How does the weather impact HFT?

Sometimes I come across an academic research paper that is just so interesting I feel compelled to share it with my MBA students.  This is one of those papers.

Here's the basic set up:

High Frequency Traders (HFT) try to make money out of tiny price deviations between stocks traded in Chicago and New York.  Same stock, two trading locations.   If you can see the stock move in New York and can get a trade in in Chicago, you can capture a profit before Chicago figures out what's going on.

There are two ways to do this. 

1. Fiber optic cables.   Very fast

2. Microwaves.  A tiny bit faster.

You also need to know something else about stock trading (and this is an area I did quite a bit of work on in my earlier days) and that is that we can look at the bid-asked spread of a stock and infer from it something called the adverse selection cost of trading the stock.  The adverse selection cost measures uncertainty about the true value of the stock.   For example, if I tell you I have two cars I am selling  - they are identical, except one comes with a warranty the other doesn't - you'll pay more for the warranty car.  In effect the reduced price of the other car reflects an uncertainty cost  - the uncertainty of how good the car actually is.

OK so back to stocks - higher adverse selection cost means that there is more uncertainty about the true value of the stock.  Its true value could be higher, or lower.   High Frequency Traders contribute to this cost as they add risk to the market by being able to exploit mispricing at the expense of other market participants.

So how does this relate to the weather?  Well it turns out that microwaves don't work when it is raining hard or snowing.   So away go some of the HFT traders - just for a short while.   But during that time, the adverse selection component declines!

It's a testament to the ingenuity of the authors to devise an experiment to capture this effect.   And this isn't merely an academic exercise, millions of dollars if not billions are spent in the pursuit of HFT gains.

The paper is here if you are interested.  The intro is well written and quite accessible.  https://papers.ssrn.com/sol3/papers.cfm?abstract_id=2848562.  Not surprisingly, this paper wound up in the very top finance journal.