Fair and foul high frequency trading (HFT) hides in arbitrage plays. Some fair plays happen but foul plays take advantage of investors. When those occur, HFT is using this common stock market strategy with unmatchable HFT speeds and their paid access to market and investor information for an unbeatable edge. That means arbitrage trades can suck money from investor pockets. Investors that know and understand HFT, can keep the impact of such actions small. However, as always, informed investors make better decisions and can trades without fear of HFT.
What you learn from this lesson:
Fair and foul high frequency trading:
The lesson explains fair and foul high frequency trading and how the arbitrage strategy gets used. As well, the lesson covers how HFT arbitrage trades depend on using their unmatchable speed. By knowing these HFT arbitrage secrets, investors learn how fair and foul trades get played. With that, you become a better informed investor. Being informed helps you filter much HFT generated misinformation.
FAQs investors asked about fair and foul high frequency trading
These questions and answers about fair and foul high frequency trading have overlapping answers which helps investors understand how stock markets, investing, and money-making interrelates.
Does high frequency trading make money?
High frequency trading schemes have produced billions in profits. They quickly dominated the arbitrage game in many markets by leveraging their technological advantages.
But their lightning-fast trade executions let them take a small cut from thousands of market orders per second, resulting in staggering sums. Many gains come from skimming their prime targets, the large institutional investors with billion-dollar funds.
Managers of those funds routinely use an unending parade of open market orders. Those orders are the prime hunting grounds for high-frequency traders to generate their stream of profits by feeding on the money of countless small investors.
How profitable is high frequency trading?
In favorable market conditions, high frequency traders make lots of money! And favorable conditions occur with virtually any market movement or change in price or volume. Any price change triggers a latency arbitrage, the bread and butter play for high frequency traders. It also means any real investor market order presents high frequency traders with a profit-making opportunity. As a result, in active markets, high frequency traders can produce millions in profit by feeding on market orders.
What is arbitrage trading?
Arbitrage trade is a strategy that involves buying low in one market and selling high in another to take advantage of price differences. This strategy can be used in any market, but it is most effective across multiple markets.
Even though electronically interconnected markets update quickly, any change in price made by a buyer or seller can create an arbitage opportunitye.
This split-second price difference is what computerized automated trading systems, like high-frequency trading, take advantage of to make a profit.
Does high frequency trading change the arbitrage trade?
In financial markets, high-frequency traders have revolutionized the way arbitrage trading works. They can capitalize on profit opportunities before other investors become aware of them!
That happens because they can access systems that receive and send data much faster than anyone else, giving them a timing and information edge.
As a result, technology-driven systems have taken over arbitrage trades, putting other traders at a disadvantage.
Do high frequency traders dominate arbitrage trades?
High-frequency traders do dominate arbitrage trading.
It happened as soon as markets accepted the unmatched trading speed and front-running capability of high-frequency trading. Those advantages put them beyond the reach of any human investor.
Now, investors steer clear of arbitrage trades to avoid having their pockets picked.
How do high frequency traders play arbitrage trades?
High-frequency traders use their incredible speed advantage in arbitrage trading to extract money from markets and investor pockets.
They get to the arbitrage trade finish line before others even know there could be a race! It is their technical and insider advantages that let them dominate arbitrage trading.
As a result, latency arbitrage trading has become an essential and reliable profit producer for high-frequency traders.
Markets present but high frequency traders dominate arbitrage plays
While not strictly controlling arbitrage trades, the effect of HFT speeds moves them into a level of advantage that gives them practical control of arbitrage. If there is a bread and butter HFT play, it is latency arbitrage. Latency is waiting or time, any delay or difference between sources. As a result, latency arbitrage is all about act with speed in time to seize the advantage. First to the trade wins. Always.
When any price changes, the change flows through markets. The price changes over a period of time even when that time is very tiny fractions of a second. One result is that exchanges, trading the same stock as another, make any change over time but different times. In a tiny flash, HFT can snatch up that difference as an opportunity for a slice of profit. No human investor can even see the opportunity let alone hope to act on it before HFT has seized it and moved on.
Arbitrage is just one of the ever growing HFT strategies in use. Like many other tales, this is one with several sides to the story. For example, part of the HFT story includes unfair market rigging. At the same time, there are fair, legitimate and justifiable HFT arbitrage plays.
Fair HFT arbitrage targets price differences, not investors. For the most part, price differences are the key to arbitrage play. As an example, sellers on one market can offer shares at a lower price than offers on another exchange. That creates the classic arbitrage opportunity. Seeing that, HFT technology reacts after picking up both prices. As a result, in less than a blink, HFT swoops in to buy low shares and sell high at the same time.
That simple play is a statistical arbitrage. A lower price entered in any market interconnected with all others will soon be wrong and gone! Those are fleeting opportunities, and as such pass unnoticed by most investors. But not everyone, HFT technology picks up and acts to seize such opportunities.
Fast arbitrage trading plays both sides of a trade and finds profit each way
Traders take advantage of prices across markets open to price and order competition. In those cases, an equity arbitrage has traders buy and sell the stock at the same time in different markets. That means, traders play in sync buying and selling. To profit, they play the price difference between markets at the same time!
When HFT arrived in markets, such opportunities were quickly conquered. But long before HFT, arbitrage were common parts of markets. Not only with stocks, but also with commodities and throughout every imaginable market. Arbitrage trading happens in currencies, cryptocurrencies, garage sales, thrift shops and antiques.
Buying low in one market while selling high in another market can produce fast money! And at times, lots of it! In such cases, both sides of an arbitrage trade happens at or near the same time. Arbitrage trades happen fast and pass as markets adjust to price differences. Those opportunities soon fade away.
Arbitrage trades are sweet for the swift!
Arbitrage is a sweet deal for the swift! And swift they must be, such profits only go to the fastest trader that seizes any price difference. In the case of HFT, they must compete with one another. Such cases are programming wars! Best coder with the fastest algorithm wins! For HFT it takes programmed and the best hardware to seize such opportunities. And there are two sides to each deal. First to complete both sides takes the profit. All others lose!
Most consider price differences between markets as legitimate and fair arbitrage opportunities. This is different from a predator play. HFT predators do pounce on real investor orders to clip a profit. Fair arbitrage does not set up real investors, clip their orders or pick their pockets. But HFT does.
Latency arbitrage by high frequency trading
A second arbitrage secret of HFT uses latency arbitrage. Latency means time delay. Although small, time delays are throughout electronic markets. They still and will always exist.
That is a simple practical fact of electronic market life. Consider, it takes time for each price change to spread to all connected markets. That applies even when the time difference is tiny. In many such cases, we humans cannot detect any difference. But technology can.
The instant a new price appears in any market, things happen. First, all other markets are out of date. In that instant they continue displaying an old price. That is a stale quote.
Stale quotes happen whenever any market posts a new price. After all, it takes time for any new price to get displayed on each of the many markets. While that delay can be a few milliseconds, it still takes that time or, perhaps a little longer.
In any event, long enough for HFT to use speed and play the latency or delay. In the case of HFT, their best technology and programs beat all others. As a matter of routine, they buy or sell the new price and match to trade at the old price.
Again and again, HFT profits from the difference. Any price movement up or down starts another race for guaranteed HFT profits. For this reason, spending each day hunting those tiny price differences pays off for HFT. So winning a few million races to collect a tiny profit can grow into serious money!
Arbitrage good, bad, fair and fowl
HFT systems watch many markets for any arbitrage situations. When opportunity appears, blazing fast systems pounce taking the spread as profit. That buying and selling harms no investor and serves to bring markets and values inline. That is good arbitrage.
An unlimited range of arbitrage trades exist. Throughout markets, any two prices for the same item creates an arbitrage opportunity. At that instant, a play or trade can happen. For clarity, the following gives a few examples of fair arbitrage. In these cases, they do not pick investor pockets.
Positive arbitrage example 1: Exchange Traded Funds
Among the arbitrage secrets of HFT this one is bread and butter. It occurs and reoccurs with no let up. ETF prices can move higher or lower than the cost of all the holdings in an ETF. So a mispricing of an ETF holding stocks may happen. Demand or most often sloppy, lazy or uncaring buying or selling can cause such price changes. The ETF price can move higher or lower than the price of the stocks held.
In such circumstances, prices can move well out of line. Price movement depends on buying or selling pressure. Those prices can trade well above or below the value of the underlying shares. In today's markets, HFT immediately responds. In those cases, HFT taking advantage of this example, does not disadvantage investors.
But, in markets today, that legitimate arbitrage play is gone in a flash. Such cases are seldom seen by individual investors. After all, it is all over once HFT technology tracks the opportunity. For one thing, HFT takes such action to a new level beyond human ability. In a blink such opportunities become HFT profits. We mere humans, can not move or think that fast.
Such opportunities are regular market occurrences although temporary and fleeting. Often happening from poor order management, the inside market crowd always points away. They love to blame Mom and Pop investors. Much of the time that is nonsense. Few mom and pop accounts hold enough inventory or order volume to move large funds.
Most often misaligned ETF prices are sloppy inside work. That sloppy work gets done by so called financial professionals. It is unfortunate, but such professional incompetence is common. The client gets the costs but the actual price differences remain hidden from them. The client does not even know the service has been shabby.
There are many examples of bad order execution by financial advisors disadvantaging clients. HFT are happy feed on incompetence to pick up profit. See Lesson 13 for strategies and methods to keep your money away from HFT.
Positive arbitrage example 2: Index tracking
An index like the DOW 30 tracks the stocks of 30 companies. The S&P 500 tracks 500 stocks and the Russell 2000 tracks 2000 stocks. From time to time, indexes change the stock they track. Some stocks get cut with new ones added to the index. The date of such changes gets announced in advance. That sets off a fury of buying the additions and selling the cuts.
This is Index arbitrage, another arbitrage secret of HFT. For investment or index funds including mutual funds and ETFs it gets complicated. They have to change on the date announced. Until that date they have to stay with the old picks to track the index.
Those index changes create an obvious arbitrage opportunity. HFT are instantly all over such an opportunity. Traders, investment fund managers and companies are also all over it! And they pour into derivatives and futures markets with sophisticated risk management strategies.
Those advanced strategies are beyond the scope of this lesson. Just know that like buying insurance, there are ways to offset costs of pending known changes.
Before HFT was a market fixture, individuals could trade these opportunities. That was then and things have changed. Especially new investors should enjoy the show when index changes happen. The pros and HFT now own this space.
Positive arbitrage example 3: Cross border listings
Many Canadian companies listed on U.S. exchanges as well as in Canada. In Canada trade is in Canadian dollars while in the U.S. the trades are in American dollars. That creates several arbitrage possibilities.
First, between markets the prices can vary. Second, foreign exchange is in constant play. Third, the variable combinations presents more arbitrage opportunities. Between Toronto’s TSX exchange, the NYSE and Nasdaq, there are dozens of such listings.
Positive arbitrage example 4: Derivatives
Among the arbitrage secrets of HFT this one can get very complex. This is no place for beginners or amateurs to make an arbitrage trade! Traders find many arbitrage plays between derivatives and assets. Derivatives are contracts giving or selling rights. They trade on the derivative market. Derivative contracts or options have a base asset.
You can buy or sell a contract to buy or sell an asset at a set price for a set time. Assets underlying derivatives trade on different markets depending on each asset. Those assets can be equities, commodities, agricultural products and others.
The value of contracts change during their term when the asset prices change. Arbitrage can be a simple price change or very complex. Weather, foreign exchange, politics and more come into play and change prices.
It is good to know these markets exist, are very useful and essential for the economy. However it is a very complex area to trade. Only consider going here after you have advanced knowledge and considerable experience. Amateurs get toasted and tossed. Stay away.
Technology genie turned loose in markets!
Opportunity let the genie loose! Savvy traders can play many types of price differences between markets. Those with technical skills immediately saw such trades as huge computer trading opportunities! Once accepted for arbitrage plays, the technology genie was loose in markets!
Once turned loose on markets, computerized trading grew at phenomenal rates. Spreadsheets of mathematical formulas became sophisticated algorithms coded into trading systems. Processing speeds needed to generate, route and execute orders made ever faster advances.
Technology seemed to grow even fast to soon range beyond arbitrage plays. It evolved to trade all aspects of markets using an ever growing number of strategies. Computer trading spawned algorithmic trading which grew to produce HFT. Now HFT volumes dominate markets.
Start at 0, grab fast profits, end at 0
The typical HFT day begins with an inventory of zero shares held. At the end of each day HFT takes no share inventory from the market. During the day HFT prey on real investor orders to buy, sell and hold a position for moments, then sell it. Or they float fake immediately cancelled orders to test for any market reaction.
Most holds are for far less than a second! Many HFT orders are nothing but noise. Daily thousands or millions of trade orders get generated to be immediately cancelled. More faked than undertaken. Faster than a blink many submitted orders get cancelled.
Arbitrage secrets of HFT continue evolving to seek ever greater advantages. Most HFT trades are quick turns of many small equity positions. Their ever evolving technology, algorithms and strategies develop, test and reach across markets.
Secret development edge of high frequency trading
In the beginning, HFT developed in secret. By doing that, the first players established lucrative profit flows. As the 21st century began, HFT technology underwent swift but still secret development. At ever faster speeds, electronic trading moved forward. That continued as computer, communication and programming developments continued to progress.
There were many lines of development. Most inventions, developments and improvements were secret private projects and initiatives. Each firm kept their technology, strategy and tests secret. Racing for praises of billions, secrecy had high value. That made sense for both the developers and owners.
Without knowing it, investors large and small were in that race. We quickly fell behind in a race we did not know existed. With HFT success, investors became prey.
Always well hidden, investors remained unaware. While investors were not aware, regulators knew. But so what! Regulators seem to be a passive or perhaps a colluding bunch. In any event, regulators accepted HFT developments. Day after day, HFT progress accelerated. During that time, HGT volume grew to be the dominant trade volume.
Hiding from scrutiny & transparency
When I first learned of HFT and how it grew in secret right in front of us, Uncle Tom’s Cabin came to mind. That Harriet Beecher Stowe American novel has plantation girl Topsy, the girl that wasn’t made,
“I ‘spect I grow’d. Don’t think nobody never made me”
when asked who made her.
Topsy grew in plain sight on a mid 19th century southern plantation. In contrast HFT developed in secret but grew in plain sight. We did not know it then but HFT insiders certainly did. They operated in secret hiding their scheme from public scrutiny and transparency.
Benefits for a few but costs like a tax to you and all other investors!
The most glaring offense of HFT is getting all investors to pay the bill! HFT delivers huge benefits to the few who control them while putting the costs across the market. In effect, HFT became a clever private tax on stock exchange orders.
Any investor, including you, gets to pay that tax! And, no you get no receipt! That HFT tax hits you as higher costs. By doing that, HFT spreads a thin cost veneer over the many investor orders. Through fees and profits the benefits flow to the few in on that rigged game.
Now You Know:
Fair and foul high frequency trading
You know how fair and foul HFT uses the arbitrage strategy. As well, the lesson covers how HFT arbitrage trades depend on their unmatchable speed. By knowing these HFT arbitrage secrets, investors learn about the fair and foul HFT. One result is you become a better informed investor. Being informed helps you filter much HFT generated market misinformation. The lesson, Fair and foul high frequency trading, shares superior investor knowledge from the Ultimate Guide To Stock Market Investing Success by White Top Investor.
You also know the answer to the question:
Does high frequency trading control arbitrage trading?
HFT dominates the classic stock market arbitrage trading and perhaps for than all others because HFT changed the arbitrage trading game. Now arbitrage trades are at the core of many HFT strategies. The lesson, Fair and foul high frequency trading explains how HFT uses unmatchable speeds to put their arbitrage trading in a class by themselves and well beyond any human investors. Investors keep the arbitrage pick pockets out of their account by avoiding arbitrage trades.
In addition you know these lesson takeaways from,
Fair and foul high frequency trading:
Fair and foul HFT hides in arbitrage plays. Some fair plays happen but foul plays that take advantage of investors also occur. Those can arise when HFT uses this common stock market strategy. When they do, unmatchable HFT speeds means such arbitrage trades can suck money from investor pockets. Investors that know and understand HFT, can keep the impact of such actions small. However, as always, informed investors make better decisions and can trades without fear of HFT.
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Fair and foul high frequency trading
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High frequency trading explained, lesson links:
Introducing high frequency trading explained Lesson 1
Racing for profits drives high frequency trading Lesson 2
Markets and technology built HFT Lesson 3
Technology powers high frequency trading Lesson 4
High frequency trading secrets exposed! Lesson 5
Laws and ethics beat investors Lesson 6
Market management burns investors Lesson 7
High frequency trader 3-Way ambush Lesson 8
Fair and foul high frequency trading Lesson 9
High frequency trading strategies, risks and regulations Lesson 10
Misinformation myths of high frequency trading Lesson 11
Markets technology and laws respond to high frequency trading Lesson 12
Investors deal with high frequency trading Lesson 13
FAQ about high frequency trading
Next lesson, course 510 lesson 10: High frequency trading strategies, risks and regulations
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Lesson Code 510.09.
Copyright © 2011-24 Bryan Kelly
Copyright © 2011-24 Bryan Kelly
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