Latency Arbitrage in Forex Trading: easy profits? Not really.

02 February 2024

Latency Arbitrage in Forex Trading: Easy profits? Not really!

Latency arbitrage has been a popular trading strategy used in the forex market for many years. However, dreams of easy profits are rarely realised and brokers on the whole treat this activity as "toxic flow" and do not want to work with traders using this strategy.  It involves taking advantage of the time delay between the price feed of different brokers to make a profit. This time delay, also known as latency, can occur due to various factors such as the distance between the broker's server and the trader's computer or network congestion. Traders should be aware that brokers now have the ability to easily identify such behaviour (in the past they were not). Most brokers are on high-alert for these strategies and latency arbitrage is generally being weeded out by the industry.

To execute a latency arbitrage trade, a trader needs to have a fast and reliable internet connection and access to multiple brokers. The trader then monitors the price feeds of different brokers and identifies price discrepancies between them. Once a profitable opportunity is spotted, the trader quickly executes a trade to buy or sell a currency pair and closes the trade as soon as the price discrepancies disappear.

While latency arbitrage can be a profitable trading strategy, it is also highly controversial as most brokers consider it to be a form of market manipulation, especially against themselves if they are managing the risk from all their client trades (running a "B-book"). Therefore, traders who want to use this strategy need to be aware of the risks, potential legal implications and ultimately the very finite nature of having access to brokers who will prevent this style of trading.

Running, LiquidityFinder I have had many conversations with traders who are looking for a new broker to accept their algo-strategy. When I ask the trader to explain more about the strategy they are using, when it turns out to be latency based, it then emerges that they have had their account closed at one broker or another and are looking for any broker that may accept them. My advice is, "change your strategy"! 

Understanding Latency Arbitrage

The goal of latency arbitrage trading is to execute trades faster than other brokers (or traders) and profit from the price difference.

In the context of forex trading, latency arbitrage involves buying or selling currency pairs at different prices on different trading platforms, with different brokers. The trader monitors the price feeds of different brokers and identifies the price differences that exist due to latency. When the trader identifies an opportunity to profit from the price difference, they quickly execute a trade on the platform that offers the best price.

Latency arbitrage is a complex trading strategy that requires a high degree of technical knowledge and expertise. Traders need to have a deep understanding of the forex market, trading platforms, and the technology that underpins them. They also need to have access to high-speed internet connections and powerful computers that can execute trades at lightning-fast speeds.

In his book Flash Boys, Michael Lewis explored the investment that HFT firms in Chicago and elsewhere made in high speed connections to New York Stock Exchanges to get a faster update on prices than their competitors, effectively allowing those firms to "front run" prices and have an advntage over their competitors in miliseconds, or even microseconds.  This was one of the main drivers behind the creation of rival exchange IEX which was founded on the principle of preventing the advantage that the high frequency trading firms had over retail investors based on their tactics of "latency arbitrage".

Despite its potential for profit, latency arbitrage is controversial in the forex trading community. Some traders argue that it is unethical and unfair to exploit the time delay between price feeds. Others argue that it is a legitimate trading strategy that is simply taking advantage of market inefficiencies.

Traders that deploy latency arbitrage strategies need to be aware that brokers now have an array of tools at their disposal to detect this behaviour! Look at the table in our review here that shows what tools are available to retail brokers for risk management. Brokkers can easily idetify latency arbitrage, along with scalping and other forms of 'toxic flow'. When this behaviour is identified, the broker will usually rapidly take steps to limit the traders ability to trade on their prices.

There are sophisticated tools that brokers use to identify latency arbitrage trading, as well as other forms of "toxic flow" [see here]

A large part of Risk Management for a broker  is detecting latency arbitrage. We have identified at least  9 3rd party providers of software that identifies latency aribtrage trading, and larger brokers may have teir own systems to identify this trading behaviour built in-house.

Latency arbitrage is a trading strategy that aims to profit from the time delay between price feeds on different trading platforms. It is now also easily identifiable by the brokers themsleves with either 3rd party software or their own systems built in-house.

The Role of Speed in Latency Arbitrage

In the world of forex trading, speed is everything. The faster a trader can receive and process information, the more opportunities they have to make profitable trades. This is especially true in the case of latency arbitrage, a trading strategy that relies on exploiting tiny price discrepancies between different markets.

Latency arbitrage is a type of high-frequency trading (HFT) that involves using algorithms to identify and take advantage of small price differences that exist for only a few milliseconds. These price differences can arise when there is a delay in the transmission of information between different markets, such as when a trade is executed on one exchange before it can be executed on another.

To be successful at latency arbitrage, traders need to have low-latency connections to the markets they are trading on. This means that they need to have access to high-speed internet connections and use servers that are located as close as possible to the exchange's data centres.

Milliseconds matter in latency arbitrage. Even a small delay in the transmission of information can mean the difference between a profitable trade and a loss. This is why traders who use this strategy often invest heavily in technology and infrastructure to ensure that they have the fastest possible connections to the markets they are trading on.

In conclusion, speed plays a crucial role in latency arbitrage. Traders who are able to receive and process information faster than their competitors have a significant advantage when it comes to identifying and exploiting tiny price differences. To be successful at this strategy, traders need to have low-latency connections to the markets they are trading on and invest in technology and infrastructure to ensure that they have the fastest possible connections.

Brokers and Latency Arbitrage

Latency arbitrage in forex trading involves exploiting the time difference between the price feed of a slow broker and that of a fast broker. This strategy requires a trader to have access to both brokers and execute trades quickly to take advantage of the price discrepancies. However, not all brokers allow latency arbitrage, and it's essential to understand the broker's policy before engaging in such trading. In general, when a broker becomes aware that a trader is exploiting their latency, they will take a dim view of the practice, withold any profits made and take action to shut the account. 

Some brokers explicitly prohibit latency arbitrage in their terms and conditions, while others allow it but with certain restrictions. For instance, some brokers may impose a time delay between the receipt of an order and its execution to prevent latency arbitrage. Additionally, some brokers may offer different types of accounts, with varying levels of access to liquidity providers, which may affect the speed of execution and the opportunities for latency arbitrage.

It's crucial to note that latency arbitrage is a controversial strategy, and some brokers may view it as unethical or even fraudulent. Some brokers may take measures to detect and prevent latency arbitrage, such as monitoring the speed of execution and rejecting orders that appear to be exploiting price discrepancies.

Traders who wish to engage in latency arbitrage should carefully research and choose their brokers. They should look for brokers that offer fast and reliable execution, low latency, and a large pool of liquidity providers. They should also be aware of the broker's policy on latency arbitrage and any restrictions or limitations that may apply.

A trader who wants to engage in trying to pick-off slow price updates from a broker, needs to find a broker that can demonstrably show slow price updates. However, after a few trades, the broker will be aware of what is happening and will look to close the account down. Unlike say 10 years ago, today brokers have a wealth of analytical tools at their disposal to identify patterns of trading behaviour and are quick to discover those deemed to be taking advantage of price discrepancies or other anomalies. The trader then has to start the hunt for another broker, and then another etc. A lot of these traders have been coming to LiquidityFinder asking for a broker to work with, either looking for a very fast to update broker, or a slow to update broker. We do not spend anytime trying to assist them, unless they can demonstrate some aspect of their strategy where the broker will not receive any toxic flow. A very rare thing to be able to do! 

High-Frequency Traders and Latency Arbitrage

High-frequency traders (HFTs) are a subset of algorithmic traders who use sophisticated computer programs to execute trades at high speeds. They rely on low latency connections to exchanges to gain a competitive advantage and engage in a variety of trading strategies, including latency arbitrage.

Latency arbitrage is a trading strategy that exploits small differences in the time it takes for prices to update across different exchanges. HFTs use their low latency connections to quickly identify these price discrepancies and execute trades before the market adjusts. This allows them to make a profit on the price difference, often in a matter of milliseconds.

In his book Flash Boys, Michael Lewis explored the investment that HFT firms in Chicago and elsewhere made in high speed connections to New York Stock Exchanges to get a faster update on prices than their competitors, effectively allowing those firms to "front run" prices and have an advntage over their competitors in miliseconds, or even microseconds.  This was one of the main drivers behind the creation of rival exchange IEX which was founded on the principle of preventing the advantage that the high frequency trading firms had over retail investors based on their tactics of "latency arbitrage".

However, latency arbitrage is a controversial strategy, as it can be seen as taking advantage of other market participants who do not have access to the same low latency connections. Critics argue that it can create an uneven playing field and contribute to market instability.

Despite these concerns, HFTs continue to use latency arbitrage and other high-speed trading strategies. They invest heavily in technology and infrastructure to maintain their competitive edge, and often operate in a highly secretive and competitive environment.

Overall, the use of high-frequency trading and latency arbitrage in the forex market is a complex and rapidly evolving area. While these strategies can offer significant profits for those with the resources and expertise to execute them, they also raise important questions about market fairness and stability.

Instruments and Markets

The most highly liquid and most frequently updated (in terms of quotes)  currency pairs for FX traders include EUR/USD, GBP/USD, USD/JPY, and USD/CHF. These currency pairs are traded 24/5 around the world, making it possible for traders to take advantage of price discrepancies between different markets.

In addition to forex trading, latency arbitrage can also be applied in the stock market. The New York Stock Exchange (NYSE) is one of the largest stock exchanges in the world and provides opportunities for traders to profit from price discrepancies between different markets.

When it comes to latency arbitrage, speed is of the essence. Traders need to have access to fast and reliable trading platforms and data feeds in order to identify and exploit price discrepancies. This requires sophisticated technology and infrastructure, including high-speed internet connections, low-latency trading servers, and advanced algorithms. HFT firms spend tens (even hundreds) of millions of dollars on technology to give then an edge on competitors in having access to the latest price updates from exchanges. This technology is not accessible to most retail traders.  

Traders who engage in latency arbitrage must also be aware of the risks involved. Price discrepancies can be fleeting, and markets can move quickly, making it difficult to execute trades at the desired price. Additionally, some markets may have restrictions on latency arbitrage, making it important for traders to understand the rules and regulations of each market they trade in.

Latency Arbitrage and Slippage

Latency arbitrage is a trading strategy that takes advantage of the time delay between the execution of a trade and the receipt of market data. In this strategy, traders use high-speed algorithms to detect price discrepancies between different markets and execute trades to profit from them. However, one of the challenges of latency arbitrage is slippage.

Slippage is the difference between the expected price of a trade and the actual price at which it is executed. It occurs when there is a delay in the execution of a trade or when market conditions change rapidly. Slippage can have a significant impact on the profitability of a trade, especially in latency arbitrage where traders are looking to profit from small price discrepancies.

Price is a crucial factor in latency arbitrage. Traders need to have access to real-time price data from multiple exchanges to identify price discrepancies. However, the cost of accessing this data can be high, and traders need to factor in the cost of data feeds and server rental when calculating their profits.

Exchanges also play a critical role in latency arbitrage. Traders need to have accounts with multiple exchanges to be able to execute trades quickly and efficiently. However, not all exchanges offer the same level of liquidity, and traders need to be careful when choosing which exchanges to use.

In summary, latency arbitrage is a trading strategy that can be profitable, but it comes with its own set of challenges. Slippage can have a significant impact on the profitability of trades, and traders need to factor in the cost of data feeds and server rental when calculating their profits. Access to real-time price data from multiple exchanges is crucial, and traders need to be careful when choosing which exchanges to use based on their liquidity.

Role of Technology in Latency Arbitrage

Latency arbitrage is a trading strategy that relies heavily on technology. It involves taking advantage of the time delay in the transmission of price quotes between different trading platforms. To execute this strategy successfully, traders need to have access to the latest technology and tools.

Data Center

One of the most critical components of the technology used in latency arbitrage is the data center. The data center is where the trading servers are located, and it plays a crucial role in reducing latency. Traders need to choose a data center that is located close to the trading servers of the liquidity providers they are using. This proximity reduces the time it takes for price quotes to be transmitted and executed, thereby increasing the chances of success.

Forex Arbitrage Software

Forex arbitrage software is another critical tool used in latency arbitrage. This software is designed to scan multiple trading platforms simultaneously and identify price discrepancies that can be exploited. The software can be programmed to execute trades automatically when it identifies an opportunity, thereby reducing the time it takes for trades to be executed.

VPS and Virtual Server

To reduce latency further, traders often use virtual private servers (VPS) or virtual servers. These servers are hosted in the same data center as the trading servers, thereby reducing the time it takes for price quotes to be transmitted. This setup allows traders to execute trades quickly and efficiently, giving them an edge in the market.

Plugin

Plugins are another tool used in latency arbitrage. These plugins can be installed on trading platforms and provide traders with additional information about the price quotes they are receiving. They can also be used to automate trades, reducing the time it takes for trades to be executed.

Robot

Robots, or expert advisors, are automated trading systems that can be programmed to execute trades automatically. These robots can be used in latency arbitrage to take advantage of price discrepancies quickly and efficiently. They can also be used to monitor the market continuously and identify new opportunities as they arise.

Latency Arbitrage Software

Finally, latency arbitrage software is a specialised tool designed specifically for executing this trading strategy. This software is designed to reduce the time it takes for trades to be executed and to identify price discrepancies quickly. It can be customised to suit the specific needs of individual traders and can be used to automate trades, reducing the time it takes for trades to be executed.

In conclusion, technology plays a critical role in the success of latency arbitrage. Traders need to have access to the latest tools and technology to execute this strategy successfully. By using a combination of data centers, forex arbitrage software, VPS, plugins, robots, and latency arbitrage software, traders can reduce latency and increase their chances of success with this strategy, but it will ultimately not be a long-lived strategy as explained below.

Why Brokers Generally Do Not Like Latency Arbitrage Trading

Latency arbitrage trading is a controversial topic in the forex trading industry. While some traders believe it is a legitimate way to make profits, brokers generally do not like it. In this section, we will explore the reasons behind this.

Some traders are known to specifically trade around the overnight close at 22.00 London, where some brokers prices disappear for a few seconds/minutes when the banks and market makers ultimately supporting their pricing update their databases between one day and the next. Some brokers prices may return slower than others. These traders are soon identified and their accounts ultimately closed after some wrangling about profits being witheld from the client.  

High Risk

Latency arbitrage trading involves taking advantage of price discrepancies that occur due to delays in data transmission. Traders who engage in this type of trading use advanced technology to place trades milliseconds before other traders. However, this type of trading is highly risky, as it involves trading on the basis of very small price differences. Brokers are often hesitant to offer their services to traders who engage in this type of trading due to the high risk involved. Once latency arbitrage trading is identified by a broker, their first course of action generally is to widen the spreads seen by that trader 9or trader's algo). The next step is to close the account!

Unfair Advantage

Brokers generally do not like latency arbitrage trading because it gives traders an unfair advantage over other traders. Traders who engage in this type of trading are able to take advantage of price discrepancies that occur due to delays in data transmission. This means that they are able to place trades milliseconds before other traders. This gives them an unfair advantage over other traders who do not have access to this type of technology.

Negative Reputation

Latency arbitrage trading has a negative reputation in the forex trading industry. Many traders view it as an unethical way to make profits. Brokers who offer their services to traders who engage in this type of trading risk damaging their reputation. They may be seen as supporting unethical trading practices, which could harm their business in the long run.

Increased Costs

Brokers who offer their services to traders who engage in latency arbitrage trading may face increased costs. This is because traders who engage in this type of trading require fast and reliable data connections. Brokers may need to invest in expensive technology to provide these connections. This can be costly for brokers, especially if they do not have many traders who engage in this type of trading.

Risks and Advantages of Latency Arbitrage

Advantages

One of the main advantages of latency arbitrage is that it can generate profits quickly and consistently. By taking advantage of small price discrepancies, traders can make profits with minimal risk. This strategy can also be automated, which means that traders can take advantage of opportunities 24/5. However, these days brokers deploy analytical tols to scan their clients' behaviour and arbitrage trading is quickly identified and dealt with, especially by brokers who manage their client risk (using a "B-book"). 

Another advantage of latency arbitrage is that it can be used as a risk management tool. By using stop-loss orders, traders can limit their losses and protect their capital.

Risks

One of the main risks of latency arbitrage is that it is a complex strategy that requires advanced technical knowledge and sophisticated software. This means that it is not suitable for novice traders.

Another risk of latency arbitrage is that it can be affected by market conditions. If the market is volatile or there is a sudden change in prices, latency arbitrage can become less profitable or even result in losses.

Mitigating the Effects of Latency Arbitrage

There are ways to mitigate the effects of latency arbitrage.

One way to mitigate the effects of latency arbitrage is to use trading algorithms that are designed to detect and respond to arbitrage opportunities. These algorithms can help to level the playing field by identifying and executing trades at the same time as latency arbitrage traders. By using these algorithms, traders can reduce the impact of latency arbitrage on their trades.

Another way to mitigate the effects of latency arbitrage is to use co-location services. Co-location involves placing trading servers in close proximity to exchange servers in order to reduce the time it takes to transmit data. By using co-location services, traders can reduce the latency of their trades and minimize the impact of latency arbitrage.

MT4 and MT5,  popular forex trading platforms provided by MetaQuotes, also offer features that can help to mitigate the effects of latency arbitrage. For example, MT4 allows traders to use averaging to smooth out price fluctuations and reduce the impact of latency arbitrage. Additionally, MT4 offers a range of tools and indicators that can be used to identify and respond to arbitrage opportunities.

Conclusion - Find an alternative strategy!

Latency Arbitrage is a complex and controversial trading strategy that involves taking advantage of price discrepancies between different trading platforms. While it can be highly profitable in theory, it is also highly risky and can result in significant losses if not executed properly.

The effectiveness of Latency Arbitrage depends on a variety of factors, including the speed of the trader's internet connection, the location of their trading servers, and the reliability of their trading algorithms. Traders who are considering using this strategy should carefully evaluate these factors and seek professional advice before proceeding.

Furthermore, it is important to note that Latency Arbitrage is not a universally accepted or legal trading strategy. Most brokers will prohibit this type of trading, and regulatory bodies may view it as market manipulation. Traders should be aware of the potential legal and ethical implications of using Latency Arbitrage and should always operate within the confines of the law. Analytical tools that brokers now user are so sophisticated that the practise of latency arbitrage has now declined significantly. Many traders have learnt the hardway that at the end of the day, if the broker will not accept their trading strategy, they have nowhere to go. Time would be far better spent researching the market for genuine opportunities that are profitable based on an understanding of the macro-economic environment and technical analysis - to find a more sustainable 'edge'. 

Have you had experience of latency arbitrage trading, either as trader, or as a broker? Do you agree that this is an unviable strategy? We would like to hear from you! Please add your comments below. 👇

Author

Sam Low is the Founder of LiquidityFinder. With over 18 years in working with FX trading technology, Sam has deep experience in the FX (forex) trading industry, working with brokers, liquidity providers and end traders themselves.  You can message Sam directly here.