Scalping Bid Ask Spreads

I do not know much of anything about trading so please bear with me here. I am wondering about scalping bid ask spreads and profiting off of them. This is not so I can trade on this, but I am just curious on the subject.

Can someone provide examples of how a trader can profit off of this? Say the spread is a bit wider on a smaller volume stock: Bid: 4.10 Ask: 4.20...How can a trader with say, $50,000 of funds exploit this and make money?

Thanks for any help.

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Comments (10)

Jan 6, 2010 - 10:00pm

This is pretty hard to do or a regular trader, especially if they don't use a program to buy the stocks quickly (i.e. high frequency trading a la Getco and even Citadel). These high frequency guys have software that's very good at predicting where a stock will go in the next few minutes, and can use this to put tons of limit orders that try to capture the bid/ask spread.

Jan 7, 2010 - 12:26am

Next "few minutes" is likely a huge stretch.

Just having a good idea of where prices and spreads will go in the next few seconds (actually much less time than that) is enough to make an arbitrage GIVEN you have perfect execution without any type of slippage. Not only that, doing this with large enough volume to make a difference becomes the real challenge and can cause your model to blow up without sufficient liquidity.

Jan 7, 2010 - 12:41am

By definition, a trader cannot realize a profit due to the bid-ask spread. It seems that you have completely misunderstood the intuition here (no offense) so indulge me this brief explanation of what's going on.

Think of a market maker like a grocery store for stocks. A very weird grocery store, however, since in addition to selling you cans of corn (stocks) they are also happy to buy them back from you. Now the grocer has to turn on the lights, mop the floor and feed his family, right? So if he bought a can of corn from one guy for $1 and then sold it to another guy for $1, not only is he making zero dollars, he also needed a dollar of capital in order to make the first purchase and operate his business. Since market makers are not in the business of providing complimentary services and having valuable capital at your pleasure for free, they invented something called the bid-ask spread. If someone wanted to sell their can of corn, the grocer would quote a BID of $0.98. If another guy wanted to buy a can of corn, the grocer (market maker) would ASK for $1.02. In this situation the grocer has no view over whether it is wise to invest long or short in cans of corn and simply wants to make a commission on every transaction and maintain a completely market neutral position. Mr. grocer sells 1 million cans and buys 1 million cans and he makes 1million x $0.04, or $40,000. The bid ask spread is a transaction cost, not an arbitrage opportunity. In fact, the existence of bid ask spreads and other transaction costs cause many apparent arbitrage opportunities to be unprofitable, since you'd spend more to make the trades than you'd make on the arbitrage.

Jan 7, 2010 - 12:58am

Jhoratio

You are absolutely correct with your analogy. However, I believe the original poster is asking about mispricing among a collective of brokers and how one would go about taking advantage of such a mispricing by playing off of each broker in concert.

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Jan 7, 2010 - 1:27am
jhoratio:
Well those are some stupid brokers then.

Perhaps, but in many markets you can see this happen from time to time among brokers even if only for a moment. Sometimes the reason for this can be something as simple as a rare latency problem due to a briefly malfunctioning server, stupid or not.
Jan 7, 2010 - 1:42am

Or, in a flat market, the trader decides to play market maker and repeatedly have his $4.10 bids hit and $4.20 offers lifted. Of course, if the market moves and you have an open position you better hope you had the right side. Keep in mind though that such a trader may actually force the bid/ask spread to shrink by bringing competition to the market makers who typically provide liquidity to the market.

Jan 7, 2010 - 2:05am

This happens from time to time in the OTC market both with crossing clients and sometimes in the broker market. Gotta act fast though or it will disappear. Market makers love this, its risk free profit.

Jack: They’re all former investment bankers who were laid off from that economic crisis that Nancy Pelosi caused. They have zero real world skills, but God they work hard.
-30 Rock

Jan 7, 2010 - 8:02am

The US equity market is very, very, very rarely crossed. It used to happen more frequently, especially on newer ECNs that didn't have very functional routing to outside markets. EDGX/EDGA used to be pretty bad. That was about two years ago. I don't remember the last time I saw a crossed market. Even locked markets are rare.

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