Under the Hood 131 Chapter 6 The High-Frequency Trading Debate 173 Now What? 195 Glossary 197 Bibliography 215 Index 219 iii

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P R E F A C E Customer: How much are these? Merchant: A buck fifty. Customer: I’ll take some. Merchant: They’re a buck fifty-one. Customer: Um, you said a buck fifty. Merchant: That was before I knew you wanted some. Customer: You can’t do that. Merchant: It’s my shop. Customer: But I need to buy a hundred! Merchant: A hundred? Then it’s a buck fifty-two. Customer: You’re ripping me off. Merchant: Supply and demand, pal. You want ’em or not? What is high- frequency trading? Great question! And it’s about time for an answer, because everyone seems to be talk- ing about it—and forming strong opinions about it—and when that happens, it’s usually a good thing to know just what it is. Does high- frequency trading relate only to stock trading? Or does it include automated trading of stock deriva- tives such as options? Does it encompass any type of auto- mated trading, where computers make the decisions humans once did? Or does it pertain only to the dubious practices of the sharks sophisticated trading firms who, like the merchant above, move markets in their favor just because they can get away with it? Well, since nobody can quite answer these ques- tions, let’s just make our own definition and get on with it. In general, high- frequency trading (HFT) refers to the buy- ing or selling of securities wherein success depends on how v

vi Preface quickly you act, where a delay of a few thousandths of a sec- ond, or milliseconds,1 can mean the difference between profit and loss. HFT happens not only in the stock markets but in the markets for stock options and futures as well. Naturally, not every reason for trading requires speedy execution. Certainly not, say, buying stock because you think the company will do well over the coming years or cashing out your 401(k) to buy the Harley you’ve had your eye on since you were sixteen. But plenty of trading strategies do indeed depend on how quickly you can spot a profitable trading opportunity in the market—and how quickly you respond with a trade order to seize that opportunity before somebody else does. We’ll describe a number of such strategies later on. The high- frequency trader evolved from the ranks of the traditional market-maker, or specialist, whose primary source of profit was the spread between the prices at which he bought and sold. Unlike the traditional market-maker, however, and owing to developments like decimalization2 and advances in technology, the high- frequency trader must settle for much narrower spreads—razor-thin margins of a penny or less. As such, high- frequency traders operate in massive scales. Indeed, the larger high- frequency trading firms now glide through the markets scooping up vast mouthfuls of trades like a whale does krill. Signs of the likely effects of high- frequency trading, and the growth of the number of firms practicing it, are not hard to find. Figure 1 shows the Security and Exchange Commission’s (SEC) calculation of the nearly threefold increase in daily 1 Increasingly, and perhaps by the time you read this book, microseconds—or millionths of a second—also matter. And it’s only a matter of time before we’re talking about nanoseconds, or billionths of a second. 2 Decimalization refers to the shift, in the early 2000s, from trading stocks in fractions of dollars to doing so in pennies, dramatically reducing the potential spread between the prices at which one can buy and sell a stock.

Preface vii F I G U R E 1 NYSE Trading Statistics 8 ! .6 • , . L ID o 25 ~ 20 ~ 15 , j 10 ~ 5 o 800 .: 600 ~ ! 400 i 200 • o NYSE-Listed Consolidated Average Daily Volume 2.1 .2005 . 2009 NYSE-Listed Consolidated Average DailyTrades 22.1 2.9 11 2005 • 2009 NYSE-Listed Consolidated Average Trade Size ,,. 268 .2005 . 2009

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