Arbitrage and High Frequency Trading

Overview

Arbitrage

Arbitrage is a strategy that looks for an asset that is trading in at leat two different markets and at different prices. The trader will buy the asset in the market with the lower price and sell in the market with the higher price. In this way, she is able to lock in a spread on the asset, and her actions help to drive efficiencies in the marketplace by ensuring that assets trading in multiple markets trade at the same price.

Arbitrage is seen as the method by which the market enforces the Law of One Price

In the field of derivative pricing, the concept arbitrage is extended to profiting off the the difference in different assets with equivalent payoffs.

High Frequency Trading

High Frequency trading is an offset from the concept of arbitrage. A high frequency trader profits from assets that are traded in different markets. An hft trader may engage in arbitrage trades, but also may buy assets from one market that she sees being bought in a separate exchange. She primarily does this because she takes purchases on one exchange to be a signal of increased demand in the security being bought.

Typically, this is because many institutional traders need to buy or sell assets in larger quantities than are offered in any given posted order. These traders will often buy and sell on multiple exchanges in order to fulfill their order. By observing the activity on one exhange, a trader who has a speed advantage can buy the given asset on other exchanges prior to the institutional trader being able to post their order, thereby beating them to the punch.

High frequency trading was greatly benefited by the SEC rule Reg NMS, which specifies that brokers must obtain the best market prices for their clients. This means that a clear hft trader can post a small lot at the best market price on one exchange. When that lot gets purchased, she then quickly buys the same security on other exchanges in front of the broker who bought the posted small lot.