Investments, tenth edition

  High-Frequency Trading 

 It is easy to see that many algorithmic trading strategies require extremely rapid trade 

initiation and execution.  High-frequency trading  is a subset of algorithmic trading that 

relies on computer programs to make extremely rapid decisions. High-frequency traders 

compete for trades that offer very small profits. But if those opportunities are numerous 

enough, they can accumulate to big money. 

 

We pointed out that one high-frequency strategy entails a sort of market making, 

attempting to profit from the bid–ask spread. Another relies on cross-market arbitrage, 

in which even tiny price discrepancies across markets allow the firm to buy a security at 

one price and simultaneously sell it at a slightly higher price. The competitive advantage 

in these strategies lies with the firms that are quickest to identify and execute these profit 

opportunities. There is a tremendous premium on being the first to “hit” a bid or ask price. 

 Trade execution times for high-frequency traders are now measured in milliseconds, 

even microseconds. This has induced trading firms to “co-locate” their trading centers next 

to the computer systems of the electronic exchanges. When execution or latency periods 

are less than a millisecond, the extra time it takes for a trade order to travel from a remote 

location to a New York exchange would be enough to make it nearly impossible to win 

the trade. 

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6/18/13   7:44 PM

6/18/13   7:44 PM

Final PDF to printer

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  How Securities Are Traded  

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 To understand why co-location has become a key issue, consider this calculation. 

Even light can travel only 186 miles in 1 millisecond, so an order originating in Chicago 

transmitted at the speed of light would take almost 5 milliseconds to reach New York. 

But ECNs today claim latency periods considerably less than 1 millisecond, so an 

order from Chicago could not possibly compete with one launched from a co-located 

facility. 

 In some ways, co-location is a new version of an old phenomenon. Think about why, 

even before the advent of the telephone, so many brokerage firms originally located their 

headquarters in New York: They were “co-locating” with the NYSE so that their brokers 

could bring trades to the exchange quickly and efficiently. Today, trades are transmitted 

electronically, but competition among traders for fast execution means that the need to be 

near the market (now embodied in computer servers) remains.