Latency Arbitrage is something that you may not necessarily be familiar with, but if you have anything more than a passing interest in the stock market, then you probably have heard of high frequency trading (after all, it has been in the news a lot recently, particularly following the May 6th Flash Crash).
High frequency traders use latency arbitrage as one of their core strategies. In fact, it forms the basis of most of their other activities.
So what is it? Basically any form of arbitrage generally involves buying (or selling) an asset in one place while simultaneously selling (or buying) a very similar asset somewhere else, to take advantage of small price discrepancies. The key thing with arbitrage is that you keep an overall flat position so that your risk is all but eliminated.
Latency arbitrage is the same thing, except for the fact that instead of buying and selling assets in different locations, you are buying and selling the same asset at slightly different times (usually no more than milliseconds or even tens/hundreds of microseconds), by taking advantage of the latency between when you (as a high frequency trader) see bid/offer prices and when those prices are seen by the rest of the market.
How do high frequency traders get to see these prices before everyone else? Simple. They follow a two-pronged approach.
First, they capture a feed of raw data direct from the exchange rather than taking prices from the consolidated feed used by other market participants. The process of consolidation takes a number of milliseconds, so this enables the high frequency traders to pick up the data before everyone else sees it.
Second, they “co-locate” their servers at the exchange data centers, so that the data feed hits their black box trading systems as quickly as possible. Speed of light is a factor here. The further away from the exchange you are (i.e. the further the electronic messages have to travel), the more latency is introduced.
Just by doing these two things, high frequency traders are able to perform latency arbitrage, giving them the ability to consistently take small profits by trading ahead of the market, with almost zero risk.
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