High Frequency Trading and Market Inefficiencies:

A Statistical Physics Viewpoint

E. Pinsky1 Ph.D, R. Sunitsky2 CFA

1
Trading Cross Connects US LLC, Wellesley, MA 02481
2
Bay Head CI US LLC, Jersey City, N.J. 07311

October 2009

Introduction

High frequency trading involves the use of algorithms, fast computers and low latency
network connectivity to detect and exploit “temporary” market inefficiencies. If such
inefficiencies are quickly identified, and the appropriate ultra low latency trading
technology is used, then by executing a large number of such transactions, traders can
earn substantial profits. It is estimated that today over 50% of the volume on many
exchanges is generated by algorithmic high-frequency trading.

In this paper, we use analogies from statistical physics to explain for the existence of
market inefficiencies. As an example, we consider an asset pricing model described by
the telegraph equation. We argue that this can be viewed as a generalization of the Black-
Scholes formula to high frequency settings. Unlike the standard Black-Scholes formula,
the generalized formula for asset pricing contains second-order terms that become
significant in high-frequency. We will use analogies from fluid dynamics to explain the
rationale for the existence of market inefficiencies in such environments.

Black-Scholes Formula from a Statistical Physics Viewpoint

The standard assumption in finance is that price of a risky asset satisfies the stochastic
differential equation that depends on the instantaneous expected return µ (t ) on the price
ratios and the instantaneous volatility σ (t ) of the price governed by Brownian motion
([4],[8],[14]). If expected return and volatility are assumed to be constant ( µ and σ ,
respectively) then under suitable transformations we have the Black-Scholes model ([12],
[15], [18]) where the price follows the geometric Brownian motion and satisfies the one-
dimensional diffusion (or heat equation):

1
 ∂u σ 2 ∂ 2 u
=
∂τ 2 ∂x 2 (1)

with the distribution function of the diffusing quantity u ( x, t ) corresponding to the asset
price C exp(rt ) and the diffusion coefficient of v corresponding to volatility σ 2 / 2 . The
Black-Scholes equation has been studied as a model for the flow of heat in a continuous
medium.

In statistical physics, equation (1) describes the density distribution of a material in a

given region over time that is undergoing diffusion where diffusion is defined as the
movement of molecules from a higher concentration area to a lower concentration area.
Diffusion is a non-equilibrium process that increases the system entropy and transforms
the system closer to equilibrium. Under diffusion we assume that the relaxation time τ
(time for a system to change to an equilibrium state from a non-equilibrium state) is small
and the external oscillations (with wavelength w ) on the system are ignored ( wτ << 1).

In statistics, equation (1) is connected with the study of Brownian motion via the Fokker-
Planck equation which describes slow diffusion flows with uniform rate. In the language
of physics, the behavior of flow described by equation (1) is the viscoelastic Newtonian
behavior. Therefore, we can think of Black-Scholes equation as describing the case
where the external changes in option pricing occur slowly ( T >> τ ), the time of interest T
is large compared to price change times, so that the market participants can “correctly”
estimate pricing and eliminate arbitrage opportunities where mispricing opportunities
(oscillations) are rare. In other words, Black-Scholes model ignores second-order effects.
Recall that the physical meaning of diffusion is that substance concentration will arise
instantaneously everywhere this substance is introduced. In other words, diffusion
equations model phenomena where information travels with infinite speed. Another way
to look at this is to note that equation (1) is a parabolic equation, and if a change is made
to u ( x, t ) at a particular point in ( x, t ) space, for example on the boundary of the solution,
its effect is felt instantaneously everywhere else. In other words, we have an “infinite”
speed for stock price motion: option price at any time would depend on all possible prices
for the underlying asset.

Extending Black-Scholes to High Frequency Trading Environment

One of the criticisms of using the geometric Brownian motion to describe the changes in
a stock price is the fact that prices have unbounded variations (i.e., prices can
theoretically have any value) and fixed volatility, which may be unrealistic in financial
markets. It is suggested by several authors to extend this model to consider stochastic
volatilities and jumps (e.g. .[3],[5],[9],[11]). In one such class of models
([1],[7],[10],[13],[16],[17]), the asset price satisfies the so-called telegraph equation:

2
 ∂ 2u ∂u ∂ 2u
τ 2
+ =v
∂t ∂t ∂x 2 (2)

In physics, the telegraph equation is used to model the flow of electricity in cables from
the stochastic behavior of charges in linear conductors ([6],[19],[20]). Such hyperbolic
equations have a finite velocity of propagation and a finite dependence range. That is, for
every asset price S (t ) and every t , only a finite range of variation of the asset prices will
influence the computation of the corresponding option prices. As a result, the solution to
such equation will be less diffusive and will contain some delay. These equations can be
used to model Black-Scholes with memory [6] and are more consistent with the
viewpoint of technical analysis.

To pursue the analogy with statistical physics a bit further, consider the flow generated
by an oscillating plate in a range of frequencies 0 < ωτ < ∞. We can think of these
oscillations as analogous to high-frequency trading on the underlying asset. This is the
case where T ≈ τ . In physics, this corresponds to the case where external forces (e.g.,
oscillations) cannot be ignored ( wτ >> 1). In such a case, the diffusion equation breaks
down and a new regime emerges ([4],[16]). It can be shown that there is a phase
transition from the viscoelastic Newtonian regime ( wτ << 1) to elastic non-Newtonian
regime ( wτ >> 1). In Newtonian fluid, stress and strain rate are linearly related through
the constant viscosity coefficient, whereas in non-Newtonian regime, flow properties are
not described by a single constant value of viscosity. For the elastic non-Newtonian
regime, the resulting stochastic equation is equation (2).

Comparing equation (1) this with equation (2) we can write the analog of Black-Scholes
in high frequency trading environment:

∂ 2u ∂u σ 2 ∂ 2u
τ 2
+ = ⋅
∂t ∂t 2 ∂x 2 (3)

Here, the parameter σ is some function of stochastic volatility described by the

underlying telegraph process. We can also rewrite the above equation as follows:

∂ 2u ∂u σ 2 ∂ 2u
τ 2 + = ⋅ 2
∂3
12 t ∂t 4
1 422 4∂4
x
3 (4)
sec ond Black − Scholes
order
term

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Without the first term on the left side, equation (4) is just the Black Scholes equation (1)
corresponding to diffusion. Without the second-term on the left side, equation (4)
reduces to the classical one dimensional wave equation.

One can think of equation (4) as a “modified” diffusion formula with an extra second
order term accounting to high frequency “oscillations”. For low frequency (no high-
frequency trading), τ is small and we ignore this second order term. The resulting
diffusion equation implies the Gaussian distribution of the underlying stock price and this
allows the closed form expressions for option pricing. As we increase τ , the second term
in (5) becomes significant and cannot be ignored. In this general case, we do not have a
closed-form expression for the distribution of the underlying stock price. As a result,
option prices have to be computed by some numerical methods ([2]).

One way to think about high frequency trading is to assume that traders (or molecules)
cannot instantaneously compute the right price (trajectory). In other words, relaxation
times τ are not negligible. If such times are longer than latencies, we have inefficiencies.
Such inefficiencies are exactly what can allow profitable strategies in high frequency.
If equation (4) can accurately describe asset prices then a generic algorithm for high
frequency trading in financial instruments described by such an equation can be
summarized as follows:

(1) Compute (numerically) prices from the “high-frequency “ formula

(2) If the observed prices deviate significantly from the model, buy/sell the
corresponding instrument(s)

In high frequency trading, such inefficiencies would be present only for short periods of
time. Therefore, for successful trading in high frequency environment we need:

(1) access to technology and the ability to quickly prototype trading ideas
(2) ultra-low latency access to the exchanges with the ability to execute algorithms in
millionths of a second – transactions could involve multiple asset classes with
trades executed at geographically distributed locations
(3) access to capital and low transaction costs – high-frequency requires high
turnover of capital

Authors: Eugene Pinsky is with Trading Cross Connects US LLC, a firm that provides
infrastructure and technology for high-frequency algorithmic trading. Roman Sunitsky is
with Bay Head CI US LLC, a firm that provides trading and working capital for high-
frequency algorithmic trading.

Disclaimer: The information presented in this work is provided for educational purpose
only and does not constitute investment advice. Any opnions expressed in this work are
those of the authors and do not necessarily express the views of Bay Head CI US LLC
and Trading Cross Connects US LLC, its management, officers or employees.

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