How Latency Arbitrage Affects the NBBO

Latency arbitrage is a result of several factors including co-location, HFT, flash trading, and SIP latency, all with their own consequences to the marketplace.  Latency arbitrage, however, has a direct effect of contributing to an altered NBBO.  The National Best Bid Offer, (NBBO), is supposed to be the one accurate price of a stock across the entire market, from all exchanges and off exchange venues. It is intended to be a representation of the “best price.” The problem with this intention is that it is impossible to instantaneously update every single participant in the market, even the national exchanges, at the very moment when a change occurs to the NBBO.  

Information about all stock price changes need to travel among all market participants and the speed at which that occurs varies greatly depending upon the distance between the firms, and the technology a firm is using.   This means that all market participants, including the national exchanges themselves, see a different view point of the NBBO at the exact same moment in time.  This information leakage is not the only pitfall of latency arbitrage.  When these privileged firms execute their privileged trades, the NBBO is actually altered by these front-running executions.  

There may be no quick solution to this latency problem, and maybe not even a long drawn out solution, but there are some tools available now that offer some assistance to traders dealing with this problem.  If we cannot stop the latency arbitrage as we know it, we can tackle it another way – with modern day latency arbitrage tactics.

One tool addressing this very issue is the IEX Signal that is used in their proprietary D-Peg® and Primary Peg orders.  The signal acts like a yellow traffic signal, warning a trader of an upcoming change to the NBBO.  Used for a predictive tool, this IEX signal is utilized in these proprietary orders, and is also termed a ‘crumbling quote indicator’.  It predicts an upcoming price change to the NBBO, basically by observing a stock’s NBBO activity, any changes in that price, and then compiling a prediction of which way it’s moving.  IEX’s signal predicts the upcoming NBBO change, and moves their D-Peg orders out of the way, protecting the investor.

This may be one small tool in a very large fight against a long-time practice, a practice the privileged participants are not willing to give up too easily.  With a computer algorithm conducting trades at lightning speed, we all must realize that we are now at a crucial point in the structure of our financial markets. Latency arbitrage must still be tolerated, although the time has come to take action whenever possible.

Great Point Capital has been serving the trading community since 2001 and our 100+ prop traders actively trade the firm’s capital, specializing in equities and equity options.  We are headquartered in Chicago with a location in Austin, TX.  Contact Great Point Capital LLC today, in either our Chicago Office, or our Austin Office, to learn more about how we can successfully trade together with high performance results.  We are one of the very few firms able to offer access to Takion Software Platform, enhancing your online equity trading performance.

Latency Arbitrage Uses Predatory Computer Algorithms

Latency arbitrage occurs when one party exploits a time disparity and earns a profit, typically with a computer algorithm, when that trade is executed solely due to a latency advantage.  Latency arbitrage has caused several heated discussions amongst all market participants, the government law makers and the SEC for many years now, yet this unfair access to US equity markets is still the core strategy of many predatory trading firms.  

An arbitrage occurs when a simultaneous purchase and sale of a stock is executed by a computer algorithm, and earns a profit based on a price difference.  Latency describes the time difference that firms receives the same publicly traded stock information compared to other one another, not all firms receive the same information at the exact same time.  Thus, a latency arbitrage happens when a firm earns a profit from the purchase and sale of stock when that transaction was executed because of a latency advantage.  

Firms pay large premiums to co-locate their equipment right next to an exchange’s servers, and pay a steep price for premium data feeds, all to reduce their latency.  Cutting edge technology with the purchase of raw data feeds, combined with a reduced latency, allows these firms to see the NBBO substantially quicker than what is publicly available through the Securities Information Processor, (SIP).  

Let’s say that a firm issues a buy order to pay the midpoint of the NBBO (the National Best Bid and Offer) for stock XYZ, and the current market for XYZ is $10.10 x $10.11. Their bid will be at $10.105. Predatory HFT firms, using faster data feeds and co-location to reduce the transmission times, may see that the $10.10 bid is now gone and the market is now $10.09 x $10.10. However, the NBBO has not changed yet, since the SIP is slower than the HFT firms, so that midpoint order is still resting at $10.105. For the HFT firm, it is simply a matter of selling at $10.105, and immediately buying back at $10.10, making a half penny.

While the half penny earned may seem miniscule, keep in mind that their computers are doing this all day long, and with the sheer volume of trades all those pennies add up to billions of dollars.  Billions of dollars that is essentially skimmed off the top of your college savings, the average middle class retirement fund, and hard earned investments.  

Add the fact that the offending firm performing the latency arbitrage assumed absolutely no risk whatsoever.  By seeing the true market before the rest of the world adjusts their orders, they know that their trade is a pretty sure bet.  All due to a speed, or latency, advantage.

This is extremely frustrating for the firm placing the original order as they are trying to get a fair price in the middle of the spread.  At the time of execution, however, they end up paying beyond the best offers in the market.

Another scenario arises due to the multiple venues available.  Various dark pools in addition to the national exchanges, can each have liquidity available, but as you go through collecting that liquidity, HFT firms can front run your order. Assume the same firm above was attempting to buy 5000 at $10.11, and the NBBO showed that quantity available at that price. But as the firm begins to send orders to various venues to purchase that amount, HFT firms see that activity, and jump ahead of the order to take it all at $10.11. The original firm may only get a few hundred shares, instead of the 5000 they saw when they placed the order. Now they are required to pay $10.12 if they want to buy the balance.

A trader gets whiplash from this ‘now you see it, now you don’t’ scenario.  Just by placing the order, they alert the HFT’s of their intention, and can plan on closing at the higher price, unless they find a way to play in the latency game.  

Great Point Capital has been serving the trading community since 2001 and our 100+ prop traders actively trade the firm’s capital, specializing in equities and equity options.  We are headquartered in Chicago with a location in Austin, TX.  Contact Great Point Capital LLC today, in either our Chicago Office, or our Austin Office, to learn more about how we can successfully trade together with high performance results.  We are one of the very few firms able to offer access to Takion Software Platform, enhancing your online equity trading performance.

Discretionary Peg (D-Peg®) Order Predicts Price Changes

IEX is the newest stock market in the United States, founded by Brad Katsuyama and colleagues who sought answers to questions others did not even know existed.  Brad and his team were recently depicted in the “Flash Boys”, the Best Seller by Michael Lewis.

IEX’s proprietary D-Peg order was designed to protect against structural arbitrage by predicting changes to the NBBO.  HFTs know when the NBBO is going to change, because they can cobble together the faster direct feeds from each exchange, and build their own NBBO.  If you are trying to get a fill at the midpoint of the NBBO, you do not want to get a fill and then have the market immediately move against you.  The proprietary signal by IEX attempts to predict that upcoming change to the NBBO, and will move D-Peg orders out of harm’s way.

For example, if you have an order in to trade at the midpoint of the NBBO, while the market is 33.95 x 33.96, a favorite strategy of the HFT is to see the quote changing to 33.94 x 33.95, sell the midpoint to you at 33.955 right before the quote change occurs, thus allowing them to buy it back immediately at 33.95 and make a half-cent profit.  To highlight just how much this strategy is occurring, in January 2017 47% of all midpoint volume on EDGX executed within 2ms of an NBBO change.

Another way to look at it would be to see how often there is no price movement after a trade at the midpoint, which is what you want to ideally see.  On EDGX, for example, there is no price movement within the following one second following a midpoint execution, only 46% of the time.  

IEX’s D-Peg orders are designed to keep you out of this predatory environment by moving you away from the midpoint if the NBBO is about to change.  There is no change in the NBBO one second after a midpoint execution on IEX 78% of the time, and only 5% of IEX’s midpoint volume is done within 2ms of a change in the NBBO.

This “crumbling quote indicator” does not in any way impede regular trading, as it is only activated for a very short period of time, five seconds per day per symbol, on average volume basis.  Protecting resting orders during times of high HFT activity can provide higher trading quality on IEX, and make a huge difference to investors.

Great Point Capital uses both IEX’s D-Peg and Primary Peg Orders.  Contact Great Point Capital today for collaboration of successful day trading strategies.

Great Point Capital has been serving the trading community since 2001 and our 100+ prop traders actively trade the firm’s capital, specializing in equities and equity options.  We are headquartered in Chicago with a location in Austin, TX.  Contact Great Point Capital LLC today, in either our Chicago Office, or our Austin Office, to learn more about how we can successfully trade together with high performance results.  We are one of the very few firms able to offer access to Takion Software Platform, enhancing your online equity trading performance.

Latency Disparity Contributes to Arbitrage

Reg NMS and the current fragmented market are obvious contributing factors to latency issues, although there a couple of additional reasons that stand out as to why not all firms receive the same information at the same time.  One contributing factor to this latency disparity is of course the speed of the Securities Information Processor (SIP), and another is the fact that firms co-locate their equipment to the servers of the exchanges.  This advantage of speed combined with a predatory computer algorithm for trading, gives a very unfair advantage of access to see the public NBBO data before trading firms with a slower connection.  

SIP

The SIP is tasked with centralizing all stock market data, then disbursing that data at the same time to all market subscribers.  the SIP has put much focus on improving its latency, although direct data feeds are historically faster than the consolidated feeds.    Some are of the mindset that reducing the SIP latency will create a more fair and efficient market, the issue of latency arbitrage is much more complicated than just reducing the latency of the SIP.  

The SIP latency refers to the time that it takes to receive all stock information, compile it together, aggregate and assemble all data, and then dispense it out.  The latency problem with the  SIP is not the time that it takes to perform these functions, even if that time is improved, it is with the method of disbursing all data.  The transportation of that data is where the challenges lie.  

There will always be a latency issue involved with consolidated data compared to direct data feeds, because there are various sources for the SIP information.  For example, the NYSE houses their data center in Mahwah, NJ, while Nasdaq’s server center is in Cartaret, NJ.  Just a slight different geographic location can make enough of a speed difference that a latency issue is created.

Flash Trading by Co-Location

Flash Trading refers to the practice of exchanges ‘flashing’ buy and sell order information to select premium subscribers, typically these are HFT firms, a fraction of a second prior to when they are publicly available.  This is very controversial as HFT firms use this advantageous information to trade ahead of pending orders, which is also known as front-running.

This predatory practice has been going on for quite a long time, as in 2009 Senator Charles Schumer requested that the SEC ban flash trading altogether, stating that it contributes to a two-tiered market, the privileged few and everyone else.  

Other factors such as computer algorithms, technology, regulations, and distance contribute to latency issues, however, these two main factors of consolidated feed vs. direct feed and flash trading, both lay the groundwork for the current two-tiered market structure.  

Great Point Capital has been serving the trading community since 2001 and our 100+ prop traders actively trade the firm’s capital, specializing in equities and equity options.  We are headquartered in Chicago with a location in Austin, TX.  Contact Great Point Capital LLC today, in either our Chicago Office, or our Austin Office, to learn more about how we can successfully trade together with high performance results.  We are one of the very few firms able to offer access to Takion Software Platform, enhancing your online equity trading performance.

Nasdaq’s Proposal of the Extended Life Priority Order

As Nasdaq continues to develop and propose, then either withdraw or justify new stock order types that seem to benefit only the select few, let’s review a recent order proposal and how it may impact investors.  

In November of 2016, Nasdaq proposed a new order type they named the Extended Life Priority Order (ELO).  This was also shortly after the IEX to became the 13th US Stock Exchange.  This ELO order type has been incorrectly compared to the time delay similar with IEX’s “speed bump”.  

The time delay was implemented by IEX to create a level playing field and prevent leakage of information  to HFT firms, whereas the feature of holding an order with priority in the ELO Order are two very different things.  It’s widely known that Nasdaq opposed the speed bump used by IEX, although it is universal and in no way identifies certain trades or the origination.

The ELO order, on the other hand, is an optional order type, and should not be confused with the universal speed bump.  Only certain customers will have access to the EDO which is specifically retail order flow, although there is a plan to include institutional investors sometime in the future.  The objective of the ELO is to reward investors that do not cancel their order for at least 1 second, by moving them to the front of the line.  The ELO order is given priority over non-ELO orders, and it is clearly identified as an order that will not cancel or change within a specified time period.

ELO Identified Order Equates to Information Leakage

The fact that the ELO order is identified and displayed as one that will not change or cancel, is evidence enough that this is leakage of information.  Some are attempting to justification this by implying that this is a way to beat the HFTs at their speed game, and your order will be filled. This comes at what price to investors?

These ELO orders that contain a unique identifier will be instantly seen by the HFT firms and any broker with a prop data feed.  This is very valuable information!  This information leak can and does alter the NBBO, swaying the price for all non-ELO orders or any trades executed on a slower platform.  Altering the NBBO with pending trades is altering the market, which is never good for investors.

John Ramsay, Chief Market Policy Officer at IEX, raised several good points to the SEC In a letter dated March 2, 2017, regarding Nasdaq’s ELO proposal.  By requiring that all ELO orders are identified alerts predatory HFTs to identify orders from institutional investors, which can be detrimental to those investors.  Prop data feed customers currently use information provided by the electronic trading firms, this mandatory identification of ELO orders will identify retail orders.  This type of order would actually elicit more predatory trades.  

John Ramsay continues to point out that while Nasdaq makes reference to the Toronto Stock Exchange’s (TSX) “Long Life” orders, they do not mention that the TSX does not identify those orders, particularly to decrease possible information leakage.  

IEX is asking the SEC to not approve this ELO proposal unless Nasdaq removes the requirement for identification.  While Nasdaq justifies how they reward participants and improve the market, it seems obvious that this ELO order is another mechanism to leak client identity and information.

Great Point Capital has been serving the trading community since 2001 and our 100+ prop traders actively trade the firm’s capital, specializing in equities and equity options.  We are headquartered in Chicago with a location in Austin, TX.  Contact Great Point Capital LLC today, in either our Chicago Office, or our Austin Office, to learn more about how we can successfully trade together with high performance results.  We are one of the very few firms able to offer access to Takion Software Platform, enhancing your online equity trading performance.

Nasdaq Withdrew Retail Post-Only Order Proposal

Nasdaq proposed to the SEC, in October of 2016, a request to change and adopt a new Retail Post-Only Order.  This was dubbed by the group over at Themis Trading, LLC as Post Only Order for Retail (POOR).  The Retail Post Only Order was essentially designed to aid retail brokers in avoiding access fees.  It would have allowed for the order to be cancelled for any reason, instead of completing with an adjusted price.  Nasdaq considers this ‘choice’ as ‘competition’ that is good for markets.  

We will have to agree with Themis Trading on this one, as we see this order proposal for what it was, another attempt by Nasdaq to give retail brokers avenues for avoiding access fees, along with undesirable retail flow execution.

This type of order would obviously violate a broker’s responsibility for best execution, simply by cancelling an order that would have been filled otherwise.  These order types contribute to a distorted price movement, all the while hindering a trader’s best execution.  By giving retail brokers strategies that could potentially hurt their clients, the SEC would be going against the very basic principles of protecting investors, both institutional and retail.  

The SEC opened the door to comments in December of 2016, deciding to take more time to review this proposal Retail Post-Only Order Proposal.   We are pleased to know that Nasdaq revoked their proposal for the rule change in January of 2017, conceivably due to the scrutiny placed on this by the Themis Trading Group.  

We are thankful to Themis for taking the time to write comment letters to the SEC with their opinions and findings on this order type proposals.  We are equally thrilled that this proposal did not come to materialization in the marketplace.

Great Point Capital has been serving the trading community since 2001 and our 100+ prop traders actively trade the firm’s capital, specializing in equities and equity options.  We are headquartered in Chicago with a location in Austin, TX.  Contact Great Point Capital LLC today, in either our Chicago Office, or our Austin Office, to learn more about how we can successfully trade together with high performance results.  We are one of the very few firms able to offer access to Takion Software Platform, enhancing your online equity trading performance.