Fair and foul high frequency trading

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 c osts 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.