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.
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.
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.
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:
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.
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.
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.
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.
Arbitrage trading is legal and encouraged in the United States because it improves market efficiency. Arbitrageurs help by providing liquidity in different markets.
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.
You use Forex arbitrage software on a trading platform like MetaTrader 4 (MT4). This software spots opportunities and makes trades for you.
Anyone can do arbitrage trading between two exchanges if they already have the stocks in their demat account.
You can lose money with arbitrage if prices change quickly before you complete your trade, reducing profits or causing losses.
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.
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