How Latency Rank Affects Order Book Imbalance Trading Profits

Summary

This study examines whether access speed affects the profitability of high-frequency order book imbalance (OBI) trading. Because historical data generally do not reveal traders’ identities or locations, the authors use an agent-based, discrete-event simulation of a continuous double auction with a single exchange. They introduce OBI traders into the simulation and vary their distance, and therefore latency, from the exchange across many simulated trading days.

The experiments find that OBI trader profits tend to decline as latency increases. They also suggest that traders’ relative latency rank matters more for how returns are divided among agents using similar strategies than the absolute latency itself. The result offers a way to study a question that is difficult to isolate in market data, but it comes from a controlled simulation. Its implications may depend on the modeled agents, exchange structure, and trading environment, so the findings do not establish how much latency affects profits in every live market.

Key ideas

• The study uses an agent-based simulation to examine latency effects that are difficult to identify in historical data.
• It tests order book imbalance traders in a single-exchange continuous double auction.
• Simulated profits decline as traders’ latency increases.
• Relative latency rank appears more important than absolute latency for distributing returns among similar traders.

Tags

# The Importance of Low Latency to Order Book Imbalance Trading Strategies


# The Importance of Low Latency to Order Book Imbalance Trading Strategies









There is a pervasive assumption that low latency access to an exchange is a key factor in the profitability of many high-frequency trading strategies. This belief is evidenced by the "arms race" undertaken by certain financial firms to co-locate with exchange servers. To the best of our knowledge, our study is the first to validate and quantify this assumption in a continuous double auction market with a single exchange similar to the New York Stock Exchange. It is not feasible to conduct this exploration with historical data in which trader identity and location are not reported. Accordingly, we investigate the relationship between latency of access to order book information and profitability of trading strategies exploiting that information with an agent-based interactive discrete event simulation in which thousands of agents pursue archetypal trading strategies. We introduce experimental traders pursuing a low-latency order book imbalance (OBI) strategy in a controlled manner across thousands of simulated trading days, and analyze OBI trader profit while varying distance (latency) from the exchange. Our experiments support that latency is inversely related to profit for the OBI traders, but more interestingly show that latency rank, rather than absolute magnitude, is the key factor in allocating returns among agents pursuing a similar strategy.

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This summary was written by Stratmill's research agent from the original; it is not a copy of the source.