Latency is an invisible cost of trading. Slow execution can lead to missed opportunities, and traders struggling with latency may be losing money. The rise of high frequency trading has contributed to a nanosecond environment, where any lag on order execution can be detrimental.

Not all retail firms focus on low latency, and some traders may use strategies that are less dependent on speed of execution. But for experienced traders competing with high frequency trading strategies, missed fills outside their control can be frustrating.

In this guide, we’ll explain how latency affects the current marketplace, and show how traders can identify how their brokerage firm addresses latency. Knowing latency’s role in trading can help you determine your strategy in a nanosecond environment.

What Is Latency in Trading?

In trading, latency is the time delay between an order being placed and its execution. With fast-moving markets, the lower the latency, the higher the possibility of filling an order at the displayed price before it changes.

While many brokerage firms claim low latency, there is no standard measurement to classify execution speed as “low.” Some brokerage firms may consider nanosecond speeds to be low latency, while others offer speeds down to microseconds.

How Does Latency Affect Traders?

Here’s the most appropriate idiom to describe latency: the early bird gets the worm.

If the order message that is routed back to the broker’s server gets delayed even for a millisecond, the price that the trader attempted for the order may have moved away, and the broker will not be able to fill that order. Low latency can lead to faster fills.

Low latency can also minimize slippage, which is the difference between the expected price of a trade and the price at which the trade is executed. Negative slippage can lead to a trader paying more than what they anticipated (or selling less than what they anticipated) when they placed the order.

Traders can gain a competitive advantage when their orders reach the market with a low level of latency, as missed opportunities from slow execution can be costly.

Low latency can lead to faster fills.

Still, trading strategies that rely on low latency aren’t right for everyone. For one, speed doesn’t guarantee a profit; operating in a low latency environment means nothing if the trade was a bad choice. Some speed-dependent strategies, such as latency arbitrage, may require an advanced skillset in algorithmic trading.

Access to low latency technology can have higher costs, depending on the brokerage firm. Casual retail traders may find the costs don’t add as much value to their strategy, but for high-frequency traders, low latency can be crucial.

What Are the Factors That Affect Latency?

Internet connectivity, software, hardware, brokerage servers, and the brokerage firm’s network infrastructure can all contribute to latency.

To start, traders can check if their internet connection is hindering their speed. Some tasks that might troubleshoot connectivity problems include:

  • Updating and maintaining computer hardware
  • Performing ping tests and running a traceroute to the appropriate servers to check the stability of the connection
  • Reviewing server-side hosting, which can help reduce outages and eliminate any client-side communication issues

After identifying any connection issues, traders can also consider at-home solutions to limit the technological effects on latency, such as:

  • Setting up more than one internet service provider (ISP) to switch rapidly to another ISP if one experiences outages
  • Using a 5G wireless internet connection as a backup, in addition to a cable connection
  • Investing in a virtual private network (VPN)

Unfortunately, a trader can’t control all latency issues with their home setup. In addition to a trader’s computer hardware and software, the technology and services offered by the trader’s brokerage firm can also have substantial effects on their latency.

Lime’s Recommended Network Setup for Low Latency

Other Factors That Affect Latency

Colocation

One prominent source of latency is the distance between the exchange and the trading system. Data transmission can be fast, but it’s still limited by the speed of light. The farther away something is from its target, the longer it will take to reach it. A brokerage firm that has servers physically located within an exchange would have a much lower latency than a firm whose servers are located miles away.

Colocation uses physical proximity to give traders a competitive edge. Exchange colocation refers to the practice of traders and firms physically placing their computers in the same data center as a stock exchange’s computer servers. A brokerage firm that offers colocation to traders may be able to provide faster access to data. Typically, the closer you are to the exchange computers that control the execution and dissemination of data, the faster you can receive the data, analyze it, and execute trades.

All the major exchange locations in the U.S. are in the New York/New Jersey area. A computer in Chicago, even at nearly speed-of-light data transmission, is at a disadvantage compared to a computer located in New York or New Jersey. Lime Execution’s network is built specifically for low latency. Dark fiber is a high-capacity fiber that offers high bandwidth and reliability, and Lime’s network leverages dark fiber links to the exchange venues for orders to arrive within microseconds.

Lime has a colocation presence at all major U.S. exchange data centers, including Carteret, Secaucus (NY4), and Mahwah
Risk Check

Regulatory requirements mandate a pre-trade risk check on each order before processing. The brokerage firm checks buying power and the notional value on the order, ensuring the market center doesn’t accept an order outside the client’s risk parameters.

Performing a risk check takes time and can add latency. Brokerage firms’ execution speeds can vary depending on how quickly they can process orders from the time they receive the order to the time when the order leaves them. For example, Lime Execution’s pre-trade risk check takes single-digit microseconds.

Reliability

How does your brokerage firm perform during high volume trading periods?

Several brokerage firms experienced outages and technical glitches during 2021, inhibiting traders during valuable market hours.

Researching how your prospective brokerage firm has performed during high trading activity may help you judge its performance for high frequency trading. For example, Lime publishes updates on its performance during peak trading periods.

Direct Market Access

In the 1990s, the Financial Information eXchange (FIX) protocol gave market participants the chance to route orders electronically to execution desks. Traditionally, an investor would ask a broker online or over the phone to place a trader. Then, the broker would search for the best prices for investors.

Direct market access (DMA) happens when traders can execute trades by directly interacting with an electronic order book rather than sending those orders through a broker.

As the technology improved, so did the race for speed. With the introduction of DMA, traders could access the stock exchange directly. DMA allows traders to choose which stock exchange receives their order.

DMA can help with execution speed because it reduces the number of steps.

What Is Latency Arbitrage?

Latency arbitrage uses trading algorithms to identify price discrepancies in the markets. A security can appear in multiple exchanges and occasionally trade at different values. Arbitrage algorithms can buy an undervalued security and nearly simultaneously sell the same security at another location where it is overvalued, locking in a small profit.

Latency arbitrage can be valuable to the market overall, since the process helps ensure prices do not deviate substantially from their expected price for too long. Latency arbitrage typically requires ultra-low latency solutions.

This practice has a significant market impact. A 2021 Bank for International Settlements study estimated the profits for latency arbitrage in the global markets were worth about $5 billion annually. However, not all brokerage firms can sustain the costs for managing colocation centers for low latency. Those who aim to employ latency arbitrage must commit to costly trading solutions.

What Are Lime Execution’s Latency Solutions?

Learn more about Lime’s low latency solutions

Next Steps

Is your brokerage firm giving you the low latency solutions you need? Learn how to transition from your current brokerage firm with our checklist for changing brokerage firms.