To understand how, you need to understand 'put options', which is a financial product available on the derivatives market. A put option is a deal to sell company stock at a pre-agreed price. Worth noting that you don't need company stock before the put option deal is reached.
So let's say the stock price of Company X is currently valued at $50, and you arrange a put option to sell stock at $50. If the stock price goes down, let's say to $25, you buy stock at $25 and sell it at $50, so you've made a profit (from what I understand, you don't even need to buy the stock in this case, the put option broker will just pay you the difference to simplify the process).
But what if the stock price rises? Let's say the stock price rises to $75. You can't buy stock and use your put option without losing money, and from what I understand you pay interest to the put option broker for the length of time you have it, so holding onto the put option causes you to lose money.
But there's a 'get out of jail free' option. When you arrange the put option you also buy stock. If the stock price goes down, you buy more stock and sell at the pre-agreed put option price. If the stock price goes up, the stock you hold is worth more and you can use this to clear the put option without losing money.
From what I understand, this is one example of 'hedging' against stock price changes, there are probably others. HFT is well suited to this kind of deal, as you can react quickly to market changes, minimising any risks resulting from delays.
So although people see the stock market as gambling, you can game the system to move the odds in your favour. The end result is huge volumes of money invested into non-productive uses of money (and because of the ways banks create money, and the ways the financial markets are regulated, the restrictions on this speculation is basically non-existent).
EDIT: I've got a downvote on this already. If anything I've said is untrue, then call me out on it.
HFT are good at options trading for the same reason all options traders have been throughout history. They can find misspricings in the market and trade them while they last. HFT is taking over those trades because HFT is much cheaper than the humans they replace & can therefore take on less high margin mispricings than humans can.
Also options trading is a regulated marketplace much like equities & commodities trading.
Finally 'yummyfajitas is an ex-HFT who has written good blog posts on the subject.
The example was just for illustration purposes, a simplified version of how it works.
>"Also options trading is a regulated marketplace"
Is that right?
https://en.wikipedia.org/wiki/Derivative_(finance)#OTC_and_e...
"Over-the-counter (OTC) derivatives are contracts that are traded (and privately negotiated) directly between two parties, without going through an exchange or other intermediary. Products such as swaps, forward rate agreements, exotic options – and other exotic derivatives – are almost always traded in this way. The OTC derivative market is the largest market for derivatives, and is largely unregulated with respect to disclosure of information between the parties, since the OTC market is made up of banks and other highly sophisticated parties, such as hedge funds. Reporting of OTC amounts is difficult because trades can occur in private, without activity being visible on any exchange."
>"Finally 'yummyfajitas is an ex-HFT who has written good blog posts on the subject."
I would welcome yummyfajitas 's feedback. I'm not attacking yummyfajitas, if that's what you're implying.
Others have already chimed in, but I'll use a real life example. At the close yesterday, NFLX was trading around $100, you could buy a put option to sell with strike price $100 expiring December 18th 2015 at a price of around $7.00 a share.
Using your strategy, you would buy one contract and simultaneously buy 50 shares. Each contract comes in multiples of 100, so your put option covers 100 shares and you own 50.
If you didn't manage the trade at all until December 18th, you'll make money if NFLX is below $86 or above $114. You'll have lost money if it is anywhere between the two numbers, because the actual realized volatility of the stock did not live up to the implied volatility price (and for many reasons that is usually the case).
Even if you did manage the trade throughout, there is no easy free lunch. You could set a rule to close the trade the moment NFLX crosses over $120 or under $80, but then you'd be giving up the upside that it hits $150 or $50.
I'm a bit confused by some of the terms used (such as implied volatility price, can you explain what this means?), but assuming I've followed enough to understand... If the put option covers 100 shares, why would you only buy 50? Wouldn't it make sense to buy 100 shares?
Some HFTs do stat arb on put call parity, though I would hardly call such a strategy "can't lose".
The bit which is likely untrue is "you can game the system to move the odds in your favour." This bit is entirely unsupported by the rest of your comment.
Nearly every time, the cost of the stock plus the cost of the put option will be exactly the same as the values of all expected outcomes.
Can you explain this further? Are you suggesting that you're obtaining the put option and the stock from the same source?
They're becoming less popular after the slew of "company goes bankrupt -> retired workers lose their income" stories that have happened in the past few decades.
