Arbitrage trading is a practice of buying and selling assets to try and make a profit from the small difference in prices. In the forex market, arbitrage trading usually refers to price alterations in a short period of time due to some discrepancies. Some traders may consider forex arbitrage trading as risk-free strategy but I do not believe this is the case. There is always risk involved with trading online and most forex brokers will quickly shut down any arbitrage trading activities.
What is Forex Arbitrage trading?
Forex arbitrage is defined as “the simultaneous purchase and sale of the same, or essentially similar, security in two different markets for advantageously different prices,” according to the concept formalised by economists Sharpe and Alexander in the 1990s.
The concept of forex Arbitrage trading is to buy and sell diverging currency prices, but likely going to converge. An Arbitrageur expects the price to move to its mean, so he/she can close the profitable trade in seconds.
The forex market is decentralized. For this reason, there exists a time when a currency pair’s price quoted in one place is differently quoted in another place. The Arbitrageur aware of this situation buys lower and sells higher of the two prices.
Forex Arbitrage Example
Consider an example of EUR/USD. The Bank of London quoted the price at 1.1125, whereas Bank of America quoted 1.1124. An Arbitrage trader would buy at a price quoted by Bank of America and sell it at a price quoted by Bank of London.
Although in the above example, the profit from an Arbitrage trade is only 1 pip, but Arbitrage trading opportunities frequently appear for a short period.
Because Arbitrage opportunities repeatedly surface during a day, many large firms try to take advantage of it. Some will even built fully automated trading systems to analyse for Aribitrage trading opportunities.
Forex Arbitrage Strategies
Although the goal is the same, there are many types of arbitrage strategies. Examples include retail, convertible, negative and statistical. In some locales, markets and asset classes, such strategies are discouraged. However, on the forex, arbitrageurs are encouraged as their activities enhance market liquidity and efficiency.
The forex Arbitrage strategies include:
1. Arbitrage Algorithmic trading
When talking about Arbitrage automated trading, an Arbitrage trader often applies Algorithmic trading.
Algorithmic trading is an automated process that requires mathematical models and programming for trade execution.
To implement the forex Arbitrage trading, an Arbitrage trader would program an algo. This algo would tell Arbitrage trader the difference between the prices and multiple buying entries. After this, he/she would execute the trade. This would remove the hassle of looking at the prices manually.
2. Cross-currency transaction
This strategy involves profiting from cross rates of the currency pairs. The approach is based on the rates of a conventional currency like JPY and doesn’t include USD.
3. Covered interest rate
This strategy includes buying a profitable currency such as USD and sell it through a forward contract. An Arbitrage trader would look to try and make money from the difference in exchange rates.
4. Uncovered interest rate
The idea of an uncovered interest rate is to change a domestic currency having a lower interest rate to a foreign currency having a higher interest rate.
5. Spot-futures market
This strategy consists of buying a currency in the spot or futures market and then selling it on either market based on a price difference.
Forex Arbitrage calculator
A forex Arbitrage calculator is a tool that tells the difference between the prices. It eliminates the time-consuming process of observing the prices manually.
Difficulties of Arbitrage trading
As mentioned at the start, the forex Arbitrage trading can presetn many challenges to forex traders.
Arbitrage opportunities emerge in seconds, so a delay in execution means a missed opportunity. Also, if the forex trading platform is a bit slow, an arbitrage opportunity would vanish.
Moreover, Arbitrage trading may only be possible for large financial institutions who have the technology, experience and connections to benefit from fractional differences in prices.
Forex Arbitrage Trading Conclusion
Arbitrage trading works due to inherent inefficiencies in the financial markets. Supply and demand are the primary driving factors behind the markets, and a change in either of them can affect an asset’s price. Forex arbitrage traders seek to exploit momentary glitches in the financial markets. They aim to spot the differences in price that can occur when there are discrepancies in the levels of supply and demand across exchanges.
The use of arbitrage can potentially be a valuable strategy for traders to make timely profits although there is also a high level of risk of loss. Advances in trading technology and high-frequency trading in some cases have made true “risk-free” arbitrage opportunities less common for small-scale investors. But they have also widened access to diverse markets where asymmetric information and market inefficiencies may still present arbitrage opportunities.
Forex Arbitrage trading requires a trader’s activeness as a trading opportunity could pass by in the blink of an eye. Some of the large institutions will try to implement Arbitrage through Algorithmic trading because it can help to eliminate the time and emotions involved in the trading process. I would personally not spend my time trying to use a forex arbitrage trading system as I believe most forex brokers would not have suitable conditions for it to be worth the effort.
If you are looking to trade forex online, you will need an account with a forex broker. If you are looking for some inspiration, please feel free to browse my best forex brokers. I have spent many years testing and reviewing forex brokers. IC Markets are my top choice as I find they have tight spreads, low commission fees, quick execution speeds and excellent customer support.
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