Chapter 1: The Essentials of High-Frequency Trading

In this article, we delve into the critical instruments that high-frequency trading (HFT) firms utilize for their daily operations.

The need for speed in trading can be likened to standing in line at a movie theater: if someone in front buys the last ticket, their speed gives them the advantage, not legality. This analogy illustrates the essence of modern financial markets, where being the quickest can lead to substantial gains.

However, it's not merely about rapid execution; high-frequency traders must also ensure the reliability and quality of their data. After all, what's the benefit of being the first if portions of your trade order go missing during transmission?

The New York Stock Exchange (NYSE) maintains its servers in Mahwah, New Jersey, while Nasdaq's servers are located in Carteret, New Jersey. The Chicago Mercantile Exchange (CME) operates from Aurora, Illinois. In the early 2000s, the HFT firm Tradebot identified a pattern: the prices of futures contracts on CME often shifted similarly to securities prices on the NYSE or Nasdaq. This observation prompted HFTs to leverage optical fiber technology for swift order transfers between these data centers.

For instance, when the price of the E-mini futures contract rises on the CME, Tradebot adjusts its bid on the SPYDER ETF (which mirrors the S&P 500) to secure a better position on the NYSE before the ETF’s price increases. Conversely, if the E-mini price drops, high-frequency traders foresee a corresponding decline in the SPYDER ETF and react accordingly by lowering their bids to preemptively sell before the price falls.

Chapter 2: The Role of Data Transmission in HFT

At the inception of high-frequency trading, optical fiber was the primary method for data transfer, enabling HFTs to be first in line for orders and seize the spread. For example, "Spread Networks" constructed a 1323 km optical fiber route from New Jersey to Chicago, achieving a latency of 6.49 ms.

Yet, light travels faster in a vacuum than in optical fiber, where it moves at about two-thirds of its potential speed. To counter this, companies like Mackay Brothers LLC began employing microwave and millimeter-wave trading. These techniques utilize radio waves for data transmission, which travel at the speed of light in the air, offering a speed advantage over fiber optics. However, radio wave trading comes with higher costs and is impractical for long distances, such as transatlantic data transfers.

To maintain effective communication, microwave systems need a series of towers within sight of each other, with a maximum range of 50 miles between them. If obstructions like buildings or trees are present, data transfer becomes impossible. Additionally, weather conditions can disrupt microwave and millimeter-wave transmissions, as rain can absorb radio waves. Although optical fiber is slower, its reliability and superior bandwidth make it a preferred option regardless of weather conditions.

In conclusion, short-wave trading, which is faster than optical and microwave methods, can also facilitate long-distance data transfer like optical fiber. This method operates within the 2–25 MHz frequency band, utilizing sky-wave propagation to send waves over the horizon. Nonetheless, it suffers from low bandwidth and reliability, making information loss during transmission a significant concern.

I will continue to share insights on specialized order types and trading strategies employed by high-frequency traders in future articles. Your feedback is invaluable for improving my writing.

For more information, feel free to check out my book on High-Frequency Trading:

Article written by William Troyaux, October 17th, 2023.

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