How to Use the Forex Arbitrage Trading Strategy
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 a number of 'market-neutral' Forex trading strategies which exist and Forex arbitrage trading is one such method. But what is arbitrage trading in Forex? What are some examples of Forex arbitrage strategies? In this article, we answer these questions and much more!
Table of Contents
What Is Arbitrage Trading?
Forex arbitrage is a form of trading where traders seek to profit by exploiting price discrepancies between similar trading instruments.
Arbitrageurs, traders who engage in arbitrage, buy in one market, whilst simultaneously selling an equivalent size in a different but related 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 be priced equally.
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 and, in doing so, secure 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 learn more about arbitrage trading, below is our previous webinar on the topic provided by expert trader Jens Klatt.
What Is Arbitrage Trading in Forex?
Now that we have answered the question ‘what is arbitrage trading’ in general terms, let's focus specifically on explaining what arbitrage trading is in Forex.
Essentially, traders seeking to engage in Forex arbitrage trading are doing the same thing as described above. They aim to profit from purchasing a cheaper version of a currency, whilst simultaneously selling a more expensive version.
A Forex arbitrage trading system may operate in a number of different ways, but the basics are always the same. Forex arbitrageurs look to exploit price anomalies for profit. One approach may involve looking for discrepancies between spot rates and currency futures. A futures contract being an agreement to trade an instrument at a fixed date in the future for a predetermined 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 arbitrage strategy in Forex tends to be limited to the institutional market.
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Forex Arbitrage Strategies
Forex broker arbitrage is not the only type of opportunity in the spot market though. One Forex arbitrage strategy involves looking at three different currency pairs.
Forex 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.
Currency pairs express the value of one currency relative to another currency. For example, the EUR/USD currency pair expresses the value of euros in US dollars.
With the Forex triangular arbitrage system, we seek to identify an implied value for one currency pair using two other currency pairs. This is most easily understood through an example.
Let’s say that the EUR/USD is currently trading at 1.05302 and the GBP/USD is trading at 1.25509. What this tells us is the 1 euro currently costs 1.05302 US dollars and that 1 British pound currently costs 1.25509 US dollars.
In order to identify a potential Forex arbitrage opportunity, we need to use this information to calculate the implied value of EUR/GBP, which we can do by dividing EUR/USD by GBP/USD.
Why do we divide one by the other? Currency pairs can be treated in the same way 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 (USD/GBP).
If the actual traded value of the EUR/GBP currency pair is different to the value implied by the above calculation, an arbitrage opportunity exists. As the name of this strategy suggests, triangular arbitrage in Forex consists of three separate trades.
Let's say that EUR/GBP is actually trading higher than the implied value, at 0.83944.
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 currency pairs, to create a synthetic EUR/GBP opposing position. This Forex triangle arbitrage 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, when we trade currency pairs, we are effectively buying one currency and selling the other.
Consider the implication of these steps, it may help to go back through them and pretend you are making physical currency transactions at each stage. In this last step we have ended up with 1,053,573 USD after initially exchanging 1,053,020 USD into EUR.
The profit of these three transactions, therefore, would be 1,053,573 - 1,053,020= 553 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 the spreads or any 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 each position.
Forex 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.
Riskless Profit
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.
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 FX 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.
Trade on a Risk-Free Demo Account
If you are interested in trying an arbitrage strategy in Forex, why not practise first? With a risk-free demo account from Admirals, you can practise Forex arbitrage trading without risking your capital! Trade using virtual currency in real-market conditions before heading to the live markets. Click the banner below to open your free demo trading account today:
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This material does not contain and should not be construed as containing investment advice, investment recommendations, an offer of or solicitation 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.
