Latency Arbitrage Wednesday November 19th, 2014 – Posted in: Arbitrage Software – Tags: Latency Arbitrage, Latenz-Arbitrage, مراجحة الكمون, レイテンシアービトラージ, 延迟套利, 잠복차익거래
In this article, we’re going to discuss latency arbitrage and the tools we have developed to help latency arbitrage traders. Let’s start with the definition first. Latency arbitrage is a type of high-frequency trading based on the use of a “fast broker” that transmits quotes rapidly to the trader. LMAX and Saxo Bank are both examples of a fast broker. Both send quotes through the FIX API or ITCH protocol. These two protocols are faster than the MT4 or MT5 one and, due to the speed of the protocols and the use of more professional bridges, quotes are provided much more quickly than they are by other brokers.
The goal of an arbitrage trader is to identify arbitrage situations and profit from them. Arbitrage opportunities come about as a result of market inefficiencies. Typically, an arbitrage situation arises when there is a price discrepancy of some sort. For instance, let’s suppose that the price of a certain security moves up. A fast broker picks up the price change faster than a slow broker, whose quotes lag behind those of the fast broker. There is now a price gap between the two brokers. An arbitrage trader monitoring the two brokers can take advantage of this price discrepancy by buying the security with the slow broker. Conversely, if the price were to move lower and the fast broker were to show the lower price before the slow broker, the trader would enter a sell order with the slow broker.
Price discrepancies usually last no longer than several milliseconds. Within those several milliseconds, an arbitrage trader has to identify the arbitrage situation and submit an order. Naturally, this is not something that can be done manually. Arbitrage trading requires the use of trading software that is designed for this purpose. The software finds a price gap and places an order; once the price gap disappears, the order is closed.
When price discrepancies happen, in most cases the price continues to move in the direction of the gap for some time. Using the example above, if the price goes up and the fast broker shows it before the slow broker does, it is probable that the price displayed by the slow broker will continue to move up. To maximize profits in such situations, the trader can use different types of trailing stops.
The type of trading discussed above is known as latency arbitrage. Contrary to popular misconceptions and some of the assertions made by various brokers, this is a perfectly legal activity. When a broker claims that arbitrage trading is illegal or that the broker does not allow arbitrage trading on its platform, it means the broker or the liquidity provider is using the B-book model to fill orders.
In theory, the job of a broker is to bring buyers and sellers together. To make sure that a buyer can find a seller, the trade should be routed to the market, as that is the place where the greatest number of buyers can meet the greatest number of sellers. In practice, however, some brokers and liquidity providers keep orders in their B-book, which means that these orders are filled on an in-house basis (in other words, the broker is on the other side of the trade). As arbitrage trading tends to be profitable, any broker using the B-book model stands to lose money when working with arbitrage traders.
Aside from being profitable (percentage-wise, monthly profits can be in the triple digits if the broker does not attempt to hinder the strategy and work against the trader), arbitrage trading is a low-risk strategy. This is due to the fact that this strategy relies on small stop losses and short-term positions.
Nevertheless, the kind of arbitrage trading described earlier is of the simplest variety and has recently become ineffective for long-term performance. The reason is the changing dynamics of the brokerage business. Brokers have discovered that the B-book model is more lucrative than the pure commissions-oriented model; increasingly, brokerage firms have been installing plugins to prevent traders from placing orders aimed at the very short term. These plugins increase the execution time of orders. Where a liquidity provider once might have filled an order in some 4 milliseconds, it now might take several seconds. This increase in the execution time is referred to as slippage, and it prevents the trader from making a profit on an arbitrage trade that needs to be filled in several milliseconds if the trade is to be a profitable one.
The need for protection against this kind of intervention on the part of the broker is obvious. This is where our company comes in. We have developed a software application called Lock Arbitrage. This program allows the trader to enter the market long before there is an arbitrage situation. This is done by placing two opposite (offsetting) orders using two different accounts, whether at the same broker or at two different brokers. The trader then ends up with a buy order in one account and a sell order in the other, with the same lot size used for both orders. Regardless of where the market moves, the trader will neither make money nor lose it – there will be a small loss in one account and a small gain in the other. The gain is offset by the loss, and vice versa.
When an arbitrage situation does come about – for example, when the price shown by the fast broker moves up – the program quickly closes the sell position. When a profit is booked, the sell position is reopened – but in the other account this time. As far as the broker is concerned, there does not appear to be anything untoward with this trading activity. The trades are not short-term in nature and, as the use of locking increases the size of the profits, profit taking seems to exceed several pips.
This is only a simple description of the program. The sophisticated algorithm built into the software uses trailing stops and manual trading emulation. The broker sees evidence of manual trading instead of trading with the help of an expert advisor. The trader is not flagged, and the broker does not use plugins to interfere with the trader’s activity.
Latency arbitrage is compatible with all the major platforms, such as MT4, MT5, FIX API, and cTrader. We have a program for each of these platforms; the trader need only determine which platform best meets the trader’s needs. Typically, the MT4 and MT5 platforms are used by traders who come to the market with more modest deposits. If you have less than $10,000 to trade, you’ll have a hard time finding a broker that will open a decent FIX API account for you. If, however, you have larger deposits, FIX API might be the way to go.
When choosing between the MT4 and MT5 platforms, you also need to be mindful of your location. In a number of countries, the MT4 platform might not be supported as well as its MT5 counterpart. If you’re in one of these countries, you might consider choosing the MT5 Lock Arbitrage or the MT5 Latency Arbitrage software. If there are no such problems in your country, we recommend the MT4 Lock Arbitrage program, as the MT4 platform tends to be more popular and more widely supported by brokers.
To reiterate, arbitrage trading is not only legal; it also makes the market more efficient, as it eliminates all kinds of discrepancies and disparities. You can read more about the legal status of arbitrage trading on such sites as Investopedia, among others, which will confirm that arbitrage trading is an absolutely legitimate way of making money that makes the market a more equitable place for all participants. Our own Latency and Lock programs will help you take advantage of arbitrage trading more effectively.