Institutional investors like hedge funds and investment banks have a significant advantage over retail investors when it comes to trading in the stock market. Not only do they have access to sophisticated trading tools and data modeling software, they also have access to extremely high-speed internet and super-fast computers.
However, these advantages come at a huge cost since institutional investors typically spend millions of dollars to acquire and use such infrastructure. Also, thanks to such cutting-edge technological infrastructure, institutional investors are capable of making high-frequency trades (HFT) within a very short period of time.
Since they possess such high levels of infrastructure, institutional investors have the bandwidth to employ a variety of trading strategies that may otherwise not be possible. One such strategy is latency arbitrage, which we will explore shortly. But before that, let’s first take a good look at the concept of latency.
What is latency?
In computer networking parlance, latency is defined as the time it takes for a signal to reach its destination. And so, the lower the latency, the faster the signal reaches its endpoint. Two of the primary factors that determine the latency of a signal are the speed of the network and the physical distance that the signal has to cover. For instance, it takes more time for a signal originating from Mumbai to reach California than it takes for it to reach Pune.
What is the role of latency in trading?
The reason large institutional investors invest a huge amount of capital towards acquiring extremely fast infrastructure is to reduce the latency to as little as possible. With low latencies, these investors get access to better stock prices fractions of a second before retail traders, who are stuck with high latency network connections and slower computers.
To bridge the latency, many institutional investors have their office spaces and servers physically close to the stock exchange’s servers. A combination of super-high-speed internet and significantly lower physical distance between servers allows these investors to tap into prices much faster than a regular individual investor or a trader.
Some institutions go even a step further and place their servers in the same premises as the servers of the exchanges themselves. This is commonly known as co-location. In return for giving such investors low latency and high-speed access, exchanges charge a hefty sum.
What is latency arbitrage strategy?
Now that you know what latency is and what its role in trading is, let’s try to understand the concept of latency arbitrage.
Latency arbitrage is a trading strategy employed by institutional investors that utilize the minor price differences in a stock that arises as a result of the time disparity between these investors and other participants. To be able to better understand this concept, let’s take up a latency arbitrage example.
Assume that you’re a trader who wishes to purchase the shares of a company ABC. The best bid is currently at Rs. 10 and the best offer is currently at Rs. 11 for the stock. And so, you decide to place a buy order at the midpoint for Rs. 10.5. But then, before you can place the order, the price feed has refreshed and it currently reads Rs. 9.5 (bid) and Rs. 10 (offer). This information takes time to reach your trading terminal or platform due to the higher latency of your network connection. And so, you still end up seeing the old bid and offer rates for the stock, which is Rs. 10 and Rs. 11 respectively, thereby leading you to place the buy order at Rs. 10.5.
Here’s where institutional investors employ latency arbitrage strategy to exploit the price difference. Since they possess infrastructure with exceptional low latency, they get access to the new bid and offer rates of Rs. 9.5 and Rs. 10 instantly (much faster than you). Seeing this, they buy the stock at Rs. 9.5 and sell it to you at Rs. 10.5 as soon as you place the buy order. By exploiting the minute time difference, the institutional trader was able to make a profit of around Rs. 1.
While a profit of Rs. 1 per trade might not seem like much, remember that these investors make high-frequency trades (HFTs). They execute as many as hundreds of trades within a span of a minute. All of it adds up at the end of a trading session, with the institutional investors ending the day with millions in profit. As you’ve seen from the above latency arbitrage example, this is how investors use the latency arbitrage strategy to earn profits.