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BY ANDREAS KROM IN MARKET MICROSTRUCTURE — MAY 20, 2023
0+: A double digit
Sharpe HFT strategy
Ever wondered how HFT strategies work?
Today, we'll explore the 0+ HFT strategy - a strategy that has been practiced for decades
by various HFT firms - but remains largely unknown to the public.
0+ is all about speed and market microstructure. If you can't be the fastest, it won't work. If
your market microstructure sucks, it won't work.
Once you become the fastest, and you have access to the right market microstructure,
you're essentially printing money. Your Sharpe ratio goes well into the double digits. The
only way you lose is if someone else becomes faster than you, or if your market
microstructure suddenly turns against you.
History of 0+
While 0+ has been known in HFT circles for several decades, it hasn't received much
coverage in mainstream media. The only source available on the web is an excerpt from
Scott Paterson's 2012 book, Dark Pools: High-Speed Traders, AI Bandits, and the Threat
to the Global Financial System, where former HFT quant, Haim Bodek, investigates a
document that he had acquired from a colleague. The document, which originated from a
Chicago HFT firm, contained a detailed description of the 0+ strategy:
"It was the Holy Grail of trading. The 0+ trader was describing a strategy that effectively
never lost. The rest of the market protected it whenever the firm’s algorithms detected
the slightest chance that the market was moving against it.
...
It’s brilliant—and diabolical. A firm that has found a strategy that is virtually guaranteed
to win on every trade has discovered a hole in the market. Trading is all about taking
risks, but this author was describing a virtually riskless trade."
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Since Paterson's book, not much has been posted about 0+.
As of 2023, the strategy remains largely unknown to retail traders, and asking ChatGPT
about the strategy renders a more or less useless answer:
"The 0+ scalping strategy is a trading approach that focuses on making quick trades to
take advantage of small price movements in the market. The "0+" in the strategy refers
to aiming for a minimal or near-zero profit target on each trade. Scalpers typically enter
and exit trades within minutes or even seconds, aiming to accumulate small profits from
multiple trades throughout the trades."
Haim Bodek, former HFT quant. Bodek came across 0+ in a document given to him by a colleague.
How 0+ Works
Like most other quantitative trading strategies, 0+ relies on probability and positive EV
(positive expected value).
With 0+, your probability of making a good trade is a tiny bit higher than your probability of
making a bad trade.
If you make 1,000 trades, using 0+, you will expect to come out on top for at least 501 of
them.
These are the kind of seemingly minor advantages that, when added up over billions of
trades, turn small HFT shops into 500 employee businesses.
So how does 0+ gain its advantage?
To understand this, one must first understand the market microstructure that makes 0+
possible.
Price Levels
A price level is a specific price, at which orders can be submitted.
For instance, for the SNAP stock, these could be the price levels:
Ticks
A tick is the minimum difference between two price levels ($0.01 in the above example).
HFT strategies generally aim for a profit of 1 tick.
Order Queues
Each price level has an order queue. The order queue contains the orders that has been
posted at the price level (and are waiting to be filled).
An order queue is sorted based on the FIFO (first-in-first-out) principle. The first order to
join the queue will also be the first order to exit the queue (in the event of a trade).
An order queue. New limit buy orders are added to the Queue Tail. Market sell orders match with orders at the
Queue Head. An order can exit the queue either through a cancellation or through a trade.
The strength of an order queue is determined by the total quantity of its orders. If a queue
has a lot of large orders in it, it's considered strong. If it has only a couple of smaller
orders, it's considered weak.
Weak queues are very easy to break. It takes only a couple of order cancellations or
trades to clear all of the orders in a weak queue.
Strong queues are the opposite.
A queue that used to be strong might become weak (due to order cancellations or trades),
and a queue that used to be weak might become strong (due to new orders joining the
queue).
From a market microstructure perspective, being in a strong queue is preferred.
If you get filled on an order, while being in a strong queue, the chance of the price moving
against you (and you losing 1 tick) is lower than if you get filled, while being in a weak
queue.
This edge in probability can turn a $0 strategy into a $100 million strategy.
Price levels, with order queues (order timestamps in small). Can you spot the price levels that have strong order
queues?
Scratching
Being in a strong queue also comes with other benefits, such as the ability to cancel your
trade.
Cancelling a trade might seem impossible to people that are not familiar with market
microstructure (trades are final, right?).
However, it's actually very possible.
Got filled on a buy order? Submit an identical sell order (same price, same quantity). Your
orders will cancel each other out.
Of course, there's no guarantee that your sell order will be filled. That's why you'll always
want to be in strong queues.
If you get filled, while in a strong queue, there'll always be other orders behind you. When
there are other orders behind you, you can always neutralize your own trade by trading
against these orders.
Cancelling your trade is called "scratching" in HFT speak.
Buy 50 gets filled at $8.03. The trader scratches the trade by placing a Sell 50 at the same price. The Sell 50
matches with the next order in the queue. The net P/L is 0 (excl. fees).
Scratching typically comes at a cost. You pay two trading fees (one on your original fill,
and one on your scratch). As such, it's only worth doing when your trading fees are lower
than the size of a tick.
In a typical HFT scenario, you can expect a near-zero trading fee (0.001% or less), and a
0.01% tick. As such, scratching becomes worth it. Paying the near-zero trading fee twice is
much better than losing the tick.
For a retail trader paying a 0.05% trading fee, scratching is typically not worth it (the fee
will be much larger than the tick).