1. The political debate on high frequency trading is
currently running at its peak. Regulators like the
Financial Services Authority (FSA) and the Securities
and Exchange Commission (SEC) on one side are
looking into the impact high frequency trading has on
the financial markets and if there is a need for impos-
ing new regulations. Firms engaged in high frequency
trading stand united on the other side claiming their
major contribution to electronic trading is the way they
increase efficiency and provide liquidity to the market.
Arbitrage and spread trading are two trading styles
within high frequency trading that we will look into in
more detail.
Arbitrage trading
Arbitrage trading is a trading activity that exploits ineffi-
ciencies in market prices. Known price relations (by ar-
bitrage reasoning) between instruments are traded and
all market participants have the same view on what the
price relation is. The instruments included in a specific
arbitrage trading strategy are fungible or cancel out at
some point, i.e. the arbitrage strategy is executed when
an opportunity occurs and the profit from the execution
of the strategy is immediately seen on the book.
Spread trading
Spread trading is a trading activity in which a trader
enters positions based on the relative value between
two or more traded securities. The price relation
between the involved instruments cannot be derived
by arbitrage arguments, but typically they are highly
correlated. The spread trading strategy is a buy and
hold strategy, i.e. the trade is entered when the price
relation between the involved instruments is outside
the range where the trader thinks it should be. In case
the trader is right in his view on the spread, the profit
is realized when the price relation returns inside the
range and the trader usually exits the spread by trad-
ing out of the held positions.
Increase in competition
As financial markets gradually become accessible to
more market participants there is a corresponding
increase in competition within high frequency trading.
This puts pressure on arbitrage and spread traders to
improve their trading to stay profitable.
What can a trader active in arbitrage or spread trad-
ing do to increase his chances of being successful in a
more competitive market? At least some answers can
be found by looking at how the trader executes the trad-
ing strategy; how the trader handles execution risk; and
how the trader takes advantage of new opportunities.
Improve execution
When trading a multi-instrument strategy, the trader’s
concern is to trade a combination of securities at the
right price. Traders have long worked multi-instru-
ment strategies manually (and for some spreads may
still do so), but as the markets become more competi-
tive it is hard for a human to compete with automated
trading strategies in the actual execution of orders in
the market.
In arbitrage and spread trading there are predomi-
nantly two automated execution styles being used.
A passive approach is to monitor the market prices
High frequency trading has become a major force in electronic trad-
ing around the world. In this article Markus Kämpe, Senior Product
Manager at Orc Software, looks at fundamentals, execution risk and
new opportunities in arbitrage and spread trading, two significant
segments within high frequency trading.
HIGH FREQUENCY ARBITRAGE
AND SPREAD TRADING
By Markus Kämpe
High_Frequency_Arbitrage_and_Spread_Trading3.indd 1 2010-04-27 16:52:07

2. in the involved instruments and when the implied
market prices in the arbitrage or spread show a
trading opportunity, orders are sent to trade on
that opportunity. Within spread trading this execu-
tion style is used by some, but
for arbitrage trading a more
active approach is required to
create the opportunity since
arbitrage opportunities very
rarely just present themselves
in the market. To increase the
number of trading opportuni-
ties, many high frequency trad-
ers actively keep orders in the
market in one or several legs
of the arbitrage or spread and
when traded on an order the ar-
bitrage or spread is completed
by executing orders in the rest
of the legs.
Traders using the more active
approach in arbitrage and spread trading will increase
the number of trading opportunities and the likelihood
of being profitable.
With the adoption of a more active approach to
trading, there will be greater opportunity but there is
still risk to manage. Successfully managing risk is the
second vital factor to maximize profitability.
Reduce risk
The execution risk in arbitrage and spread trading
is mainly the legging risk, i.e. the risk of not getting
trades on all legs included in the spread or arbitrage.
Since the active execution style works orders in the
market, it is sensitive to latency not only when send-
ing an order to trade the hedge, but also when updat-
ing the order posted in the market.
If the price and volume in the hedge leg is no
longer available when the hedge order enters the
market, the arbitrage or spread trade will not be
complete. The trader in this situation is exposed to
significant risk since he has an open position in one
of the legs. The only way to reduce the risk is to take a
reduced profit (or even a loss) on the trade by accept-
ing a worse price in the hedge leg or trading out of the
open position.
The obvious way to keep execution risk as low as
possible is to make sure trading is done with the low-
est possible latency. Without low-latency trading, the
spread trader is at greater risk of getting legged or
trading the spread at worse prices than desired with a
negative P&L impact. For an arbitrage trader (where
other market participants try to take advantage of ex-
actly the same market) low-latency is essential to have
a chance at being profitable at all.
Even with low-latency trading
there is a still a risk of not getting
the hedge trade at the desired
price. A higher level of sophisti-
cation in the way the hedge leg
is managed can further improve
the spread or arbitrage execu-
tion.
By sending the hedge order
at a price that is one tick worse,
the chance of getting the hedge
immediately is significantly
increased since the hedge order
will trade even if the market
has moved a tick. If the market
hasn’t moved, the traded price
will be the same as without giving a tick on the hedge
order. To many traders it is an improvement to get the
complete arbitrage or spread trade at a lower profit in
the situation where the market has moved compared
to not getting the hedge immediately.
Other approaches to increase the sophistication
of the hedge are gradual price improvements or
ultimate stop loss execution where the hedge order
doesn’t initially get traded. This ensures the strategy
completes at a low cost without residual risk.
Once the latency and risk aspects of arbitrage and
spread trading are under control, many traders
can diversify into new trading opportunities, taking
the experience and concepts used to trade more
familiar products and applying them to new prod-
ucts or markets.
Capture new opportunities
Traders are continuously in search of new arbitrages
and spreads to trade in order to stay profitable as new
market participants enter the market and capture
some of the existing profit opportunities.
Without low-latency trading, the spread
trader is at greater risk of getting legged
or trading the spread at worse prices than
desired with a negative P&L impact.
”
“
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3. There are many different ways a trader can expand his
trading activity to capture new opportunities, and the
way the trading activity evolves at a trading desk varies
significantly depending on the most suitable direction for
the specific trading desk. Some examples follow.
Traders active in gold futures on NYSE Liffe US ver-
sus COMEX can expand their trading activity by also
trading gold futures on TOCOM. Trading gold fu-
tures in Japan and the US has been done for a long
time, but as a number of Japanese exchanges have
upgraded their trading platform lately, there is an
even more attractive opportunity in Japan today.
“The response time
of our new trading
platform has signif-
icantly improved to
10 milliseconds per
transaction, which
is the level of low
latency required
for high frequency
trading,” says Mitsuhiro Onosato, Executive Officer
of TOCOM. “There are high frequency traders, both
in Japan and abroad, who have been interested in
the Japanese markets but wanted to wait until the
conditions were met, now entering our markets.”
Including the TOCOM gold futures in the portfolio
of traded instruments adds additional complexity to
the trading activity since the contract is traded in JPY
and the currency risk needs to be managed.
Another example:
Traders arbitraging the Nikkei 225 futures between
Osaka Securities Exchange (OSE) and Singapore Stock
Exchange (SGX) can expand their trading activity to also
trade warrants and options in Hong Kong. There are
arbitrage opportunities in trading warrants listed on
The Stock Exchange of Hong Kong (HKSE) together with
options listed on Hong Kong Futures Exchange (HKFE)
with substantially the same strike and expiry date on
the same underlying stock.
Also in this example there is additional complexity
added to the trading activity by introducing volatility
products to the arbitrage activity.
In addition to the two examples above there are
many other ways traders can expand their trad-
ing activity to capture new opportunities. Traders
active in index futures might expand the trading
activity to include ETFs or the underlying basket of
stocks. Arbitrage traders in multi-listed European
stocks can add new liquidity pools once a new
MTF gains enough liquidity. A more daring, but
still fully viable, approach to capture new opportu-
nities is to look into new asset classes. The recent
increased interest in
arbitrage and spread
trading within com-
modities is an example
of how traders try to
improve profitability
by moving into a new
asset class.
A general rule of
thumb when expanding
the trading activity is that there usually is an addi-
tional complexity that comes with new opportunities.
However, as long as the traders are comfortable man-
aging the additional complexity, the profit potential
can be substantial.
Conclusion
In arbitrage and spread trading the path to contin-
ued profitability goes through efficient execution,
keeping the trader competitive for the arbitrages
and spreads currently traded, as well as the ability
to capture unexploited opportunities by adding new
symbols, new liquidity pools, new instrument types
or new asset classes to his portfolio of traded instru-
ments. Trading desks that are prepared and capable
of doing this are in a good position going forward,
able to defend their current profitability and take
advantage of future opportunities, regardless if these
opportunities are new liquidity pools, new asset
classes or something else altogether. 
A general rule of thumb when expanding the
trading activity is that there usually is an additional
complexity that comes with new opportunities. How-
ever, as long as the traders are comfortable managing
the additional complexity, the profit potential can be
substantial.
”
“
Take Advantage www.orcsoftware.com
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