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.
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