By Vikas Arkalgud– 21 March 2021
Speed. What would you give to do something quicker? Perhaps you would spend a couple of extra dollars on a quicker route to campus. Maybe you would spend a few hundred on a quicker, faster CPU. You may even be willing to spend thousands of extra dollars on a quicker, faster internet connection.
How about spending $300 million on a 1,331km fibre-optic cable running between Chicago and New York so that your customers can get information on futures contract 3 milliseconds faster than everyone else?
This is exactly what the company ‘Spread Networks’ did for a few firms engaging in high-frequency trading.
Sound extreme? It is – but not to many of the aforementioned high-frequency traders who use this cable at a high premium. For them, a few milliseconds could mean the difference between losing millions of dollars and making millions of dollars on a trade.
Still trying to wrap your head around this? Don’t worry, me too. However, an analogy helped me understand this a little better. Say you want to buy 1000 apples. You go to a market to buy them but realise the vendor only has 100 apples to sell you at $1/apple. You buy those 100 apples from the vendor but still want another 900 so what do you do? You drive your car to another market in search of a vendor who can sell you more apples. Now, when you bought those first 100 apples, say there was a guy called John who saw you place that buy order for 100 apples at $1/apple and knows you want more apples. He now has the key piece of information that you want to buy more apples, and he has this information before everyone else. While you’re driving in your car to the next market, John gets into his private jet and makes his way to the next market to buy the apples from the next vendor – importantly, he gets there before you. He buys all available 100 apples from the next vendor for $1/apple and then waits for you to reach that market. When you arrive, he sells you those 100 apples for $1.01/apple (because he knows you have the demand to buy it), netting himself a $1 profit. Alternatively, John can tell the vendor he just bought the 100 apples from that you are coming to buy some more apples, and can sell the vendor the 100 apples back at $1.01/apple.
Again, the key point to all this is that John knew the price and quantity of the apples that you wanted to buy before others in the market.
Bringing the discussion back to the $300 million fibre-optic cable, if an institution buys futures in bulk in the New York market, thereby driving up the price of the future, it will take a certain number of milliseconds for that price information to arrive at the Chicago market if the ordinary cable between the two markets is being used. However, with the new cable that transmits this information quicker, those firms using the quicker cable can know this information before the others in the Chicago market – they get a head start. If you look back at our earlier apple analogy, it should be obvious as to what happens next. The firm will buy the futures then sell them at the higher price the institution is willing to pay.
If you, like me, are new to trading, you might be thinking – “This is ridiculous…3 milliseconds isn’t enough time for humans to act upon meaningfully…” You would be right. Humans aren’t fast enough – but computers are. They are the ones acting upon the assumptions and formulas that humans have built for them via programs. There are a whole number of discussions that can stem from this, but for now, the key point is that when we trade, we are very often competing with computers.
Ultimately, speed and timing really do matter in trading. There are some that have gone to extreme lengths to ensure they are the master of faster in this domain. As I continue to learn about this fascinating area of finance, I’ll be sure to remember that fortune favours the fast.
• Papadopoulos, Loukia (2020) There is a Secret $300 Million Cable Between New York and Chicago, URL https://interestingengineering.com/video/there-is-a-secret-300-million-cable-between-new-york-and-chicago
• The Investor’s Podcast (2015) TIP19: How High Frequency Trading Works – by Michael Lewis, URL https://www.youtube.com/watch?v=-zjErl_UZuw
• Meerman, Marije (2010) Quants: The Alchemists of Wall Street, URL https://www.thecolumbiareview.com/quants-alchemists-wall-street-2010/
• Seth, Shobhit (2020) The World of High-Frequency Algorithmic Trading, URL https://www.investopedia.com/articles/investing/091615/world-high-frequency-algorithmic-trading.asp