"In reality the other HFT are not buying/selling new orders. Instead what they are doing is cancelling or modifying their existing orders so that they don't get hit by incoming orders."
Right. One of the strategies is:
- Put in standing order to sell a small amount of security slightly below market and leave it active.
- Wait until a buy order triggers it.
- Buy same security faster than rest of buy order can be processed.
- Sell security just bought at higher price.
- Profit.
There are lots of variations on this, but that's the basic idea. It has the profitability of front-running, but is legal.
This strategy could work, but only on exchanges where your own private trade confirmations are faster than the public quote broadcasts, and only if you can use the information to aggressively trade a different, but highly correlated security.
> Buy same security faster than rest of buy order can be processed.
How? You can't because your competition is already resting orders there (from potentially weeks ago) and any order you put in there will be behind your competitors no matter how fast you are.
What does happen is that you all are resting orders up and down the order book. When a big order takes out several levels of your orders, you race as fast as possible to cancel those same levels at other exchanges. If you are faster than the big order you only get hit for a single exchange.
Its a risk mitigation technique, to keep your profits from your regular business of making the spread, not risk free profit.
So one place firms are racing is on the cancel side. The other is on filling back in orders after the big order has cleared levels. The faster you are there the better priority your resting orders will have (potentially weeks from now).
Would eliminating the sub-penny rule remove the need to use this strategy? If there were basically an infinite number of points orders could be resting, you could just get in an epsilon above or below some other fund's order to get ahead in the queue?
Right. One of the strategies is:
- Put in standing order to sell a small amount of security slightly below market and leave it active.
- Wait until a buy order triggers it.
- Buy same security faster than rest of buy order can be processed.
- Sell security just bought at higher price.
- Profit.
There are lots of variations on this, but that's the basic idea. It has the profitability of front-running, but is legal.