This article will discuss and guide you through a topic well known from advanced traders but hard to understand for beginners: Latency Arbitrage!
The aim is to give you all the information needed to have a good understanding on how it works so you can decide whether this type of trading is worth trying or not.
What is latency arbitrage?
We first need to understand what arbitrage means. It is a trading strategy used by many market participants, such as banks or funds, on a wide range of financial markets (centralized and OTC).
The idea is to take advantage of inefficiencies by buying / selling when a price discrepancy is detected on identical or similar financial instruments.
There are plenty of automated trading systems used by banks and hedge funds that scan and track arbitrage opportunities all day long on the equity market, fixed income and Bonds.
When the algos detect an opportunity they will immediately realize the arbitrage and cash the money in. These are part of the so called “free trades” understand here a trade with nearly no risk that everybody wants to take.
As for everything in trading the rule of first arrived first served applies, that’s why short term arbitrage opportunities usually don’t last long!
Now that we know what arbitrage is, it’s fairly simple to understand what latency arbitrage is: To take purely advantage of price discrepancies caused by the latency of pricing systems / engines between two identical or similar financial instruments.
How does it apply to a Forex & CFD broker?
To price any product such as a Forex pair or a CFD, the brokers need liquidity and market data (the feed that gives your beautiful charts).
They take this data from liquidity providers such as banks or other brokers and stream this on their trading platform with wider spread, higher commissions. The result is the chart you see moving on your platform.
The main point for you to understand here is the price you receive from your broker always comes from somewhere; the broker just takes it from somebody else and re stream that on its platform. This is what potentially creates the latency in prices.
It can come from the network latency of the broker; from a specific GUI the broker uses, or from the MT4 setup itself…there can be many different reasons.
Practically speaking the broker ends up having what is called a SLOW FEED: in simple words the prices streamed on his platform update slightly slower than they should due to latency.
Now I’m sure you start to understand completely the concept of latency arbitrage and you’re wondering: Can we look at the platform of a broker with a FAST FEED (a broker whose pricing is really fast) and know in advance where the price is going with a broker that has a SLOW FEED to make a few pips on each trades?
Well Yes and No…It’s actually a lot more complicated than that! Before we go further and understand how to take advantage of latency in prices to do arbitrage, we have to talk about the subject that matters the most: Trading execution.
Trading Execution with FOREX & CFD Brokers
To place a trade you need somebody to execute your transaction otherwise there is no trade happening. When you go long or short on your trading platform, and click on the buy / sell button, somebody will execute and take the risk for your trade. He will be your counterpart: essentially if you are long he is short, if you are short he is long.
Most of the brokers operate in the same way: they can be your counterpart (market-making) or decide to STP your trades to somebody else (the liquidity provider) if they feel they are not going to make any money with you.
In the business when a broker takes the risk for your trades it is called B-Book. If he decides to STP your trades to somebody else it’s called A-Book.
When you get executed on the B-Book of the broker it’s usually extremely fast, you place your trade and it’s done in milliseconds. You get a price very close to the one you requested.
If you are on A-book, you are getting executed by the liquidity provider or whoever the broker STP the business to. The execution speed can still be very fast but the key difference with B-book execution is the price you get.
In fact you get executed on the FAST FEED of the liquidity provider which is not latent at all. It means that you are not likely to get the price you requested on the SLOW FEED…
Let’s take a concrete example here : The liquidity provider is pricing EUR/USD @1.35000, Your latent MT4 Broker is a bit delayed and is still pricing EUR/USD @1.34970 (3 PIPS difference). When you are on A-book even if you click 1.34970 you will get executed at 1.35000 because it’s the LP is executing you. The difference between the price you requested and the price you got executed at is called slippage, it can be positive or negative, but let’s be honest a minute, it’s most of the time against you.
How latency traders do it practically?
First of all forget about trading this strategy manually, indeed all traders in this field use expert advisors or homemade algos doing the job a lot quicker and better than any manual trader. If you think about it, you need first to spot the arbitrage opportunity comparing a FAST FEED and a SLOW FEED, then you have to open the position with the broker who is latent and close it right away, all of that in less than a second…it’s very unlikely to happen. So you need an algo that can do the job!
You can find many websites selling arbitrage EAs on google but don’t expect any good results from them. That’s why the typical latency trader is someone with programming skills who will be able to create his own automated system to spot and trade arbitrage opportunities. For sure it’s not an easy job but on the paper I understand it looks like the road to a holy grail!
Where is the trick?
Do you remember our explanation about trading execution and the difference between B-Book and A-Book? The first issue is here…and I’m sure you already got it!
As long as you trade vs the B-Book of the broker, you will get the latent price and you will be able to make money on latency. When the broker will switch your execution to his liquidity provider (put you on his A-Book) you will get slippage and each single trade will result in a loss.
As you might expect, obviously brokers are monitoring this very closely. Actually Forex & CFD brokers are monitoring everybody on their B-Book to make sure they keep on managing their risk properly. A soon as the broker will realize you are trading latency he will immediately switch you to A-book, it can happen pretty fast if the broker has got automated systems checking this or it might take a few hours to half a day if his trading desk is doing it manually!
The result is not only you will lose all the profits you made (and surely faster) you will probably also lose your capital as well.
The second issue with this trading strategy is that you are not making money genuinely trading the markets. In fact you are taking advantage of the weakness of the IT systems of a broker. It is considered to be an ABUSIVE type of trading by most of the brokers and a breach to their terms and conditions. So let’s say you eventually manage to stop your latency EA when you realize that you have been switched to A-book and you have made profits overall. The broker can still find a way to avoid paying you the profits claiming a breach of the terms and conditions. It’s not an amazing deal in the end…
The other types of arbitrage in trading
For your knowledge here are other types of arbitrage on the same basis as the one explained above:
Arbitrage future / CFD
The idea here is to realize an arbitrage on CFDs, specifically the ones that are priced from a future contract: Indices and Commodities mainly.
To price CFDs the brokers can take CFD liquidity and market data from a Liquidy Provider or can go directly to the exchange and take the price from the future contract. The broker makes a fair value of the future price to turn it into a cash product and streams this on its platform.
The Arbitrage is done by comparing the feed of the CFD to the future contract. Because the future contract is the source where the price comes from you will not get any faster and many brokers are actually latent if you compare their CFD price to the future one!
Obviously the same limits apply here: this is not a genuine type of trading and will be considered abusive by any broker!
Triangular Arbitrage on FX
This type of Arbitrage is slightly different because it involves not two but three different currency pairs. The idea is to open 3 positions that will hedge between themselves to have zero market risk. Understand here that whatever direction the market is moving to, it won’t affect the global P&L.
As soon as a specific currency starts to be inefficient or starts to show latency, the trader will see profits coming. Then it’s just about closing all the three trades at the same time to cash the P&L in.
We hope you liked this article and it gave you some good understanding about latency trading. Feel free to comment and don’t forget to follow us on Twitter @FXTradingReward