I am making a little game using node.js for the server and a .js file embedded in a HTML5 canvas for clients. The players each have and object they can move around with the arrow keys.

Now I have made 2 different ways of Updating the game, one was sending the new position of the player everytime it changes. It worked but my server had to process around 60 x/y pairs a second(the update rate of the client is 30/sec and there were 2 players moving non-stop). The second method was to only send new position and speed/direction of the player's object when they change their direction speed, so basically on the other clients the movement of the player was interpolated using the direction/speed from the last update. My server only had to process very few x/y7speed/direction packets, however my clients experienced a little lag when the packets arrived since the interpolated position was often a little bit away from the actual position written in the packet.

Now my questions is: Which method would you recommend? And how should I make my lag compensation for either method?

If you have Low Latency, interpolate from the position in which the object is drawn up the new position. In low latency it does not represent much of a difference.

If you have high latency, you can implement a kind of EPIC. http://www.mindcontrol.org/~hplus/epic/

You can also check how it is done in Browser-Quest. https://github.com/mozilla/BrowserQuest

Good luck!