How hedge funds exploit market mechanics - YouTube

Okay, let's suppose you live in Seattle and you want to make an order.

You look at the prices on your computer.

You see what you think looks like the prices are going to go up.

So you enter a buy order.

Now your order travels all the way across the country.

And because you use ETrade it stops in Atlanta, and

then it hops to New York City.

Let's now zoom in and

see what's happening at the Exchange in New York City.

So, we've zoomed into the New York Stock Exchange, and the order book there is

visible to you over in Seattle, but also to computers that are colocated.

So, let's suppose our hedge fund has a colocated computer.

And it's observing the order book as well.

Now here's the advantage that this colocated hedge fund has.

It's computer is located maybe a 100 meters away from the main exchange

computer that holds the order book.

So that 100 meters amounts to 0.3 microseconds in terms of how long

it takes information about the order book to reach that hedge fund computer.

You, on the other hand, are located at least 2500 miles away.

And that means when this order book changes,

it takes 12 milliseconds at least for that information to get to you and

12 milliseconds at least for your order to reach the exchange.

So, here's how what I call the order book exploit works.

The hedge fund is continually observing the order book.

And remember, it takes only 0.3 microsceconds for it to do that.

Based on what it sees at the order book, it thinks the price is going to go up.

The hedge fund buys some of that stock based on what it sees.

You're thinking the same thing, so you've entered buy.

And your order starts making its way across the country.

While your order is coming across the country, indeed,

the price is going up, because other orders are coming in from other places.

Eventually, your order makes it to the New York Stock Exchange and

is executed there.

And, in fact, the hedge fund sells it to you.

And over this few fractions of a second,

the hedge fund has bought some stock, watched it go up and sold it.

It might have held this 100 shares of stock for only a few milliseconds and

made a profit.

And the hedge fund is exploiting essentially

all these people remotely located around the country observing the order book,

essentially late sending in orders that it can take advantage of because

it can act much earlier before those orders from around the country arrive.

There's certainly many sorts of ways to exploit market mechanics.

Here's one more.

I call this one the geographic arbitrage exploit.

Suppose we have exchanges located some distance away and

because they're located distantly prices may drift a little bit up or down.

Now a hedge fund might place their own servers at each of these Exchanges and

connect them with an ultra high speed dedicated connection.

And they're observing the order book,

the prices at both these locations all the time and comparing notes.

Let's suppose a difference emerges that in New York

the price is a little bit lower, in London price is a little bit higher.

The fund will immediately buy in New York, and sell in London.

They're not necessarily even transferring those same shares.

They might buy some set of shares in New York City, and

sell a different set in London.

But they're getting that difference in price advantage immediately.

Now, because hedge funds do this, because they're monitoring the prices

that exchanges all over the world, these sorts of differences rarely arise and

when they do it's just by fractions of a cent.

But those differences do arise because there are inefficiencies in the markets

and there are hedge funds there to pick those pennies up off the ground.

Again, this is geographic arbitrage.