High frequency trading mostly revolves around the order book, one of previous article on 'Empirical Analysis of Limit Order Books' can be a helpful in understanding order book dynamics. The market microstructure, whether they are order driven or price driven, plays a crucial role in building a HFT strategy.
Orderbook displays the best bid and best ask for the traded securities. Market makers sole objective is to buy at best bid and sell at best ask and pocket the difference known as bid-ask spread. There is no fundamental or technical analysis involved in HFT. The only philosophy is to be time efficient and obtain the best price. High-frequency trader has no intention of holding the security for a long term. The longest holding period in a HFT environment could be minutes.
Let us have a look at some of the HFT strategies as related to order book”
Market OrdersOne of the easiest strategies where you execute trades at the current available price. This strategy is suitable if you want to take position in the security (buy) or if you want to square off your position (sell). While this guarantees trade execution, downside comes in the form of paying bid ask spread.
Poke for BargainsThis is a type of limit order where the trader tries to do better than paying the market spread. Following example can help us better our understanding:
Consider an order book with following dynamics: $1.00 x $1.10 for security ABC
This means if you want to buy 1 share of ABC you have to pay $1.10 and if you want to sell 1 share of ABC you would get $1.10.
Suppose you want to poke for bargains, you would keep a buy request at $1.09. If there is someone out there willing to trade at this price and/or if the market moves in the favour of poker investor this order gets executed.
Join the MakersMarket makers profit the bid ask spread by buying at best bid and selling at the best ask. As an investor, you could give a try to follow the market makers by placing limit orders that mimic marker makers.
Reverse OrdersThere are markets which allow an order to be placed in the book but not displayed.
Example: A market displayed as 700|0.99 500|1.00 x 1.10|500 1.11|900 may in reality not be a dollar bid for 500 shares, but for 900 shares i.e there is a dollar bid – in reverse – for 400 shares. A market order to sell, say, 700 shares will fill entirely with the $1.00 price. Were there no bids in reserve, the market order would fill 500 with a price of $1.00 and 200 with a price of $0.99.
Iceberg OrdersAn iceberg order ia variation on the reverse order which is also known as hidden-size orders. The exchange displays only some of an order size and holds the remainder in reserve.
Example: A market displayed 1200|0.99 600|1.00 x 1.10|500 1.11|900 may in reality be a dollar bid for 600, but, say, for 3500 with 2900 of those shares hidden. In other words three is an order to buy 3000 for one dollar but the investor has instructed the exchange to only display 100 at a time. When the 100 bid is hit, the exchange replenishes the bid with another 100 until the entire 3000 lot order is filled. Note also that if someone hits the bid with more than 600 shares, the exchange will usually fill from the reserve size (the 2900 hidden in this case) until those shares are gone, as opposed to filling at the inferior displayed price, in this case, $0.99.