What type of broker is best for arbitrage traders? Tuesday March 10th, 2020 – Posted in: Arbitrage Software
As an arbitrage trader, you need to use a broker that will let you earn profits quickly, keep your risk as close to zero as possible, and, most importantly, use that broker for as long as you can. Proper broker selection is therefore paramount. To choose the right broker, you need to understand the different types of brokers that exist.
Broadly speaking, there are three types of brokers: B-book brokers, STP (A-book) brokers, and hybrid brokers. It might be helpful to explain the difference between the A-book and the B-book. A broker using the A-book model transmits all orders to the market, to be filled by the broker’s liquidity providers. B-book brokers, on the other hand, fill orders on an “in-house” basis; a B-book broker is trading against its clients. A pure B-book broker wants you to lose money because your loss translates into the broker’s gain. To accomplish that, the broker will increase your order execution time and resort to slippage. Aside from generating revenue from commission fees, B-book brokers also gain by trading against their clients.
To get back to the three broker types:
- B-book brokers use the B-book only.
- STP (A-book) brokers send all orders externally to liquidity providers.
- Hybrid brokers use a mix of both.
STP brokers are exceptionally uncommon when you’re working in an MT4 or MT5 setting, while you probably don’t want to be dealing with a pure B-book broker anyway. Your best bet, then, is a hybrid broker.
Hybrid brokers are not uniform in their models. Some hybrid brokers initially put all of their accounts in the B-book; accounts that perform well get moved to the A-book. Other hybrid brokers put all of the accounts in the A-book, moving accounts that lose money to the B-book. The exact structure and sequence depend on the broker.
Account profitability is not the only determining factor when it comes to deciding whether an account should be moved to the A-book or the B-book. Size does matter. For instance, if a trader uses outsized lots, the broker might keep the account in the A-book even if the trader is losing money, since placing the account in the B-book will expose the broker to unnecessary risk. Also, brokers have tools to identify so-called toxic traders. Toxic traders are traders using arbitrage trading strategies. If the broker determines that you’re using an arbitrage trading strategy, your account will probably be moved to the A-book.
Let’s say you’ve zeroed in on a hybrid broker. What next? You will want to follow these steps:
- Open two different accounts. Note: they might be at the same broker or at two different brokers. If you want to use the same broker, the accounts will have to be under different names.
- Keep your deposits relatively small. All in all, they should not be more than $5,000 or so. A deposit that is significantly higher than this amount will get you flagged as a high-risk trader. You want to be seen as a low-risk one so that your account can be moved between the B-book and the A-book freely by the broker.
- Add both accounts to your lock arbitrage strategy.
- Use a large difference-to-open value so that no orders are opened.
- Create locks for positively correlated pairs, in the same direction. An example of two positively correlated currency pairs is EUR/USD and GBP/USD (note that the US dollar is the quote currency in both pairs). Again, make sure the locks are in the same direction.
Once the locks are created, you now need to wait. The market changes all the time. At some point, one of the accounts will start losing money. Conversely, the other account will be in the black. Once you’ve lost 50% in one account and gained 50% in the other (due to commissions, it will actually be slightly less than 50%), close the locks.
There’s not much else you can do with the account that is up, so close it and withdraw your funds.
You will now work with the account where you have a loss. Open an order and review the amount of time it took the broker to fill the order. You want to see a number that is in the vicinity of 50 milliseconds. That number means your account has been placed in the B-book. You can start trading by using an arbitrage strategy of your choice.
Keep an eye on the order execution time for each of your orders. Make sure it stays at the same level as it was on your first orders. If the number shoots up, the broker has figured out that you’re using an arbitrage trading strategy. In that situation, you should withdraw your money and shut down the account – there’s no sense in trying to continue.
A few caveats:
- When creating locks, make sure you do it on Monday. If nothing happens with them before Wednesday afternoon, close the locks. You need to do that because rollover happens at 05:00 p.m. EST every Wednesday, and you don’t want to be hit by it.
- Close and reopen your locks occasionally so that it looks like there is trading activity.
- Avoid using a VPS that is too popular with traders. Provided that your account is in the B-book, you can use practically any VPS. Just make sure that your VPS is in the same data center as the broker’s server.
- Certain brokers apply delays in the B-book as well. Try to figure out if a broker you’re considering using does that. If yes, stay away – you won’t be able to work with that broker.
- The best hybrid broker is one that uses plugins that are based on profitability. These plugins flag your account for switching to the A-book only if your profits reach a predetermined level (e.g., a given percentage of your deposit). As long as your profits stay under that level, you can use the broker without problems. Conversely, brokers that use plugins that aim to identify arbitrage trading strategies cannot be used for any meaningful amount of time.
In conclusion, if you use our instructions and advice, you should be able to engage in latency arbitrage in a profitable manner while keeping your risk near zero. Aside from following our advice, be sure to constantly monitor your slippage and order execution times.
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