From CNN Money:
A Berkeley professor finds out just how much a certain type of high frequency trading costs the average investor.
FORTUNE -- Two recent studies of latency arbitrage suggest the stock-market structure needs a remodel if it's ever going to stop billions of dollars going from unwitting investors into the pockets of high-speed trading firms.See also:
"Latency" refers to the time it takes for a stock quote to get from an exchange's server to a trader's screen. This varies from exchange to exchange and from trading computer to computer. Latency arbitrageurs take advantage of these inconsistencies.
It's well known that some high-frequency computer geeks at firms like Getco LLC take advantage of latency, just as it's well known that some Blackjack-playing computer geeks count cards in Las Vegas casinos. But it's never been clear how much this type of trading costs the little guy on Wall Street.
Terrence Hendershott, a professor at the Haas business school at the University of California at Berkeley, wanted to find out. He was recently given access to high-speed trading technology by tech firm Redline Trading Solutions. His test exposes the power of latency arbitrage the way Ben Mezrich's Bringing Down the House exposed the power of card counting.
According to his study, in one day (May 9), playing one stock (Apple (AAPL)), Hendershott walked away with almost $377,000 in theoretical profits by picking off quotes on various exchanges that were fractions of a second out of date. Extrapolate that number to reflect the thousands of stocks trading electronically in the U.S., and it's clear that high-frequency traders are making billions of dollars a year on a simple quirk in the electronic stock market.
One way or another, that money is coming out of your retirement account. Think of it like the old movie The Sting. High-speed traders already know who has won the horse race when your mutual fund manager lays his bet. You're guaranteed to come out a loser. You're losing in small increments, but every mickle makes a muckle -- especially in a tough market.
"It's clear to us these guys are just raping, pillaging, and plundering the market," as Joe Saluzzi, co-founder of agency brokerage Themis Trading put it.
Here's how Hendershott's latency-arbitrage strategy worked: Redline allowed him to use its "direct market access" -- cables that run directly from exchange servers to its own. Redline's server was co-located with that of BATS Exchange so that the "latency" on information and orders coming from BATS was cut down to barely one thousandth of a second. As a result, some of the quotes on public feeds such as the crucial "national best bid and offer" feed were a few milliseconds behind those Hendershott could see on his direct link with the exchanges. With a half-decent trading algorithm, Hendershott would have had ample time to buy Apple at a stale price with a guarantee that he could sell at a profit. Every couple of seconds. All day. Risk on the trades: zero....MORE
The Costs and Benefits of High Frequency Trading: A Profoundly Deep Dive
Because of the lucidity of this post I'm thinking of taking back all the economist jokes (except the J.K. Galbraith, it's not really a vocational jest*) and other negative things I've thought or written about the profession over the years.High-Frequency Trading Is Bad For Profits, Including Those Of High-Speed Traders: Study
"High-Frequency Trading: Not as Profitable as You Think"
Morgan Stanley on High Frequency Trading and the Inevitable Destruction of the Equity Market (futures too)
HFT: "Some Things We Learned From The GETCO 8-K" (KCG)
Nanoseconds for All? UBS BizDev Says HFT Will Diffuse to Asset Managers (when do mom and pop go low latency?)
My Second-to-Last Comment on Izabella Kaminska at Tyler Cowen's Marginal Revolution
...How many arbitrages do they think present themselves each year?
Spotting and acting on an arb is pure alpha and here is a dirty little secret:
The entire amount of alpha available to the entire hedge fund industry is only $30 billion per year.
As reported by a hedge fund maven via Investment News back in 2006:
...PHILADELPHIA - Everyone in the crowd assembled for the CFA Institute's hedge fund conference took notice when David S. Hsieh said that the amount of alpha available in the hedge fund industry each year is $30 billion.Got that? All alpha not just arbitrage but all alpha was just $30 bil. in '06....
Mr. Hsieh, a professor of finance at the Fuqua School of Business at Duke University in Durham, N.C., presented a synopsis of his ongoing research, which focuses on the style, risk and performance evaluation of hedge funds, at the Feb. 16 conference here. As part of his work, Mr. Hsieh questioned whether flows into hedge funds are causing a decline in hedge fund returns and what might happen if the high rate of inflow continues.
Because of difficulties in obtaining reliable hedge fund data, Mr. Hsieh used fund-of-hedge-funds data and broke down returns into alpha and beta sources. He said the research led him to "feel comfortable" determining that there is a finite amount of alpha - conservatively, $30 billion - managed by the approximately $1 trillion hedge fund industry. And even if capital invested in hedge funds were to rise, the amount of alpha would remain the same....
