What is Forex Arbitrage? & How To Use Forex Arbitrage Strategies
Reading time: 10 minutes
When people talk about Forex trading, this means that they are attempting to profit by anticipating the future direction of a market. But have you ever wondered if there is a way to profit from the Forex market, without having to correctly pick the direction of a currency pair? You might be interested to find out that there are a number of market-neutral strategies. Perhaps the least risky of these is Forex arbitrage.
Before we look at the specifics of arbitrage in Forex, let's first talk about arbitrage in general. Simply put, arbitrage is a form of trading in which a trader seeks to profit from price discrepancies between extremely similar instruments. Traders who use this strategy are known as arbitrageurs.
Arbitrageurs aim to: Buy in one market, while simultaneously selling an equivalent size in another interrelated market, to take 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, all listings of a certain stock should have parity in their pricing. After all, we're talking about shares in the same company.
In reality, the flow of information to all parts of the world is not perfectly instantaneous, nor do markets trade with complete efficiency. Therefore, when both stock exchanges are open, it is possible that prices may differ between exchanges. The first person to notice the price difference could: buy the stock on the exchange with the cheaper price while selling on the exchange with the higher price. Want to know the best part? By doing so, you can potentially lock in a profit.
Forex Arbitrage Explained
We briefly defined it before, but when looking at it in further detail, what exactly is Forex arbitrage? Traders seeking to arbitrage Forex prices are in essence, doing the same thing as described above. They effectively aim to purchase a cheaper version of a currency, while simultaneously selling a more expensive version.
Once they subtract their transaction costs, their profit is the remaining difference between the two prices. A Forex arbitrage system might operate in a number of different ways, but the essence is the same. Namely, arbitrageurs aim to exploit price anomalies. They might attempt to exploit price discrepancies between spot rates and currency futures.
A future is an agreement to trade an instrument at a certain date for a fixed price. Forex broker arbitrage might occur where two brokers are offering different quotes for the same currency pair. In the retail FX market, prices between brokers are normally uniform. Therefore, the feasibility of this strategy tends to be limited to the institutional market. This is also not the only type of arbitrage Forex trading opportunity to arise in the spot market. Another type of Forex arbitrage trading involves three different currency pairs.
Forex Arbitrage Strategies
Forex Triangular Arbitrage
Forex triangular arbitrage is a method that uses offsetting trades to profit from price discrepancies in the Forex market. To understand how to arbitrage FX pairs, we first need to understand the basics of currency pairs. Let's run through some quick basics. When you trade a currency pair, you are in effect taking two positions: Buying the first-named currency, and selling the second-named currency.
A currency cross is an FX pair that does not include the US dollar. A theoretical or synthetic value for a cross is implied by the exchange rates of the currencies in question, versus the US dollar. For example, let's suppose that the EUR/USD currency pair is trading at 1.1505, and the GBP/USD currency pair is trading at 1.4548. We can calculate an implied value for the EUR/GBP currency pair by dividing one by the other.
- Example: 1.1505/1.4548 = 0.7908
Why do we divide one by the other? Simply put, currency pairs can be treated as fractions with numerators and denominators.
Dividing by GBP/USD is the same as multiplying by the inverse. Therefore: EUR/USD x USD/GBP = EUR/GBP x USD/USD = EUR/GBP. If the actual traded value of the EUR/GBP currency pair diverges from the value implied by the major pairs, an arbitrage FX opportunity exists. As its name suggests, triangular FX arbitrage consists of three trades. Let's say that EUR/GBP is actually trading at 0.7911.
Source: Admiral Markets MetaTrader 4 Supreme Edition
It is higher than our implied value, and we want to sell it. We also need to place two trades in the two related majors, to create a synthetic EUR/GBP opposing position. This will offset our risk and thereby lock-in profit. Because the price discrepancy is small, we will need to deal in a substantial size to make it worthwhile.
Let's work through the numbers to complete our example for this Forex arbitrage strategy. If we purchase 10 lots of EUR/USD - one lot is 100,000 units of the first-named currency. When we buy a currency pair, we are buying the first currency and selling the second. So we are buying 10 lots x 10,000 EUR = 1,000,000 EUR.
As we are dealing at a EUR/USD rate of 1.1505, we are selling 1,000,000 x 1.1505 = 1,150,500 USD. We simultaneously want to sell an equivalent amount of EUR in EUR/GBP. So we sell 10 lots of EUR/GBP, which is 1,000,000 EUR. As we are dealing at a EUR/GBP rate of 0.7911, we are buying 1,000,000 x 0.7911 = 791,100 GBP.
Lastly, we also sell GBP/USD in order to complete the triangle. This leaves us with no overall exposure to any of the three currency pairs. To remove our exposure to GBP, we would sell the same amount that we bought in the EUR/GBP trade. Therefore, we sell 791,100/100,000 = 7.91 lots of GBP/USD. We are dealing at a GBP/USD rate of 1.4548, so we are buying 791,100 x 1.4548 = 1,150,892 USD. Consider the implication: if you were physically exchanging currencies at these rates and in these amounts, you would have ended up with 1,150,892 USD after initially exchanging 1,150,500 USD into EUR.
So your profit would be: 1,150,892 - 1,150,500 = 392 USD. As you can see, the profit is small, and relative to the large transaction size. Also note that we have not taken into account the bid/offer spreads, nor other transaction costs. Of course, with a retail FX broker you are not physically exchanging currencies either. You would have locked in a profit with the trades, but you would still have to unwind your positions. Keep in mind that daily SWAP adjustments would quickly erode the notional profit you have locked-in.
Forex Statistical Arbitrage
While not a form of pure arbitrage, statistical arbitrage Forex takes a quantitative approach, and seeks price divergences that are statistically likely to be correct in the future. It does so by compiling a basket of over-performing currency pairs, and a basket of under-performing currencies. 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.
Arbitrage is sometimes described as riskless, but this isn't really true. A well-implemented Forex arbitrage strategy will be fairly low risk, but implementation is half the battle, because execution risk is a significant problem. You first need your offsetting positions to be executed simultaneously, or near-simultaneously. It gets more difficult because the edge is small with arbitrage - slippage of just a few pips will likely erase your profit.
Other Problems With Arbitrage in Forex
Problems 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. 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 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 Forex arbitrage. The fastest price feeds are essential if you want to be the one to profit. For example, our Zero.MT4 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 arbitrage software can give you a competitive edge. Feel free to try out new and varying strategies before you jump into trading with real money.
Also note that the speed of the modern market means that you will likely have to use an automated trading system, for successful arbitrage. After opening an account: your best move is to download the feature-rich and award-winning MetaTrader 4 Supreme Edition trading platform. Simply put, MT4 Supreme offers the ultimate automated trading experience, so why not try it out and see how you perform with Forex arbitrage strategies?
Forex Arbitrage: Final Words
All trading systems are subject to the risk that profitability will erode with time. As new participants chase the same strategy, opportunities dwindle. Arbitrage is no different. The fierce competition in the FX market means you may discover pure arbitrage opportunities are limited. However, you will likely find the theory useful for exploring related strategies, and further trading possibilities. If you would like to learn more about different Forex strategies in general, make sure to check out the following articles:
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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.