How Does Latency Affect Traders?
Here’s the most appropriate idiom to describe latency: the early bird gets the worm.
If the order message that is routed back to the broker’s server gets delayed even for a millisecond, the price that the trader attempted for the order may have moved away, and the broker might not be able to fill that order.
Low latency can lead to faster fills.
Low latency can also minimize slippage, which is the difference between the expected price of a trade and the price at which the trade is executed. Negative slippage can lead to a trader paying more than what they anticipated (or selling for a price less than what they anticipated) when they placed the order.
Traders can gain a competitive advantage when their orders reach the market with a low level of latency, as missed opportunities from slow execution could be costly.
Still, trading strategies that rely on low latency aren’t right for everyone. For one, speed doesn’t guarantee a profit; operating in a low latency environment means nothing if the trade was a bad choice. Some speed-dependent strategies, such as latency arbitrage, may require an advanced skillset in algorithmic trading.
Access to low latency technology can have higher costs, depending on the brokerage firm. Casual retail traders may find the costs don’t add as much value to their strategy, but for high-frequency traders, low latency can be crucial.
What Is Latency Arbitrage?
Latency arbitrage uses trading algorithms to identify price discrepancies in the markets. A security can appear in multiple exchanges and occasionally trade at different values. Arbitrage algorithms can buy an undervalued security and nearly simultaneously sell the same security at another location where it is overvalued, locking in a small profit.
Latency arbitrage can be valuable to the market overall, since the process helps ensure prices do not deviate substantially from their expected price for too long. Latency arbitrage typically requires ultra-low latency solutions.
This practice has a significant market impact. A 2021 Bank for International Settlements study estimated the profits for latency arbitrage in the global markets were worth about $5 billion annually. However, not all brokerage firms can sustain the costs for managing colocation centers for low latency. Those who aim to employ latency arbitrage must commit to costly trading solutions.