This article is an excerpt from the Shortform book guide to "Flash Boys" by Michael Lewis. Shortform has the world's best summaries and analyses of books you should be reading.
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What are latency times? What are the three factors that contribute to network latency?
According to Michael Lewis in his book Flash Boys, “latency time” refers to the amount of time it takes to electronically send data from one destination to another. Latency can be used by high-frequency traders to receive stock order prices faster than everyone else, which gives them an unfair advantage.
Let’s learn how HF traders lower their latency times in three ways: using co-location, creating better code, and using fiber-optic cables.
Lewis explains that in stock trading, speed is a crucial factor. Traders are always looking to lower their latency times, or the time between sending and receiving a signal about market data or a stock order so that their orders are sent and received faster than everyone else’s. A faster trader can buy and sell stocks at better prices. Lewis explains that a lower latency also gives traders an extra split second to evaluate stock information, which can help them make better decisions. It’s the same concept that would give you an advantage if, for example, you’re taking a test and you get the questions five minutes before everyone else.
Lewis describes three factors that affect the latency times of an electronic trade:
- The hardware: This is all of the physical technology—computers, signal amplifiers, and so on—involved in transmitting data.
- The software: This is the programming and code used to operate the hardware. It generates the data needed to perform functions and process information.
- The cable: This is the telecommunication line that transmits data between pieces of hardware. The cable can run cross-country, like a Verizon line, or it can connect computers within the same room.
|How Much Does Speed Matter?|
While Lewis asserts that speed is an important factor in HFT, critics argue that speed has always been an important factor in any trading. This may be one reason that HFT has still gone unregulated, as regulators haven’t identified where to draw the line when it comes to speed and whether it’s even appropriate to punish certain traders solely because they took advantage of better technology to decrease the latency times of their trades.
Critics also argue that HFT doesn’t matter for retail trading since it’s not time-sensitive. Most regular investors use a long-term buy and hold strategy, so paying a few pennies or dollars more—due to HFT’s fast and frequent trades—when placing the trade isn’t significant in the overall return or risk.
But HFT’s speed does impact big investors, as a quick change in stock price can result in large losses. If, for instance, news of your pending purchase or the special knowledge you have hits the market before your trade and drives shares up even four or five dollars, the impact on your trade would be $4-5 million.
Lewis explains that traders have found ways to reduce the latency associated with each of these three factors through three methods: co-location, better code, and fiber-optic cable, each of which we’ll describe below.
1. Co-Location: Make the Hardware Faster
To speed up their electronic trading—and thus reduce their latency time—financial traders use co-location. Lewis explains that co-location is when exchanges place trading computers as close as possible to an exchange’s matching engine, in which pairs buy and sell orders for a given stock. When the computer is closer to the matching engine, it can send and receive signals milliseconds faster, thus reducing its latency time. Think of it like running a race where one runner starts five feet ahead of everyone else.
Co-location is so important that trading firms have gone to great lengths to get closer to matching engines. Lewis describes how one firm moved its computers from Kansas City to Nutley, New Jersey (closer to the NYSE engines), reducing their latency times from 43 milliseconds to 3.8 milliseconds.
Exchanges and other data centers took advantage of this trend and made millions of dollars by renting out space near their matching engines to HFT firms. Then, these firms paid even more money to move their machines closer—even by a few inches—within that space, showing the enormous profit potential of reducing latency times by even a few milliseconds.
2. Better Code: Make the Software Faster
Lewis explains that another way to reduce latency times is by creating faster code—stronger and speedier algorithms that facilitate trades. When your code can process information faster, it can make quicker market decisions, thus executing orders faster. This has led to trading firms seeking out talented programmers to improve their trading algorithms.
3. Fiber-Optic Cable: Make the Cable Faster
Lewis explains that the third method of decreasing latency times is to improve the cable that transmits the data between locations. To do this, firms use fiber-optic cable, which offers the most speed. These cables can be used between computers within the exchanges, but they’re also used for telecommunications routes that transmit data across the country, like the ones used by Verizon and AT&T.
Wall Street firms go to great lengths to improve their fiber-optic cable. Lewis describes a stock trader named Dan Spivey who saw an opportunity to improve latency times by building his own $300 million telecom route. The fastest existing line was 14.65 milliseconds, meaning it took 14.65 milliseconds for information from Point A to reach Point B. But Spivey’s would be 13 milliseconds.
To create this faster line, Spivey made the line out of fiber-optic cables and constructed it in as straight a line as possible between Chicago (where the Chicago Mercantile Exchange is) and Newark, New Jersey (where the Nasdaq data center is). Unlike other telecom companies, Spivey minimized the number of curves and turns, which would slow down the transmission of data. This required drilling through mountains and laying their cable through parking lots.
But all of this effort benefitted Spivey: He sold the use of the line to trading firms for millions of dollars, showing how far traders were willing to go to gain a 1.65-millisecond speed advantage.
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Like what you just read? Read the rest of the world's best book summary and analysis of Michael Lewis's "Flash Boys" at Shortform .
Here's what you'll find in our full Flash Boys summary :
- Why high-frequency trading (HFT) is a threat to your investments
- A look at Wall Street’s greedy response to HFT
- How Canadian trader Brad Katsuyama tried to fight the problem