When it comes to trading on the stock market, institutional investors such as hedge funds or investment banks have an advantage over retail investors. They have access not only to advanced trading tools and data modeling software but also to super-fast internet and computers.
These advantages, however, come at a high price as institutional investors often spend millions to acquire and maintain such infrastructure. Institutional investors can also make high-frequency trades (HFTs) in a short time period thanks to this cutting-edge technological infrastructure.
Institutional investors can use a wide range of trading strategies because they have such high-levels infrastructure. We will soon be looking at latency arbitrage as an example of such a strategy. Let's take a look at latency first.
Latency, in computer networking parlance is the time it takes for a signal reach its destination. The signal will reach its destination faster if it has a lower latency. The speed of the network's connection and the distance the signal must cover are two of the main factors that affect the latency of a signal. It takes longer for signals from Mumbai to reach California than for them to reach Pune.
Large institutional investors spend a lot of capital to acquire extremely fast infrastructure. This is because they want to minimize latency. These investors have access to stock prices that are better than retail traders who trade with slower computers and network connections.
Many institutional investors have their offices and servers located close to stock exchange servers in order to bridge latency. These investors can access prices faster than regular traders or individual investors thanks to super-fast internet and a significantly shorter distance between servers.
Some institutions even go one step further by placing their servers in the same building as the exchange servers. This is known as colocation. Exchanges will charge large sums in return for providing investors with low latency and high speed access.
Let's now understand what latency is and how it affects trading.
Latency arbitrage, a strategy used by institutional investors to exploit minor price differences in stocks that result from time discrepancies between them and other participants, is a trading strategy. Let's look at a latency arbitration example to help us better understand the concept.
Let's say you are a trader and wish to buy shares in company ABC. The current best offer is Rs. The best offer currently is Rs. 11 for the stock. You decide to place a purchase order at the middle point for Rs. 10.5. The price feed refreshes before you can place an order. It currently reads Rs. 9.5 (bid) & Rs. 10 (offer). Due to the slower latency of your network connection, this information may take some time to reach your trading platform or terminal. You will still see the old offer and bid rates for the stock (which is Rs. 10, and Rs. You can place your order for Rs. 10.5.
This is where institutional investors use latency arbitrage strategy in order to take advantage of the price differential. They have access to the latest bid and offer rates for Rs. because they have infrastructure that is extremely low in latency. 9.5 and Rs. 10 immediately (much quicker than you). They see this and buy the stock for Rs. 9.5 and then sell it to your at Rs. You must place the order immediately. The institutional trader made a profit of approximately Rs. by exploiting the minute difference in time. 1.
A profit of Rs. Although a profit of Rs. 1 per trade may not sound like much, these investors engage in high frequency trades (HFTs). In a matter of minutes, they can execute hundreds of trades. It all adds up to a trading session that ends with institutional investors making millions of dollars. This is how latency arbitrage strategies are used by investors to make profits, as you can see from the example above.