What is Arbitrage in Forex Trading?

Last Updated on September 19, 2021 by Alphaex Capital

This will probably be the last page you visit on understanding what is arbitrage.

In this article, you are going to uncover what is arbitrage and how they are used for trading opportunities.

Even better:

You’ll discover the different types of arbitrage that traders take advantage of every day.

Here’s how:

What is arbitrage in forex trading?

Forex arbitrage is a risk-free trading strategy with no open currency exposure where two brokers are offering different quotes for the same currency pair. 

The aim here is to take advantage of miss-pricing from several brokers and lock in the price difference between them.

This can happen because:

The broker’s prices may be off because they are based on different data feeds, liquidity providers, or due to a host of other reasons.

Thus making a risk-free profit.

So no matter what happens, you’ll have guaranteed a profit.

Therefore, the probability of this strategy involves acting on opportunities presented by pricing inefficiencies in the short window. 

Arbitrage opportunities are hard to find and especially difficult for a retail trader to find. This is because of the inefficiencies that occur from time to time.

How does arbitrage work?

The arbitrage strategy is the process of taking advantage of pricing inefficiencies between two or more markets.

For example, if a trader knows that there are discrepancies on one currency pair and another trading account offers him/her different prices then it’s possible to make a profit without any risk.

This is because they will be able to buy at the lower price and sell at the higher one with no market risk whatsoever.

It’s worth noting that arbitrage opportunities can be created when the market has gaps in prices between different exchanges/brokers, or even within the same exchange but for vastly different currency pairs.

What is Arbitrage

Types of arbitrage in trading

There are three types of arbitrage that traders use to take advantage of potential discrepancies in the market. They’re:

Forex Triangular Arbitrage

Triangular arbitrage is a type of scalping strategy that takes advantage of the spread between three different currencies for increased profit.

What this all revolves around is finding two opportunities to sell and one opportunity to buy and as soon as your trade has been made, then you need to shut it off and wait for another opportunity.

What traders should be aware of though is that if their target currency depreciates in value during this time period, then they’re left with losses on all three trades – not just one like with regular arbitrage trading.

Triangular arbitrage is exceptionally difficult to get away with because you’ll need a substantial amount of capital on hand and be able to move it quickly around the various financial exchanges, which can take up time that’s better spent elsewhere.

It also requires an intimate knowledge of all four markets and how they’re interconnected or – even more challenging – being aware when two different rates are about to converge so you can exploit them for profit at just the right moment before they pass one another by without providing any opportunity.

This means there needs to be significant volatility between separate prices for a triangular arbitrage trade to have potential success.

This type of trading only works if none of those factors change during your transactions (i.e. if the assets you buy don’t become cheaper or less valuable, and the asset that you sell doesn’t increase in value).

In other words, the greatest difficulty with this is having to buy and sell across all the brokers instantly.

Covered interest arbitrage

Covered interest arbitrage is a strategy in which an investor uses a forward contract to hedge against exchange rate risk.

By hedging, the trader will be able to maintain their position at all times and not have any losses or gains due solely from fluctuations of currencies on different exchanges which would otherwise occur without using this technique.

Covered Interest Arbitrage is one way that traders can protect themselves when it comes to currency fluctuation during trades involving investments across differing countries’ markets by making use of Forward Contracts; these contracts lock the value for future transactions so they are always equal no matter what direction international trade takes place

Covered interest rate arbitrage is a form of investment that makes use of favorable currency rates to earn more money in the financial market.

By using this method, investors will be able to take advantage of some great opportunities with their investments and also hedge against any exchange risk they might have by investing in both currencies at once.

This strategy can only work if the cost to hedge exchange risk (i.e., convert your investment back into dollars) is less than or equal to what you would have made by investing exclusively in a higher-yielding currency.

Covered interest arbitrage is a strategy of hedging against the risk of rising and falling interest rates in currency markets.

This process involves buying bonds or other assets that will lock in an agreed-upon rate, while simultaneously agreeing to sell similar securities at a future date with higher returns– locking these gains upfront by selling them now before they’re purchased on tomorrow’s market for more profit later down the line.

This way of making money is complicated. It does not offer much money on a per-trade basis. But the trade volume could make up for it.

These opportunities are based on the principle of covered interest rate parity.

Statistical arbitrage

Also called quantitative analysis, a trading strategy is when someone takes advantage of differences in prices among related securities.

What this means is that an arbitrage trader will purchase one security and then simultaneously sell the same type of security at another exchange for higher prices in order to profit off the difference between their buy and sell prices.

One example would be if Company A’s stock were $25 per share on the New York Stock Exchange (NYSE) but $27 per share on NASDAQ, a high-frequency trader might execute both trades by purchasing shares from NYSE stocks while selling them through NASDAQ.

– Additionally, forex traders often try to take advantage of different interest rates offered when exchanging currencies.

Well-known practitioners include global investment banking giants like:

  • Goldman Sachs Group Inc.,
  • Morgan Stanley,
  • J.P. Morgan Chase & Co.,
  • Citigroup Inc.,
  • Bank of America Corp.,
  • Barclays PLC,
  • Deutsche Bank AG
  • UBS AG

These companies will employ their own proprietary algorithms to capitalize on these opportunities.

Index arbitrage

Index arbitrage is a trading strategy where people buy and sell when the price of an index changes.

This can be done in many ways. It depends on where the price discrepancy comes from:

  • It may involve buying the same index on two exchanges and profiting from differences in the prices.; or
  • It may when the prices have temporarily diverged from its fair value pricing.
  • It may also be an arbitrage if an instrument tracks the index (e.g. index ETFs), and the components that make up the index.0

Spot-Future Arbitrage: Cash and Carry

We have seen that arbitrage opportunities exist when the same asset is trading at different prices in two markets.

What if you were a forex trader and wanted to make some money on an investment?

What would be the best way for this to happen?

You could try to exploit spot-future price differences by buying currencies from one market while simultaneously selling them elsewhere, or vice versa.

This is known as carry trade arbitrage.

The difference between what you buy with your funds (e.g., USD) and sell it back later will be your profit margin – which means not just any currency pair will work!

There are several factors that affect whether such trades can actually take place;

  • Including regulations limiting short positions by country,
  • Interest rates charged on holding the currency itself,
  • Retail traders routinely underestimate the costs associated with converting currencies.

Why do traders look for arbitrage opportunities?

To be blunt:

It’s to make a risk-free profit.

However, as you’ll be aware it’s not as easy as it sounds.

A popular method, if you are interested, used however is Grid Scalping.

Advantages and disadvantages of arbitrage in forex trading 

Pros:

Arbitrage in forex trading may help traders to minimize the risks of price changes.

An arbitrage can provide a reasonable return on investment, and it’s very low risk compared with other investments.

Cons:

Arbitrage in forex trading isn’t without its disadvantages just as everything we do has its pro’s and con’s.

The time it requires to identify opportunities that are good for you, so what is arbitrage may not suit everyone.

Some brokers prohibit arbitrage trading in their Terms of Services.

If the market moves too quickly and you can’t complete the arbitrage

It can cost you money if you are not quick enough to complete the arbitrage

Ideally, you need software to help place such orders easily.

Tips for successful arbitrage trading

Arbitrage in forex trading can be successful by following these tips:

  • Keep in mind that the more risk you take, the greater your reward potential.
  • Be sure to use a reliable broker with minimal spreads and fees.
  • Make sure that there is adequate liquidity on both sides of the trade so as not to be left hanging if one side runs out of orders.
  • Identify when a currency pair has been moving away from its usual trend and then wait to see if the price goes back towards the norm; this could signal an opportunity for what is arbitrage.
  • You should look at forex pairs that correlate.

If you see a divergence between forex pairs, then there could be an arbitrage moment.

However, recognize that other factors might come into play like seasonal trends and economic data releases which may affect how well you profit from any given trade with what is arbitrage.

If you’re looking for a way to minimize your risk and increase your potential profit, then what’s not to love about finding an arbitrage.

Now you understand what is arbitrage trading and its various forms of risk-free opportunities.

The tips we’ve provided will help ensure that you have a successful experience using arbitrage in your forex trading repertoire.

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