Forex arbitrage trading has emerged as an attractive approach for traders to make profits with minimal risk. However, arbitrage strategies in the forex market require fast and intelligent trade execution. Therefore, not everyone is able to do it. In fact, we can say that this strategy is not recommended for beginners.
Indeed, arbitrage in forex trading consists of taking advantage of the difference between the prices of an instrument on two different trading platforms. The trader executes simultaneously or almost the purchase and sale of the same currency pair on the market. The goal is to get the price difference between the two.
How is the Forex arbitrage strategy applied?
As explained earlier, the arbitrage strategy takes advantage of the differences between the prices of pairs in the market. This difference can occur when two brokers offer different prices for the same pair.
For example, suppose there are two brokers, Broker A and Broker B. They offer different prices for the EUR/USD pair with the following details:
Broker A:
| EUR/USD buy price (bid) = 1.1000
EUR/USD Sell Price (ask) = 1.1005 |
Broker B:
| Buy price (bid) of EUR/USD = 1.1002
Ask price EUR/USD = 1.1007 |
In this hypothesis, you can see that there is a price difference between two brokers for the same currency pair, right? The arbitrage strategy involves taking advantage of this difference to make profits.
Triangle Arbitrage Strategy
Arbitrage strategies using price differences among forex brokers are not the only possibility. You can also arbitrage using three different currency pairs that move closer to each other in order to make a profit. This strategy is called triangular arbitrage.
Consider the following example.
Let’s assume that EUR/USD is currently trading at 1.05302 and GBP/USD is trading at 1.25509. This means that the current value of one euro is 1.05302 US dollars and the current value of one pound sterling is 1.25509 US dollars.
To identify arbitrage opportunities in the forex market, you need to use this information to calculate the value of EUR/GBP, which you can do by dividing EUR/USD by GBP/USD.
| EUR/USD: GBP/USD = EUR/GBP |
This is because when you divide EUR/USD by GBP/USD as a fraction, it is the same as multiplying the inverse. Therefore :
| EUR/USD x USD/GBP = EUR/GBP x USD/USD = EUR/GBP |
If the actual value of the EUR/GBP pair is different from the implied value calculated above, an arbitrage opportunity exists. Suppose EUR/GBP is trading higher than the implied value of 0.83944, then you should sell it because the trade value is higher than the implied value.
You should also place two trades in two related pairs. By doing this, triangular arbitrage will offset the risk and lock in the profits you make.
The price difference in the example above may be too small. That’s why we present here an example of calculation on larger volumes so that you can understand it better.
Triangular arbitrage strategy: steps
You purchase 10 lots of EUR/USD (1 lot = 100,000 units). The forex arbitrage strategy can be achieved by going through the following three steps:
- Step 1: For long positions, you buy the base currency (EUR) and sell the quote currency (USD). So, if you buy 10 lots (1,000,000 EUR) and the EUR/USD pair is trading at 1.05302 exchange rate, you will also sell 1,053,020 USD (1,000,000 x 1.05302) when the position is closed.
- Step 2: You sell an equivalent amount of EUR into EUR/GBP. In other words, you sell 10 lots of EUR/GBP. If the current price of EUR/GBP is 0.83944, we can say that you bought 839,440 GBP.
- Step 3: In the final position, you sell GBP/USD for the same amount you bought EUR/GBP. So you sell for GBP 839,440. If the value of GBP/USD is 1.25509, you buy 1,053,573 USD (839,440 x 1.25509).
In this last step, after converting 1,053,020 USD to EUR, you will get 1,053,573 USD. The transaction reveals a difference, which can constitute your profit:
| $1,053,573 – $1,053,020 = $553 |
As you can see, the profit from triangular arbitrage is very small compared to the size of the trade you made. Not to mention the calculation of spreads and other brokerage fees.
Statistical arbitrage trading strategy
Arbitrage strategies can also take a quantitative approach by looking for possible price differences in the future. This method is called statistical arbitrage strategy.
The method begins by collecting historical data on the performance of each currency. This collection allows you to short sell the best performing currency and buy the worst performing currency.
Suppose you have two currency groups based on random data, namely “Group A” and “Group B”. You select five pairs for each group and record the relative price difference between the pairs over a period of time.
Other Types of Forex Arbitrage
- Currency arbitrage involves the exploitation of the differences in quotes rather than movements in the exchange rates of the currencies in the currency pair.
- A cross-currency transaction is one that consists of a pair of currencies traded in forex that does not include the U.S. dollar. Ordinary cross-currency rates involve the Japanese yen. Arbitrage seeks to exploit pricing between the currency pairs, or the cross rates of different currency pairs.
- In covered interest rate arbitrages the practice of using favorable interest rate differentials to invest in a higher-yielding currency, and hedging the exchange risk through a forward currency contract.
- An uncovered interest rate arbitrage involves changing a domestic currency that carries a lower interest rate to a foreign currency that offers a higher rate of interest on deposits.
- Spot-future arbitrage involves taking positions in the same currency in the spot and futures markets. For example, a trader would buy currency on the spot market and sell the same currency in the futures market if there is a beneficial pricing discrepancy.
Advantages and Disadvantages of Forex Arbitrage Strategy
While arbitrage can be profitable in certain situations, it cannot be the only way to profit from trading. There are several reasons why arbitration is not always reliable.
Disadvantages
- Arbitrage opportunities are not always present and may not present themselves in a short period of time.
- Profit opportunities are very low and require large trading volumes to generate significant profits.
- Arbitrage does not avoid transaction costs, including spreads, commissions and other fees.
- Despite the minimal risk linked to the absence of market fluctuations, arbitrage strategies are subject to slippage.
- The execution of arbitrage trades must be extremely fast and accurate. The slightest technical problem can disrupt execution.
Benefits
- Ability to make profits risk free.
- Arbitrage can be an opportunity to make consistent profits if you know how to identify opportunities consistently.
- In the short term, arbitrage strategies can help improve market efficiency because they eliminate price differences between pairs that should have the same value.
- They allow you to develop a diversified trading portfolio.
In Conclusion
Foreign exchange transactions are never without risks, whatever form they take. If you have decided to trade, you must be ready to bear the risks. There is also no simple method to profit from foreign exchange trading. You must always learn, have a lot of knowledge and practice often to become more proficient.
Instead of relying on arbitrage strategies as the only way to make profits, try to find and increase opportunities through other forex strategies. There are many strategies you can learn about. The richer your bank of strategies, the more likely you are to accumulate profits in the forex market.
FAQ
Is trading arbitrage illegal?
Arbitrage trading is legal and encouraged in the United States because it improves market efficiency. Arbitrageurs help by providing liquidity in different markets.
Is arbitrage trading profitable?
Arbitrage trading can make money but carries risks. Problems like price changes, withdrawal delays, and exchange outages can happen. Many traders use automated bots to trade more effectively.
What platform is forex arbitrage on?
You use Forex arbitrage software on a trading platform like MetaTrader 4 (MT4). This software spots opportunities and makes trades for you.
Can anyone arbitrage trading?
Anyone can do arbitrage trading between two exchanges if they already have the stocks in their demat account.
Can you lose with arbitrage?
You can lose money with arbitrage if prices change quickly before you complete your trade, reducing profits or causing losses.
Is Forex arbitrage trading difficult?
Finding a sure arbitrage opportunity in Forex is hard. Pricing technology improvements mean price differences don’t last long. Algorithms now often spot and act on these opportunities.
