Forex Arbitrage Trading Strategy Guide
Forex trading is all about attempting to profit by anticipating the price direction of a currency pair. But what if you could profit from the Forex market without having to do this? There are, in fact, a number of 'market-neutral' Forex trading strategies which exist. Forex arbitrage is perhaps the least risky amongst these strategies. Find out how you can capitalize on the differences within the exchange rate with our 2021 Guide - How to Use the Forex Arbitrage Trading Strategy with Admiral Markets.
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What is Arbitrage Trading?
Arbitrage is a form of trading where traders seek to profit from price discrepancies between extremely similar instruments. Traders who use this style of trading are known as arbitrageurs.
Arbitrageurs buy in one market, whilst simultaneously selling an equivalent size in a different and interrelated market. They do this with the aim of taking advantage of price divergences between the two.
Sometimes, in financial markets, products that are effectively the same thing, trade in different places or in slightly different forms. For example, some large companies are listed on more than one stock exchange. Theoretically, as the shares on each stock exchange all belong to the same company, they should have parity in their pricing. However, in reality, the flow of information to all parts of the world is not instantaneous and, furthermore, markets do not operate with complete efficiency.
Therefore, when both stock exchanges are open, it is possible that the share price may differ between them. The first person to notice the price difference could, buy the stock on the exchange with the cheaper price, whilst selling on the exchange with the higher price. In doing so, this lucky person can potentially lock in a profit!
Arbitrage is not an illegal practice. It is a perfectly legitimate trading technique and could, in fact, be seen as helping to improve market efficiency. This is because, once the arbitrage opportunity has been identified and exploited, the market should begin to automatically correct itself.
If you would like to hear professional trader, Jens Klatt, explain the arbitrage trading concept, go ahead and check out the below video. You may also open a Demo Account with us if you'd like to experiment with forex arbitrage in a NO RISK environment - you can then move onto a Live Account, when you're ready.
Forex Arbitrage Trading Explained in Detail
Now that we have defined arbitrage in general terms, let's focus specifically on Forex arbitrage. Essentially, traders seeking to arbitrage the Forex market are doing the same thing as described above. They aim to purchase a cheaper version of a currency, whilst simultaneously selling a more expensive version. Once our Forex arbitrageur subtracts their transaction costs, their profit is the remaining difference between the two prices.
A Forex arbitrage system may operate in a number of different ways, but the basics are always the same. Arbitrageurs look to exploit price anomalies for profit. One approach may involve looking for discrepancies between spot rates and currency futures. A future contract being an agreement to trade an instrument at a set date for a fixed price.
Forex broker arbitrage may occur when two different brokers are offering different quotes for the same currency pair. However, in the retail FX market, prices between brokers are normally uniform, meaning that this particular strategy tends to be limited to the institutional market. This is not the only type of arbitrage opportunity in the spot market though. One Forex arbitrage trading strategy involves looking at three different currency pairs.
Forex Arbitrage Trading Strategies
FX Triangular Arbitrage
Forex triangular arbitrage is a method that uses offsetting trades to attempt to profit from price discrepancies in the Forex market. In order to understand how to arbitrage FX pairs, we need to first have a basic understanding of currency pairs.
When you trade a currency pair, you are effectively taking two positions: buying one currency in the pair and selling the other.
A currency cross is an FX pair which does not include the US dollar. A theoretical, or synthetic, value for a cross is implied by the exchange rates of the currencies in question versus the US dollar. For example, let's say that the EUR/USD currency pair is trading at 1.1710 and the GBP/USD pair is trading at 1.2739. In order to identify a potential arbitrage opportunity, we need to calculate the implied value of EUR/GBP from these numbers. We can do this by dividing EUR/USD by GBP/USD.
- Example: 1.17058/1.27390 = 0.91890
Why do we divide one by the other? Simply put, currency pairs can be treated the same as fractions. Therefore, EUR/USD divided by GBP/USD = EUR/GBP.
This is because when you divide by GBP/USD, like with fractions, it is the same as multiplying by the inverse. Therefore: EUR/USD x USD/GBP = EUR/GBP x USD/USD = EUR/GBP.
If the actual traded value of the EUR/GBP currency pair is different to the value implied by the major pair, an arbitrage opportunity exists. As the name of this strategy suggests, triangular arbitrage consists of three separate trades. Let's say that EUR/GBP is actually trading higher than the implied value, at 0.91917.
Source: Admiral Markets MetaTrader 5
As the trading value is higher than the implied value, we want to sell it. We will also need to place two trades in the two related major pairs, to create a synthetic EUR/GBP opposing position. This will offset our risk and lock in the profit. Because the price discrepancy in this example is small, we will need to deal in substantial volume to make it worthwhile.
One lot is 100,000 units of the first-named currency, let's say we buy 10 lots of EUR/USD, so 1,000,000 EUR. Remember, that when we are taking a position in a currency pair, we are effectively buying one currency and selling the other. For a buy trade we are buying the first named currency and selling the second. So in this case, we are buying 1,000,000 EUR. The EUR/USD pair is trading at 1.17058, which means if we are buying 1,000,000 EUR, we are simultaneously selling 1,000,000 x 1.17058 = 1,170,580 USD.
At the same time as taking this first position, we want to sell an equivalent amount of EUR in EUR/GBP. Therefore, we sell 10 lots of EUR/GBP, or 1,000,000 EUR. EUR/GBP is currently trading at 0.91917, meaning we are also buying 1,000,000 x 0.91917 = 919,170 GBP.
In our third, and final, position we sell GBP/USD in order to complete the triangle. This third trade leaves us with no overall exposure in any of the three currency pairs. To remove our exposure to GBP, we would sell the same amount that we bought in the EUR/GBP trade. Therefore, we want to sell 919,170 GBP or 9.19 lots. We are dealing with GBP/USD at a rate of 1.2739 so we are buying 919,170 x 1.2739 = 1,170,930.66 USD.
Consider the implication of these steps, it may help to go back through them and pretend you are making physical currency transactions. In this last step we have ended up with 1,170,930.66 USD after initially exchanging 1,170,580 USD into EUR.
The profit of these three transactions, therefore, would be 1,170,930.66 - 1,170,580 = 350.66 USD. As you can see, the profit is small relative to the large sizes of our transactions. Also bear in mind that we have not accounted for bid/offer spreads nor other transaction costs. Of course, with a retail FX broker, you are not physically exchanging the currencies either. These steps would have locked you in a profit, however, you would still have to manually unwind your positions. Keep in mind the daily SWAP adjustments could also quickly erode the profit you have locked in.
FX Statistical Arbitrage
While not a form of pure arbitrage, Forex statistical arbitrage takes a quantitative approach and seeks price divergences which are statistically likely to be correct in the future.
It does this by compiling a basket of over-performing currency pairs and a basket of under-performing currency pairs. This basket is created with the goal of shorting the over-performers and purchasing the under-performers.
The assumption is that the relative value of one basket to the other is likely to revert to the mean with time. With this assumption, you would want tight historical correlation between the two baskets. So this is another factor that the arbitrator must take into account, when compiling the original selections. You also want to ensure as much market neutrality as possible.
Arbitrage is sometimes described as riskless, but this is not exactly true. A well implemented Forex arbitrage strategy would be fairly low risk, but implementation is half the battle. Execution risk is a significant problem. You need your offsetting positions to be executed simultaneously, or close to simultaneously. It gets more difficult because the edge is small with arbitrage, slippage of just a few pips will likely erase your profit.
Other Challenges With FX Arbitrage
Challenges arise with the volume of people using the strategy. Arbitrage fundamentally relies on price differentials, and those differentials are affected by the actions of arbitrageurs.
The existence of arbitrage will affect the FX market by causing currency exchange rates to correct themselves. Overpriced instruments will be pushed down in price by selling. Underpriced ones will be pushed up through purchases. Consequently, the price differential between the two will shrink.
Eventually it will disappear or become so small that arbitrage is no longer profitable. Either way, the arbitrage opportunity will dwindle. The Forex market's vast number of participants is generally a large benefit, but it also means that pricing disparities will be rapidly discovered and exploited.
As a result, the quickest player wins in the game of arbitrage. The fastest price feeds are essential if you want to be the one to profit. For example, our Zero.MT5 account offers institutional-grade execution speed, which is essential for this type of trading, as you will be competing against the fastest in the world. Seeing as how execution speed can make all the difference, choosing the right Forex arbitrage software can also give you a competitive edge. Feel free to try out new and varying strategies before you jump into trading with real money.
Also note that the speed of the modern market means that you will likely have to use an automated trading system, such as a Forex robot (bot) or an Expert Advisor (EA) to trade strategies such as the Forex triangular arbitrage successfully.
All trading systems are subject to the risk that profitability will erode with time. As new participants chase the same strategy, opportunities dwindle. Arbitrage is no different. The fierce competition in the FX market means you may discover pure arbitrage opportunities are limited. However, you will likely find the theory useful for exploring related strategies, and further trading possibilities. Put your knowledge to the test RISK FREE, with NO capital, by signing up for a Demo Account.
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This material does not contain and should not be construed as containing investment advice, investment recommendations, an offer of, or recommendation for, any transactions in financial instruments. Please note that such trading analysis is not a reliable indicator for any current or future performance, as circumstances may change over time. Before making any investment decisions, you should seek advice from independent financial advisors to ensure you understand the risks.