Types of High Frequency Trading Algorithms
Different types of high-frequency trading algorithms are used by hedge funds to trade individual securities and baskets of securities to make a short-term profit.
One kind of algorithms are statistical arbitrage algorithms. They are used to identify securities that have historically moved together but have diverged recently. A statistical arbitrage algorithm will buy one security and sell the other. The goal is to realize a profit when the prices of the securities eventually converge.
On this page, we discuss different types of statistical arbitrage algorithms in more detail. In particular, we will discuss:
- Pairs trading
- Index arbitrage
- Basket trading
- Spread trading
- Mean reversion
- Delta neutral strategies.
Statistical arbitrage algorithms
The types of statistical arbitrage algorithms include:
- Pairs trading. When the prices of two securities diverge from their historical pattern, the outperforming security is shorted while the underperforming security is bought. If the relative prices of these securities converge again, a profit will be earned.
- Index arbitrage. These algorithms seek out temporary differences in price performance between securities and the sector to which they belong. For example, the price of Coca Cola should be correlated with its food and beverage industry group.
- Basket trading. Basket trading consists of applying statistical arbitrage strategies to groups of securities, rather than to individual securities. Instead of trading one individual security against another as in pair trading, we should trade one basket of securities versus another basket.
- Spread trading. Spread trading is a type of statistical arbitrage that takes long and short positions in two closely-related futures contracts, on the notion that the spread between the two will change. Traders use tools called spreaders to manage these trades.
- Mean-reversion. Mean reversion algorithms are based on the idea that when the price of a security drifts away from its recent historical mean, its price will likely move back towards that mean.
- Delta neutral strategies. These arbitrage strategies are designed to produce a small profit regardless of whether the market goes up or down.
Types of spread trades
With regard to the spread algorithms, we can actually distinguish four subcategories:
- Intra-market spread trading: A long position in one contract month and a short position in the same futures contract in another contract month.
- Inter-market spread trading: Purchasing a futures contract in one market and selling futures on a different (buth highly correlated) commodity
- Inter-exchange spread: Buying a commodity future on one exchange and selling a similar commodity future on a different exchange.
- Multi-legged inter-exchange spreads:
- crack spread: crude oil vs. petroleum products
- spark spread: price of electricity from a gas-fired power plant vs. fuel prices
- crush spread: soybean futures versus soybean oil futures and soybean meal futures.
On this page, we discussed the most popular types of high-frequency trading algorithms.