Concerned About Your HFT Exposure? Hedge It!

Mar 26 2015 | 1:06pm ET

By Irene Aldridge and Steve Krawciw
Able Alpha Trading

High-frequency trading (HFT) has been a persistent storyline for several years.  The trading strategies, fast and perceived to be elusive, have occupied the imagination and instilled fear in many investors. Drastic regulatory reforms have been proposed to curtail the abuses thought to accompany HFT.  A private sector solution for hedging the HFT risks, however, has been considered impossible – until now.  The AbleMarkets Aggressive HFT Index ( tracks aggressive HFT participation and reports it to all interested investors at desired frequencies.  

Aggressive HFT represents a number of HFT strategies where HFTs capitalize on temporary price imbalances by using liquidity-removing market orders.  By contrast, passive HFTs use limit orders to create market-making liquidity-providing strategies.  By removing liquidity, aggressive HFTs have been shown to occasionally worsen volatility and realized prices, inducing slippage, facing other traders and investors using market orders. 

A myriad of solutions for dealing with the aggressive HFTs have been proposed to date.  Regulators have been called upon to ban HFT from the markets altogether.  New exchanges have sprung up with the aim to exclude HFTs from their ranks.  None of these approaches give investors any ability to experience the upside of HTF while tuning out its downside. 

In response, Able Markets’ index tracking aggressive HFT activity in real time and near real time was developed.  Iteratively researched over the past eight years, the computationally-intensive methodology for estimating aggressive HFT participation examines every movement of market data and delivers estimates of the percentage of volume driven by HFT orders in any electronically-traded financial instrument: equities, commodity futures, foreign exchange and options.  Armed with this information on HFT participation, traditional portfolio managers, low-frequency quant strategists and regular investors can hedge their exposure to aggressive HFT.

Our research shows that a simple daily procedure for adjusting the portfolio weights of various financial instruments comprising one’s portfolio significantly increases portfolio returns and reduces portfolio volatility.  The process can be remarkably simple: increase the holdings of securities where the proportion of aggressive HFT has decreased and vice versa. 

How does HFT hedging work in practice?  For long-only portfolios, the simplest aggressive HFT hedging strategy works as follows:

1. Obtain the previous day’s AbleMarkets Aggressive HFT Index or all the securities in your portfolio.  We will denote this number as AHFT.

2. Compute the existing percent allocation, also known as “weight”, of each security in your portfolio by value.  E.g., if the total holding of AAPL in your portfolio is $20,000 and the total dollar value of your portfolio is $100,000, then the weight of AAPL in your portfolio is 20%.

3. Multiply all the weights computed in 2 by the following factor: (1/AHFT). 

4. For all the securities in your portfolio, find the sum of all weights (1/AHFT): SAHFT = (1/AHFT1) + (1/AHFT2) + … + (1/AHFTN), where N  is the total number of securities in your portfolio.

5. Divide the weight of every security by SAHFT obtained in step 4 above.   

The resulting strategy could not be simpler and delivers sizeable returns for portfolios of any composition.  As our recent research indicates, for the long-only S&P 500, this simple strategy delivers about 1% extra unlevered return and 0.1 improvement in Sharpe ratio.  When the portfolio is sizeable, such gains amount to a considerable increase in return.  Furthermore, the strategy works in all markets: moving up or down, calm and volatile, making the AbleMarkets Aggressive HFT Index an indispensable tool in every investor’s portfolio.

Best of all, AbleMarkets Aggressive HFT Index allows investors to contain the impact of aggressive HFT on their portfolio with minimal disruption to their current way of doing business: no switching exchanges or adjusting for new regulations is required.  How much is the peace of mind worth to you to contain the impact of aggressive HFT algos on your portfolio holdings?

Steve Krawciw is CEO of AbleMarkets.comIrene Aldridge is Managing Director of Able Alpha Trading, LTD., and and author of High-Frequency Trading: A Practical Guide to Algorithmic Strategies and Trading Systems (2nd edition, Wiley, 2013).

In Depth

PAAMCO: Will Inflation Deflate the Asset Bubble?

Jan 30 2018 | 9:49pm ET

As the U.S. shifts from monetary stimulus to fiscal stimulus, market pricing should...


CFA Institute To Add Computer Science To Exam Curriculum

May 24 2017 | 9:25pm ET

Starting in 2019, financial industry executives sitting for the coveted Chartered...

Guest Contributor

Boost Hedge Fund Marketing ROI By Raising Your ROO

Feb 14 2018 | 9:57pm ET

Tasked with delivering returns on client capital, a common dilemma for many alternative...