An arbitrage occurs when a simultaneous purchase and sale of a stock asset executed by an algorithm for trading earns a profit based on a difference in price. Latency refers to the time that a firm receives the same market information faster than other market participants. Thus, a latency arbitrage occurs when a firm earns a profit from the purchase and sale of stock, and when those transactions were executed because of a latency advantage. For example, when interacting with American servers in Hong Kong, the time delay between performing an action and the server receiving the action is generally about 200 milliseconds due to the physical distance. This means that the state of the server is not changing instantaneously. There is a slight delay.
Let’s say that a firm issues a buy order to pay for stock XYZ, and the current market for XYZ $10.10 x $10.11. Their bid will be at $10.105. Arbitrage trader, using faster data feeds and co-location to reduce the transmission times, may see that the $10.10 bid is now gone and the market is now $10.09 x $10.10. However, the NBBO has not changed yet, and the order is still resting at $10.105. For the Arbitrage Trader, it is simply a matter of selling at $10.105, and immediately buying back at $10.10, making a half penny.