Week 7 - High Frequency Trading Flashcards
how can we measure efficient markets?
liquidity and price discovery
what is liquidity
the markets ability to facilitate the buying and selling of assets easily, quickly and cheap
why does liquidity matter when trading?
it reduces trading costs, increases trading volume and lowers the required return on investments, encouraging more investment
what happens when liquidity goes down?
trading becomes costlier and riskier, and companies are less likely to invest
what are the 3 measures of liquidity
bid ask spread
number of orders available
price impact of trades
what is the bid ask spread
the difference between the best price a buyer is willing to pay and the best price a seller is asking
why are less liquid assets riskier?
they are harder to sell quickly without discounts, so they require a higher return to compensate for the risk
what is the role of market makers?
to maintain liquidity by always being ready to buy and sell; they profit from the bid ask spread
what is liquidity price?
the cost (spread) we pay for being able to buy an asset immediately in the market
why do higher quality products like whiskey have a higher liquidity price?
they’re riskier to stock due to lower sales volume, so sellers charge a higher margin
how do we proxy liquidity in pricing?
using the mid price - the average of the bid and ask prices
how do we calculate mid price?
(ask price + bid price) / 2
what does quoted spread assume about trade execution?
it assumes that buy orders are executed at the ask price and sell orders at the bid price (ie outside the spread)
why is effective spread a better measure than quoted spread?
it accounts for trades executed inside the bid ask spread using mid-price, making it more accurate
what are the 3 main reasons market makers charge a bid ask spread?
adverse selection
inventory holding costs
order processing costs
what is adverse selection?
the risk that market makers trade with better informed counter parties
examples of order processing costs
trading fees
clearing fees
exchange membership
IT costs
admin costs
what is algorithmic trading?
the use of computer algorithms to automatically make trading decisions, submit order and manage them
what is high frequency trading HFT?
a subset of algorithmic trading that executes orders at ultra high speed, measured in milliseconds
what are the positives of HFT’s?
they provide liquidity
increase efficient price discovery and reduce noise
they’ve reduced the cost of trading
what is quote stuffing?
its rapidly placing and cancelling orders to mislead the market, then trading for profit - its a form of market manipulation
why is quote stuffing illegal?
because it manipulates market prices and deceives other traders
what is asymmetric information ?
when one party in a transaction has superior information than the other
how does asymmetric information create adverse selection?
it leads to unfair trading advantages, causing misinformed traders to consistently make worse trades
can HFT’s create adverse selection without inside information ?
yes - they react faster to public information, creating a speed based advantage over slower traders
how do HFT’s increase systemic risk ?
by contributing to extreme price movements and potentially destabilizing the market
what is one consequence of HFT’s in fast moving markets?
they can cause high volatility, which impacts market stability and investor confidence
