Institutional investors acquire technologies such as super-fast computers and high-end super-fast broadband for high-speed internet to employ high-frequency trading strategies. One such strategy they employ with the help of these cutting-edge technologies is Latency Arbitrage, which is a method of buying stocks at a lesser price before retail investors due to faster latency. To understand this concept more clearly, stick with us while we break the term and gain more clarity.
Arbitrage, in simple words, is the practice of buying a stock and reselling it instantly at a higher price. This difference in buying and selling price is the profit the traders earn by executing arbitrage trades.
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Frequently, traders use this method to purchase a security in a foreign market that is yet to incorporate the change in price for the exchange rate, allowing them to get the stock at a cheaper rate.
Latency in computer networking terms stands for the time a signal takes to reach the destination from its source.
The lower the latency, the faster the signal travels to the destination.
Latency is affected by several factors, such as the speed of the network and the distance between the source and receiver.
Latency arbitrage is a strategy used by traders, primarily institutional investors, to profit from the stock's minor price fluctuations due to the latency difference between the systems of these investors and other market participants. To get more clarity, let's explore an example.
For instance, the shares of company X are up for trading, and the best bid on the stock is Rs 20, while the best offer stands at Rs 21. And you are a trader who placed the buy order of Rs 20.5, i.e., midpoint. However, while you were placing the order, the rates changed to Rs 19.5 for the bid and Rs 20 for the best offer, but this change in the price was not reflected in your device due to its high latency, and you ended up placing the order for the previous bid, i.e., Rs 20.5. In this way, you end up with a minor loss.
On the other hand, institutional investors with huge infrastructure and better technology have lower latency, and they can access the price change to Rs 19.5, place the order for it, and then sell it to you at Rs 20.5. Thus making a profit out of this minute time difference due to latency differences.
Latency arbitrage helps institutional investors execute high-frequency trade and make profits from it. They try to lower the latency and reduce their distance from stock market servers to increase their accuracy.