How Does Latency Impact Trading?

Benjamin Franklin's 1748 writing "Advice to a Young Tradesman" is often credited with coining the phrase "time is money."^[1] Unbeknownst to Franklin, his quote fits the world of modern electronic trading perfectly. The speed by which a trader can access market information, place an order upon the market and have that order filled, are of paramount importance to attempting to achieve long-term profitability.

What Is Latency?

In simplest terms, "latency" is defined as being any delay or lapse of time between a request and a response.^[2] As it pertains to trading, latency directly influences the amount of time it takes for a trader to interact with the market. The timely reception of pertinent market information and the ability to act upon its receipt are often greatly impacted by latency issues.

As trading-based technology has grown, the possibility of a trader gaining a competitive advantage or disadvantage due to latency issues has become intensified. As far as the active trader is concerned, latency needs to be quantified and managed in order to maximise the odds of success.

Latency In The Marketplace

In order to compete in the near-light-speed digital markets of today, it is a necessity that surplus latency is reduced as it appears in each facet of the trading operation.

Market Data

The flow of market-pricing data originates at the exchange or marketplace, and it's passed on to the trader for interpretation via the online trading platform. Streaming data-transfer speeds are typically measured in milliseconds from origin to client.^[3]

Excess latencies can be present in the following parts of the data stream:

• Exchange or market based servers
• Brokerage servers
• Internet connectivity
• Client computer hardware and software

"Data lag" is a common problem and the result of inefficiencies present in the data-streaming process. Many causes of data lag are out of the trader's control. Occasional problems with hardware located at the exchange or brokerage firm in addition to internet "bottlenecks" arise without warning and often go unrecognised by the trader.

Order Routing And Execution

Order routing and order execution are areas of electronic trading where the playing field can be skewed directly because of latency issues. Consistent order fills and low slippage are key components of profitability that depend on an order arriving at market ahead of the competition.

Depending on whether or not the market being traded is exchanged-based or over-the-counter (OTC), the typical routing of a retail trader's market order is as follows:

1. Order is entered by trader remotely via online trading platform
2. Order is received by brokerage servers
3. Order is relayed by broker to exchange or market
4. Order is placed in queue at exchange or market

At no fault to the trader, latency can plague each stage of the order-routing process. Unfortunately, an order that arrives late to the market is likely to be filled at a disadvantageous price, increasing the potential for loss due to slippage.

Latency Management

Different types of trading operations address the issue of latency in vastly different fashions. Institutional trading firms have the ability to invest large amounts of capital into low-latency infrastructures, while small retail traders are faced with the challenge of minimising latency issues wherever they can.

One manner in which institutional investment firms gain a competitive advantage in the marketplace is through securing direct market access (DMA). It is the direct connection of a buy-side entity to the order book at the exchange. The implementation of DMA can be a costly undertaking, and until recently has been exclusive to well-capitalised trading operations.

The order routing process under DMA:

1. Order is entered by the trader via connectivity to exchange or market
2. Order is placed in queue for execution at the exchange or market

Through the elimination of several steps in the routing process, the order reaches the exchange and is executed ahead of the competition. Commonly, institutional investors center trading operations on DMA capabilities.

From the standpoint of the retail trader, the use of DMA services is limited. However, as electronic trading has evolved, services claiming to provide DMA to retail traders have begun to address the demand from within the industry. Until the time in which DMA is readily available to the independent retail trader, several steps can be taken to increase the overall efficiency of the trading operation. In order to optimise performance and limit latency when interacting within the marketplace, a trader is well-advised to perform the following tasks:

• Update and maintain computer hardware
• Perform internet connectivity tests with regularity. "Ping" tests with brokerage servers can be a valuable tool used to measure internet performance.
• Evaluate trading platform performance daily. Lag issues can manifest themselves in the timely updating of charting applications and pricing quotes.

Summary

The topic of "latency" as it pertains to electronic trading is a complex one. Ph.Ds. in physics and computer science are seemingly prerequisites for one to gain a comprehensive understanding of the subject. However, effective trading and function are what is important, and addressing the variables which affect performance is a necessary part of competing in the digital marketplace.

Any opinions, news, research, analyses, prices, other information, or links to third-party sites are provided as general market commentary and do not constitute investment advice. FXCM will not accept liability for any loss or damage including, without limitation, to any loss of profit which may arise directly or indirectly from use of or reliance on such information.