Before we get into the main topic, let's talk about some preliminary knowledge. The world of high-frequency trading is on the surface a digital and electronic arena, but by its very nature, it is always human participation behind the scenes. Therefore, to survive in this arena, you need to understand the market participants before you understand the market.
The trading market is a vast ocean with a wide variety of motivations and behaviors among its participants. However, it can be broadly divided into three categories (this classification method is based on Trading and Exchanges: Market Microstructure for Practitioners):
People who trade based on some kind of realistic need. For example, investors buy financial assets such as stocks and hold them for a long time in order to enhance their current assets and get a higher return than bank interest; manufacturing companies hedge in order to lock in production costs. For these people, because of realistic needs, they have to trade, and their main concern is whether the price of the trade is reasonable, as for whether the trade itself makes money, not the point.
Professional traders who expect to make a profit from the trading behavior itself; including what we often call stock manipulators, arbitrageurs, market makers, etc. These professional traders use their technical accumulation to generate steady or exaggerated profits on the trading person and are the protagonists of most of the Yangtze legend.
It is not necessary to say much about the people who are everywhere in the world, such as the exiles whose minds are blinded by the legends of the various rivers. These people are known as Noise Trader, popularly known as idiots, and the end result is often miserable. But unfortunately, the most inexhaustible resource in the world is idiots.
In this system, the only winners are the two; for the two, the existence of the one and the three provides them with the necessary resources on which they depend. The one is the first impetus of the entire ecosystem, which translates some external value into the system, as a cost to the two. This relationship is actually quite stable, so the one is also a stable link.
For 2, further subdivision can be made into professional speculators and market makers.
The so-called professional speculator, or Informed Trader, refers to a person who has an extraordinary ability to judge prices and values. Their way of survival is to always find the true value of a commodity (in this case, a specific financial product). Specifically, each professional speculator will be different, some rely on experience, some on intuition, some on philosophy, some on complex mathematical models, and of course some on the inner lines, but in the end they must always look for a price that is not comparable to the true value.
Another role, which is also the main character of this story, is that of a market maker; they have basically abandoned the work of judging the value of this extremely difficult task, and are merely a merchant who sells a product. This product is called a liquidity buffer. This is a method of bilateral trading that uses both sides to buy and sell simultaneously, earning a small price difference between the buy and sell pairs.
Buy - price 100, quantity 1 I'm going to sell it - price 101, number 1
In this way, as long as someone completes the two transactions separately from the seller, he earns a price difference of 101-100 = 1. This business, although profitable, is sufficient to survive as long as it is large.
From the above analysis, it can be seen that at the top of the food chain are the professional speculators, the god-killers, the Buddha-killers. At the bottom are the relatively moderate market traders, who earn only the costs and costs paid by 1 and 3.
In this regard, the main topic of this article: Adverse Selection, first of all, see the definition:
Reverse option refers to a phenomenon in which the average quality of products traded in the market decreases due to asymmetric information on the two sides of the trade and a decrease in market prices. For example, in the product market, especially in the second-hand market, because the seller has more information about the quality of the goods than the buyer, the buyer is only willing to pay based on the average quality of the goods because he cannot identify the quality of the goods, which causes the price of the quality goods to be underestimated and withdraws from the market transaction, resulting in only the delivery of inferior products, which leads to the termination of the transaction.
This is itself a general economic concept, which must be adapted to the context of high-frequency trading based on the market structure described before understanding it. For the main market maker, the quality products in the market are the traders of types 1 and 3, who are market makers by providing them with liquidity, charging them the difference in the bid and offer prices in return.
Buy - price 100, quantity 1 I'm going to sell it - price 101, number 1
When someone trades one of these (e.g. at a price of 100 sold to a market maker), (in the statistical sense) as long as the price does not change for a period of time and another person completes another trade, the market maker can earn a difference. If the market price moves in a more favorable direction for the market maker, for example, someone willing to buy at a price of 102, the market maker can also earn an additional profit.
The worst case scenario is that the market moves in the opposite direction, for example, the market maker may find that no one is willing to buy at the price of 101, but instead all buyers only accept to buy at the price of 99.
From this it can be seen that the first person to sell to the market maker at a price of 100 is a key role; because if this person does not complete the transaction, the market maker only needs to adjust his bid without having to bear the final loss of the transaction. Who is then most likely to force the market maker into this situation?
Therefore, from the point of view of a market trader, professional speculators are a particularly inferior product in this market. The limit order that you put up, you don't want to be eaten by them anyway. Unfortunately, however, in a limit order market, there is no way to tell if a trader is a professional speculator, you won't even know exactly who is trading with you (exchanges won't send you this information); that's why we call it a typical reverse option problem.
Is there a way to protect yourself as a market trader? There is a simple answer: Kung Fu, unstoppable, not broken. The only way to escape from the mouth of the top predator is to escape quickly...; the only other way is to get bitten and then quickly pull other bad guys to replace yourself.
The term quick escape refers to the ability to quickly adjust your bid according to the market market, through quantitative analysis of the market, to cancel the hanging Limit Order in time when the market is more volatile (for example, there is a greater Imbalance between the Bid / Offer).
If you are bitten, don't panic, there is a strategy to save yourself. Continue reading Order Book, and let's add a little information.
Buy - price 100, quantity 1, by Trader 1; price 100, quantity 1, by Trader 2 Selling - price 101, quantity 1, trader 1
Attention, the added information contains information about the hanging person, and the hanging order queue. In the buy queue, there are two Limit Orders, assuming that Trader 1 is our market maker. Trader 2 is some innocent guy (the other is a market maker, or a type 1 or 3 player).
In this case, when a professional speculator appears and eats 100 payments from Trader 1 as a market trader, as long as the market trader is fast enough, he can immediately sell the product purchased at the price of 100 to Trader 2 at the price of 100; thus, although the market trader made two trades, the price difference between the buy and sell is zero, ensuring no loss ((of course, also know that for being a market trader, the exchange has benefits and subsidies in terms of fees)).
This strategy has two crucial prerequisites. First, to be at the front of the buy queue, which means to issue a Limit Order faster than others when the market changes, to ensure that you are at the front of the queue; second, to make judgments and actions in the shortest possible time when the trade occurs, to ensure that the risk is passed on to the innocent guy behind.
This is why in a world where electronics are marketed, only the king of speed can survive. To reach the speed of God, an arms race of technological upgrades is necessary, which is a dead end.
Written by Donko Translated from The Shock of the Consultation