Strategies for High Frequency FX Trading - The choice of bucket size

Abstract: This thesis aims at developing and evaluating a model for high frequency foreign exchange data, that beats the TWAP benchmark the majority of the time. This is done by dividing the total order time into smaller time buckets and trading a smaller quantity of the total order volume in each bucket. The second purpose of the thesis is to determine if there is an optimal bucket size in which to trade in order to achieve the best results. Four different models were developed and it was found that the model that traded both passively and aggressively without a set order time performed the best. It was discovered that this model always beats the TWAP benchmark on an average day on the market. The best performing model also took the prevailing market conditions, modelled as market risk and spread risk, into account. The market risk was modelled using a prediction of the volatility during the time interval of the order and the spread risk was modelled by using a prediction of the spread. The purpose of the risk factors was to get an indication of how to choose the level at which to trade passively and aggressively in the buckets, which will be explained further in this thesis. It was concluded that an optimal bucket size does not exist. Instead, it was decided that the client’s preferences regarding potential risks and profits should be the deciding factor in determining optimal bucket size for an order. This is achieved by allowing the client to choose a certain probability of succeeding with a passive trade in a bucket and calculating the bucket size based on this probability. Prior to making the choice, the client is presented with the potential profit, market risk and spread risk for each probability. A low probability results in shorter bucket sizes and thus a shorter order time. This in turn results in a low market risk but a high spread risk. A high probability on the other hand, results in longer bucket sizes and a longer order time which implies a low spread risk but a high market risk. This means that a risk averse client chooses the low probability with less risk of market changes at the expense of loosing the spread, and vice versa for a less risk avert client. The three currency pairs that were considered in this thesis are EUR/SEK, EUR/NOK and EUR/USD. High frequency was in this thesis defined as second-by-second up to minute-by-minute observations.