Just like the highways of a city, markets are connected by pathways...
No market exists in isolation. GDAX is connected to Binance and Bittrex not by physical arteries but by invisible connections. Arbitrageurs connect the prices on each exchange, making sure trades don't deviate too far from one trading venue to another.
The flipside is that a big order on one exchange can be transmitted to other exchanges.
This dynamic is an example of a broader umbrella subject known as market microstructure which studies the pathways that money takes and tries, uniquely in economics, to find the impact that small rules have on trading and investing activity.
While market microstructure might appear to be a small part of the overall financial picture, its effect can be profound.
Some people use microstructure to make a tremendous amount of money. These are often some of the fastest traders on the planet.
How can someone make money using the minute structure of financial markets alone???
Let's assume for a moment you possess a "fast" algorithm. Fast is in quotes because that definition depends to a certain degree on the market in which you are trading. For the sake of this example, assume you are one of the top three fastest firms in the market.
What is the simplest algorithm that could make you money in this scenario?
Intermarket arbitrage? Too many moving parts. Suppose I want something really stupid simple that will generate cash: it trades one product in one market.
Surely even blazing speed can't squeeze blood from a stone? But that sort of thinking would be incorrect...
This next strategy goes by many names. A version has no doubt existed since the beginning of trading pits. We can assure you we did not invent this, nor did any of the firms we have worked for in the past that might lay claim to it. In its most general sense, this strategy illustrates a simple way to extract what market makers call book edge: or the edge you gain from leaving an order sitting in the book.
Let's define the strategy for our strategy's bid (the ask is a mirror image).
Quoting logic:
- Place a new order on the inside bid if the inside bid has greater than or equal to B contracts in total
- Modify your standing order to the inside bid - N ticks if the inside bid has less than B contracts in total
- Is your fill price == the current bid?
- YES: Place profit order at fill price + 1 tick
- NO: Place exit order at fill price
- Upon every update you receive, check whether: 1) is the inside bid the same as last time? AND 2) is the total number of contracts on the inside bid is greater than or equal to B_exit?
- YES: sit tight and wait
- NO: Modify your order down (i.e. sell into the bid, or pull order into new ask if bid has disappeared and repeat (2))
- The first, and most intuitive, is the value it provides to the owner of the order
- The second is the value it provides to other market participants
Your order in the book has value to you because you legitimately want to buy. Your order in the book also has value to my strategy because it acts like a "free" put option, capping the max loss for my strategy as long as it remains in the book.
Thus, if my order to buy gets filled ahead of your buy order, I can "lean" on your order. As long as you and enough other interested parties want to buy on the bid, I can safely place my order to sell on the inside ask and wait to get randomly filled (or not and just dump my position on the bid) then repeat the process over again. The strategy's only true dangers are "sweeps" -- orders that remove multiple levels from the order book at the same time -- and latency. Sweeps can be minimized by avoiding specific times of day, or by including volatility filters which remove the strategy from the market under volatile conditions.
The lower your latency the more you can trust your market data and the smaller B and B_exit can be, all other factors remaining equal.
How can I maximize the chances of getting filled ahead of the pack? Again, this depends on the market, but in a FIFO market (first in first out) it is the relative age of your order that determines when the matching engine dispenses a fill. You may have noticed the line of logic:
- Modify order to the inside bid - N ticks if inside bid has less than B contracts
This increases the book edge of my order, i.e. the probability that any given 1 lot trading into the bid will get dispensed to my strategy. If an inside bid gets knocked out of the book by a large order, my strategy's order could become the best inside bid for an instant, exposing my bid to great fills ahead of newer orders on the bid.
In other markets the process is far simpler. Some markets have Pro-rata components: i.e. the bigger the size of your order relative to other orders the more fills your algorithm will receive from the matching engine. E.g. if your order is 100 and there are 900 contracts you will get 10% of the fills that execute against that bid. A lot of interest rate markets are like this (treasury roll contracts, short term interest rates, the two year US treasury...), as well as options, FX, and other markets that like to attract huge posted size.
You can think of this like an arms race: if you show more I have to show more and so does everyone else. In these types of markets you can see a 20-lot trade into the bid and see 20000 orders cancel from the bid. 20 is all anyone ever really wanted, but to get any fill you have to post big size. Sweeps get particularly disastrous in these markets.
Some equity markets have toyed with orders specifically that confer a higher probability of fill ahead of the pack. We are not talking about this kind of nonsense, but are referring instead to "legitimate" ways to extract value from the order book. By legitimate we mean its not just given away by a desperate exchange.
This is obviously a spectrum with many shades, as we've known of some major futures exchanges in the past which unwittingly conferred an advantage to algos which chopped up their orders into many parts (e.g. its better to show 100 1-lots than 1 100-lot) and other situations where such order trickery is endemic. We know impropriety when we see it but its hard to provide an all encompassing definition in this situation.
The main takeaway here is that this strategy, theoretically, creates an asymmetric payout structure: it has shifted the payout on the downside outcome to 0 (minus transaction costs) and the upside remains in tact. While this strategy only exists on its own in specific markets, you can bet your bottom dollar that versions of this logic are embedded in the majority of more complicated liquidity providing strategies in some form or another. Why would anyone not want free money, from a mathematical expectation perspective?
That being said, to describe strategies like this as "zero risk" obscures the true risk these strategies take. This type of strategy exhibits extreme tail risk; each day it must earn money from the market (rent) in order to pay for the occasional hurricane of sweeps or execution failure that will cost the firm dearly.
If used as part of another liquidity providing strategy, extracting book edge in this fashion can be a smart decision for the systems developer. If used on its own, strap on your safety belts and make sure you have logic for the times when a sweep + communication error with the exchange loads your strategy up with 5x its max position limit. Remember, if you trade all the time the probability of seeing a tail event is 100%
Disclaimer: If you have to ask if you're fast enough to implement this, you're not. Please do your own due diligence. We are not responsible for the things you do at any speed.
a Great posting with amazing contents. Thanks!!!!
Is it possible for us to utilize it?
Absolutely fascinating, what did you do before Crypto markets?
prop trader, interest rates e.g. US treasuries, Bund, Bobl, Schatz, Long Gilt, STIRs...
That ought to be. Since such people sit back and studied the paths that money usually takes and the rules guiding trade and investment.
I wish to belong to that categories of people who studied the money markets and the rules governing it before investing.
Thanks for sharing this amazing topic @marketstack but i must confess this topic is in depth and well detailed
i appreciate your comment! this is a viewpoint not often shared outside trading floors, but i agree: people who invest time and effort in understanding the flow of money should earn a return from that investment.
just keep studying, i remember when i was a young kid reading about the trading strategies of established market wizards and wondering how i could learn what they know.
then one day, over a decade later... after hard work i realized my trading desk was expanding into the old offices of one of the very market wizards i had read about. i helped pry his name off the door. it was surreal
the markets are a unique place where greats can become has-beens in a short time.
the upshot is that nobodies can become greats at a similarly breathtaking pace!
Thanks for the amazing feedback....following up your blog continuously....i don't i would ever made mistake in trading.
Good information you shared here brother...
thanks dude!
Not easy to understand!
yeah i know this is next level shit no joke
basic idea is that this strategy utilizes 1) this thing called book edge and 2) shear speed
book edge is something that every limit order can possess. this is a concept that might seem wierd at first but is fundamental to scalping. the concept was developed by the locals who scalped in trading pits
in a FIFO order book like the crypto or stock markets, a general rule is the older your order the more book edge it posesses
This piece is so informative, Kudos for the great work done . The research work would have take your time. Keep the good work flowing man and. Thank for usual support
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The market may seem to be a small part of the overall financial picture of the microstructure, posters know a lot. @marketstack Thanks
You are right. I support you.Stotya very cognitive. Good luck.
Hello sir, @marketstack
Thanks for sharing your investing sir. I like your analysis about market. It's really help us. keep sharing sir.
Wishing you all the best.
Very wonderful explanation on the market
I wish to invest in some of the processes you have chosen for us
I trust you so much my friend
I love to read the information about trade here. I have not understood much about trade information, but I will continue to follow your next development. thank you marketstack
Congratulation marketstack! Your post has appeared on the hot page after 28min with 20 votes.
Thanks for sharing this informative article <3
cool
Good information, excelent
Hello @marketstack
I love your publications ... they have a lot of valuable information that is important to read ... I would like to know if you are interested in having your content written in Spanish, I would be very interested in taking charge of this task! I think it's valuable information for the Hispanic community!
how would that work?
Do you have a user in Discord?
the publications would be headed with a clarification that they are the Spanish version of the articles that you have produced ...
I usually request that the publications be voted by the original author so that they have greater visibility and have some kind of reward for the work!
Wanderful track in big city
information is very good
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STOPThat's right
No market exists in isolation.