What is the Latency Arbitrage Strategy?

Key Highlights

• Latency arbitrage enables high-frequency trade execution and profit-making for institutional investors.
• To improve accuracy, they try to shorten the time delay and distance from stock market servers.

What is Latency?

Latency refers to the time it would take a signal to reach its destination, as defined by computer networking terminology. The lower the delay, the faster the signal will reach its destination. The speed of the transmission network and the physical distance to which it must travel are two primary factors that determine signal delay. For example, a signal originating in Mumbai takes more time to reach California than it takes to reach Pune.

What is the Role of Latency in Trading?

Reducing delay as much as possible is one of the reasons why large institutional investors are spending huge amounts of money on acquiring highly rapid infrastructure. As long as there are low delay times, these investors will be able to access superior stock prices fractions of a second ahead of retail traders, who suffer from high latency network connections and slower computers.

Many institutional investors have physical space and servers close to stock exchange servers in order to mitigate the lag time. Such investors are able to buy prices much faster than ordinary individuals or traders thanks to a combination of high Internet speeds and significantly lower physical distance between servers.

Moreover, some institutions are taking a step forward and placing their servers in parallel to those of the exchanges themselves. It's commonly referred to as colocation. Exchanges are charging a massive amount for providing investors with such low latency and rapid access.

What is Arbitrage?

Arbitrage is the act of buying a stock and selling it immediately at a higher price, in simple terms. This difference in the prices of purchases and sales is the profit that traders make from arbitrage trading. This method is often used by traders buying securities in a foreign currency market where the exchange rate changes are still to be incorporated, allowing them to buy stock at a lower price.

Understanding Latency Arbitrage Strategy

Let's take a look at the concept of latency arbitrage now that you know what latency is and its role in trade. An arbitrage strategy employed by institutional investors, who use minor price fluctuations in stocks that are caused by a time gap between them and other participants, is latency arbitrage. Let us take a latency arbitrage example to get an idea of this concept.

Example of Latency Arbitrage Strategy

Suppose you are an investor who wants to buy shares of a company called ABC. There's currently a best bid of 10 and an offer of 11 for the stock. Well, then you're going to place a buy order at the midpoint of Rs. 10.5, and now your price feed has been updated so that it is currently reading Rs. 10. 9.5 is the bid, and Rs. 10 is the offer. Due to higher network latency, this information may take longer to reach your trading console or platform. You accordingly still see the previous offer and bid prices for the stock, which are Rs. 10 and Rs. 11, respectively, and decide to place a buy order at Rs. 10.5.

This is where the latency arbitrage strategies of institutional investors are used to benefit from price differences. They can benefit from the new bid and offer rates of RS because they have an infrastructure with very low latency. That's right, 9.5 and Rs. 10 in the blink of an eye, a lot faster than you are. Considering this, investors buy the stock at Rs. 9.5 and sell it to you at Rs. 10.5 when you place the buy order. The institutional trader was able to make a profit of around INR 1 by exploiting the minute difference.

Conclusion

Even though these investors only make one trade profit of Rs. 1, keep in mind that they engage in high-frequency trading (HFTs). Within a matter of minutes, they will execute hundreds of transactions. This adds up to millions in profits for institutional investors at the end of a trading day. As you can see from an example of latency arbitrage, that's how investors make a profit by exploiting this strategy.