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I've been reading about algorithmic trading, which involves using complicated mathematical and statistical models to profit from market inefficiencies. Usually the gains from each trade are small, but when added together, they can generate huge returns.

But why don't these trading firms simply buy a good stock, and hold the position until they make a profit?

(1) Pick a stock with good long-term fundamentals and strong short-term momentum.

(2) Set the price target at 1% higher than the current price (1% is pretty easy to achieve, because of short-term price fluctuation and the fact that the stock has upwards momentum).

(3) Buy the stock, and wait until the price hits the target.

(4) Sell the stock, rinse and repeat.

While gaining 1% per trade may not seem to be much, but when added together, they can generate huge profits.

So why don't trading firms simply do this? It seems to be a much more easier strategy than using complicated algorithms to look for small arbitrage opportunities or whatever.

EDIT:

Someone asked a similar question on Quora, but the answers are not what I am looking for......

https://www.quora.com/How-do-traders-lose-money-For-example-if-a-trader-buys-can%E2%80%99t-they-just-keep-waiting-until-the-price-goes-above-what-they-bought-it-for-even-if-they-have-to-wait-for-a-few-days

Anonymous
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2 Answers2

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In poker, the 'rake' is the fee taken on each hand by the operator of the game. The amount of the rake depends on the predetermined rules and this is what generates revenue for the house.

So why doesn't the house play the game (as you suggest) rather than just collect the rake? Because playing the game entails risk which can lead to losses, sometimes large, whereas there's no risk involved with collecting the rake on every hand.

Latency arbitrage is a high-frequency trading strategy used to front run trading orders and like the rake, it skims a very small amount off the top of trades made by traders and investors. It's almost riskless because the trades occur in a fraction of a second.

Like the house in poker, why would HFT take on the risk of playing the game when they can just skim profits off of the game?

Bob Baerker
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Because sometimes you’ll turn out to have bought at the peak, and the price will never go 1% above what you paid, or at least won’t do so for years. This only has to happen once to wipe out your strategy, and it may wipe out your entire investment if the company goes bankrupt. Stocks with “upward momentum” are especially likely to be in this category, because what that really means is “high volatility”.

Mike Scott
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