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Modern Day Latency Arbitrage: Predicting Price Changes

Traders Magazine Online News, April 11, 2017

Eric Stockland

Over the past few weeks, IEX upgraded the IEX Signal, a proprietary model that IEX uses to predict when and how a stock price is about to change, and expanded the IEX Signal’s protective benefits to our Primary Peg order type. Including the IEX Discretionary Peg (D-Peg®), two out of five IEX order types are now armed with this breakthrough innovation.

Stock exchanges update functionality and offerings all the time, for any number of reasons. But unlike other exchanges, IEX is built with the express purpose of protecting investors. We focus our innovation on those investors, as well as IEX Members, and evaluate every decision based on how it will affect them.

The NBBO Today

The idea behind the National Best Bid and Offer (NBBO) is that even though there are twelve active U.S. stock exchanges, there is one “best price” for a stock across the market.

The problem with this concept is that there is no way to instantaneously update every market participant – including the exchanges themselves – when the NBBO changes. Data about price changes must literally travel the distance between participants, and that trip can be faster or slower depending on the technology a firm is using and how far a participant is from the source of the data.

While connections are faster than they have ever been, not every participant in the market can compete at the bleeding edge of speed. Some firms that handle trading on behalf of customers don’t have the leeway to use some of the fastest technologies, such as microwaves and lasers, because they are less stable and reliable, and firms that trade for customers have regulatory obligations that proprietary trading firms do not. Some are mired in legacy systems that just can’t achieve the internal processing times of the fastest participants, or have other business priorities that preclude making the investments – including huge sums of money for the fastest data and connectivity – they would need to compete in the speed race.

Regardless of the reason, these speed differentials mean that market participants – again, including the exchanges themselves – have different views of the NBBO at the exact same moment in time.

In other words, at any given moment in time, there is no universal agreement of prices. This is especially true when you’re talking about sub-second increments of time, which is the speed of today’s markets.

Traditional Latency Arbitrage

The discrepancy among different views of the NBBO creates actionable windows of time for faster traders to use their information advantage to trade with orders at stale prices, earning a low-risk profit at the expense of slower investors. Because exchanges often process price changes more slowly than the fastest traders, those traders can execute at stale prices on exchanges that haven’t yet processed the change in NBBO.

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