Arbitrage has been in practice since ancient times. Arbitrage is a speculative strategy, where someone attempts to profit from price differences of the same instrument either in the same market or in different markets. It involves buying and selling an asset at two different prices in order to profit from the difference.
Finding the right conditions and applying an arbitrage trading strategy is not easy because everyone is looking for a loophole in the market in order to make a profit. Therefore, by the time it comes to your attention, someone else may have already placed a trade and closed. So, arbitrage is mostly a strategy for market participants with the best and quickest information and technology systems.
Arbitrage can be applied when the same product has two different prices.
What Is Forex Arbitrage Trading?
Financial arbitrage consists of buying and selling a product or financial instrument (or two very similar instruments) as quick as possible, profiting from the price difference. You buy the instrument when you see it costs less in a market and then sell it in another market or in the same market where it costs slightly more. The markets are not perfect and there are inefficiencies — these are what create arbitrage opportunities.
In fact, arbitrage minimizes market inefficiencies because if a product is undervalued, the arbitrage players will immediately jump to increase the demand for it, thus increasing the price. As the price of the product goes up, demand will decrease and the supply will increase until they reach a balance and the price of the product reaches the right value. In currency trading, forex arbitrage is accomplished through the buying and selling of currency pairs.
In theory, there are three conditions to be met for a trade to be considered ‘arbitrage’:
- The price of the same or similar products is different depending on the markets.
- The price of two or more products with identical cash flow is different depending on the markets.
- The actual price of a product is different from the future price discounted at the interest rate.
Arbitrage might occur as two-way or in a multitude of ways. For convenience and comprehension, the literature refers to multiple arbitrages as ‘three-way arbitrage’. We´ll refer to them as two-currency and three-currency arbitrage.
There are many types of arbitrage, such as labor arbitrage between one or two markets. The labor price and demand between the East and West European member states are different. That is why many Eastern Europeans take their labor to West Europe and close the arbitration gap. This is labor arbitration within one market. The difference between the EU and African labor markets is an arbitrage in different markets. This is just a simple example to help explain how arbitrage works.
Forex arbitrage, or “two currency arbitrage,” is achieved when you buy a currency pair in an exchange that offers a lower price, and then sell the same pair in another exchange at a higher price. For example, assume you have accounts with two different brokers and they offer a slightly different price for EUR/USD; broker X has an exchange rate of 1.1010 while broker Y has a rate of 1.10.
If you buy ten EUR/USD with the second broker you´d get 909,090 EUR for 1,000,000 USD. If you then sell the Euros to a second broker at a rate of 1.1010, you´d get $1,000,909. You just made $909 by forex arbitrage. If both of the brokers have a 1.5 pip spread for this pair, the transaction costs would be $300 for this amount, which would leave you with a $609 profit.
A 10 pip rate difference is not very common, but you can find 1-4 pip differences for the same pair amongst many brokers. I often see 1-3 pip rate differences between Oanda and ETX Capital for the same exotic currency pairs. However, since the spread for these pairs is often more than 5 pips, the arbitrage trading strategy is not feasible.
For more on currency trading strategy:
Fair Value – An Efficient Way for Trading Currencies – Forex Trading Strategies
Carry Trade Strategy – Forex Trading Strategies
As we said above, arbitrage can be used even when there are rate differences between several pairs. To make it simple, we´ll explain triangular arbitrage. This is a bit more complicated than two-way arbitrage but the basic logic is the same. For example, let’s assume that three different brokers have the following rates for the designated pairs:
The arbitrageur buys $1,000,000, which means selling 10 lots USD/CHF to broker X. Now he has 817,100 CHF. Then he sells 817,100 CHF in exchange for British Pound Sterling on the broker Y which would give him 686,062 CHF. As a final step to the triangular arbitrage trading plan, the trader changes the GBP back into USD, ending up with US$ 1,005,081 (686,062 x 1.465). A $4,631 profit is realized if the brokers maintain a 1.5 pip spread for all pairs involved.
This type of arbitrage is not easy because it requires rapid calculations to determine if there is a profit to be made. However, rates change all the time, making it nearly impossible for a human to calculate.
Risks Of Forex Arbitrage
Arbitrage sounds like an easy and profitable trading plan, but it is a bit more complex in real-life. There are several downsides and risks associated with arbitrage. The biggest risk of all is the execution process. When you execute the open and close of two separate trades, you have to execute them instantly. If not, you risk carrying the price difference between the entrance or exit of both trades. If the sell trade closes above the buy trade, then the difference is a loss for you.
For instance, you sell EUR/USD at 1.20 with one broker and buy at 1.1997 with another broker to profit from the price discrepancy. Then you try to close them when the price of both brokers has reached 1.1210, which means losing 10 pips from the first trade and winning 13 pips from the second. The problem is that sometimes the execution might take a few seconds. So, if the buy trade closes immediately at 1.2010 but the sell trade closes a few seconds later at 1.2015 you will lose 15 pips from the second trade, which means a 2 pip loss in total. Opening the trade faces the same risk. Trade-related latency plays a huge role in just how successful a forex arbitrage strategy can be.
Spread is another risk. Many brokers have fluctuating spreads which tend to narrow and widen. The spread might be 1.5 pips on both brokers, meaning 3 pips in total for two trades. In essence, there is a 5 pip price discrepancy for the same pair between both brokers. This seems like a good deal, but when the spread widens to 3 pips when you are trying to close the trades you will pay 6 pips for the spread and win 5 pips from arbitrage. The net result is a one pip loss.
Arbitrage Trading Is A Tough Business
Arbitrage offers nice winning opportunities, but they are very rare for the normal trader. It also requires large amounts of funds and high leverage to maximize the profit from small discrepancies of the same pair. High-frequency trading firms are the ones that take advantage of this and make the most profit. The high-speed arbitrage trading systems can detect small price gaps and close them quickly. That adds liquidity and brings the market as close as possible to perfection.