Latency Arbitrage Explained
Latency arbitrage is a high-frequency trading strategy used to front run trading orders.
Both institutional and retail traders are the victim of this predatory trading strategy.
In this article I will explain this concept to you using a very simple analogy. As a trader it is very important to know the mechanics of the markets you trade.
What is Latency?
For our example, latency will refer to the delay between your instructions and the time it takes for them to be executed.
Imagine sitting in a room next to your best friend and sending them a text message? From the time you hit send until they receive the message will likely take a second, or two at most. This is latency
Latency Arbitrage – Multiple Markets Example
Now let’s imagine you are looking to purchase 100 iPhones for your online Amazon store to stock up for the holiday season.
You find out that you can purchase these phones across these wholesale stores:
- Store A (5km away): 25 phones for $1,000
- Store B (10km away): 50 phones for $1,000
- Store C (15km away): 25 phones for $1,000
Here is a visual representation of the above scenario.
One thing you will notice is that these stores are actually increasingly further away in distance, but sell the phones for the same price.
So you jump in your car and drive to store A. Then store B. Finally, store C. Therefore, now you own all your phones and you are all set.
Not so fast…
Meet Mr. Latency Arbitrage
Now imagine that a person named Latency Arbitrage decides they want to make some holiday money too. So latency arbitrage waits at the closest store, store A – waiting to see if any big orders come in.
They talk to the clerk at store A and find out you are planning to buy 100 units and you are on your way to the store right now.
As a result, latency arbitrage jumps in their Porsche to race to Store B and buys all 50 phones. Meanwhile you are still on your way to Store A to purchase your first batch of 25 phones.
When you arrive at Store B, they are all out of stock.
Latency arbitrage meets you in the parking lot and says, hey, I got 50 phones for sale. Pay me $1,250 for them, I know you need them.
What just happened?
Latency arbitrage hiked the price on you because of their information and speed advantage. You got your phones, but ended up paying more for them.
Meanwhile latency arbitrage made a pretty good return for a 5km drive.
Latency Arbitrage – Stock Market Edition
This exact same example occurs in the stock market on a daily basis.
Famous author Michael Lewis wrote a book to expose this malicious practice called Flashboys.
Unfortunately, not many retail traders know that a market like “Nasdaq” routes orders to dozens of smaller exchages and dark pools.
These high frequency trading firms will pay the most money for a retail trader’s market order. As a result, the exchange generates more revenue.
Using latency arbitrage, orders are then “front-run” by using the speed advantage.
This is the reason it costs millions of dollars to rent “office space” nearest to the exchange data centers.
In fact, the exchanges themselves even rent out space in the very same building in which their computers route trading orders.
What is even more astonishing is that over 60% of all market volume is now done by high frequency trading computers.
But is this the root of the problem?
High Frequency Trading
It is very important to note that not all high frequency trading is predatory latency arbitrage.
In fact, high frequency trading through algorithms provides liquidity to the markets to help maintain an accurate market price of many assets.
There is no issue with high technology deployed to re-balance portfolios efficiently. Heck, even to arbitrage the difference between two correlated assets.
The problem arises when these powerful computers are coded to make money on the back of real traders looking to exchange shares. The real loser is the retail and institutional trader.
Most importantly, the stock market is a tool for companies to raise capital from investors. Traders help this process by providing liquidity so there is always a buyer and seller ready to transact with.
Latency arbitrage is just unfairly skimming off the top of these investors and traders.
Latency Arbitrage Defenses
Many companies have developed tool to fight latency arbitrage. They are slowing down the fastest orders, and creating high frequency programs to deliver an order to all exchanges at the same time.
In response, latency arbitrage strategies are trying to get even faster to adapt to these defenses. As a result, it is a race of speed.
As a retail trader your best defense is learning to read order flow like the professionals.
In our futures day trading we share all the analytical and trading strategy tools to track the big orders, and profit using this information.
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The information contained in this post is solely for educational purposes, and does not constitute investment advice. The risk of trading in securities markets can be substantial. You should carefully consider if engaging in such activity is suitable to your own financial situation. TRADEPRO Academy is not responsible for any liabilities arising as a result of your market involvement or individual trade activities.