Forex trading represents a plethora of opportunities to make money. With various strategies employed in the forex market, trading forex has grown and become one of the largest markets in the world.
One of the strategies that have made billions for traders is arbitrage.
The arbitrage trading strategy represents the best opportunity for low-risk profits. But what is arbitrage, and how does it work?
This is a form of trading whereby a trader seeks to make profits from the discrepancies in prices of identical or related financial instruments.
The inefficiencies occur when a given asset like the EUR/USD is priced differently by several financial institutions.
Basically, the strategy means that a trader buys an asset at a particular price from the first institution and almost instantly selling the asset to another institution, making a profit from the difference in the quotes.
The speed at which the transactions take place means the trader is exposed to a slight risk.
However, trading forex comes with some risk, especially when the prices are shifting quickly or merely liquidity is low.
Value Trading and Arbitrage Aren’t the Same
To better understand arbitrage trading, it’s significant that you differentiate between trading on valuation and arbitrage.
Often, most folks would buy or sell a security when it’s overvalued or undervalued with the “hope” of profiting once the price gets back to fair value.
Now, when it’s all about “hope,” that’s not true arbitrage. Buying an asset that is undervalued or selling the overvalued asset is value trading.
True arbitrage doesn’t take the market risk. A trader structures a set of trades that guarantees a riskless profit, regardless of what the market does afterward.
How Does Forex Arbitrage Trading Work?
Simply put, the forex market is not perfect, and inefficiencies are very much present – these inefficiencies are what create arbitrage opportunities.
For a trader to be considered arbitrage, some conditions have to be met, such as:
- The price of similar assets is not the same depending on the markets
- The actual cost of an asset is not the same as the future price discounted at an interest rate
- The cost of products with similar cash flow is not the same depending on the markets
Types of Arbitrage
Forex arbitrage can occur in three various types:
- Two-way currency arbitrage – this is exploiting multiple quotes of two forex pairs rather than the differences in the price of two currencies in a pair.
- Triangular arbitrage – it’s a form that occurs from differences in the price between 3 different currencies and conversion of a currency into the other two before being converted back to the first currency and hoping for a profit.
- Covered interest arbitrage – in this strategy, a trader exploits the difference in the interest rate of two countries, and in the process, use the forward contract as a hedge in covering the exchange rate risk.
Tools for Arbitrage Forex Trading
To start arbitrage forex trading, the following are some of the tools you need:
- An Excel calculator to help work out numbers behind arbitrage to know if there’s a profit to be made from a given opportunity
- Several prices feed as the strategy is best when the trading servers for both brokers are in different time zones
- Trade alert software to monitor the price feeds over several currency pairs as well as instantly provide an audible alert when an opportunity appears.
Challenges of Arbitrage Forex Trading
The market makers are the source of major challenges in forex arbitrage trading because they mostly make money from acting as counterparties to losing trades of the retail traders.
Usually, they block attempts by the traders to perform the arbitrage trades- done by:
- Placing a ban on arbitrage trading
- Setting minimum time when trades are left open
Furthermore, the issue of spreads is another challenge. When the asset traded has a huge spread, arbitrage trading becomes more difficult to profit. Therefore, this trading style is not suitable in exotic forex pairs.
Also, during the times of major news release, arbitrage trading is not suitable because it causes intense volatility as well as slippage.
Arbitrage trading can also be done by trading the futures contracts using the prevailing interest rates.
Arbitrage offers excellent winning opportunities, but for the ordinary trader, they are infrequent.
However, as much as it’s considered risk-free, it’s significant to calculate the transaction costs as well as slippage as they can make the opportunity worthless.