Have you ever wondered how people profit from selling one commodity in one market when they have bought the same commodity in another? The difference in prices causes most people to benefit. In a real example, avocado could be going for $2 in one market and go for $3 in another. If you buy an avocado in the cheapest market and sell it next, you will have a $1 profit. You can keep doing this over and over again and continue making more profits. This is the pedestrian explanation of arbitrage. Arbitrage is the simultaneous purchase and sale of a commodity or asset due to an imbalance in the prices. Securities, commodities, or currencies are used in most arbitrage cases.
Arbitrage takes advantage of the price differences to make a profit. Since no market is efficient, these differences in prices have to exist. The trade of using such differences and making a profit out of it is arbitrage. Arbitrage exists in two broad types: pure arbitrage; and risk arbitrage. Pure arbitrage is risk-free, whereas risk arbitrage is speculative. This is because it is founded on the presumptions of future events that may or may not actually occur. Arbitrage works best in the forex situation; hence the term ‘forex arbitration.
What does arbitrage mean?
In theory, arbitrage represents the possibility of instantaneously buying the asset for a low price, selling it for a higher price, and getting risk-free profit after transaction costs. However, in practical online trading, there are always risks in arbitrage (i.e., execution risk) when traders try to profit from a difference in the asset’s price between markets.
Now, let us see what is arbitrage in trading:
What is arbitrage trading?
Arbitrage trading in forex is the process of purchasing assets in one market and immediately selling them in another market to benefit or profit from the differences in prices. Arbitrage trading’s goal is to exploit the pricing inefficiencies in different markets for the same asset.
You end up with a risk-free profit. Here is a practical example: Company A’s stock is trading at $20 on the New York Stock Exchange (NYSE). The same stock is trading at $20.50 on the Toronto Stock Exchange (TSE). If a trader purchases the stock in the NYSE and sells the stock immediately in the TSE, they will earn $0.5 per share. This is trading in stocks. The immediate need for purchase and selling is based on the fact that prices can change, leading to better profits, no change in the profit margin, or less profit. If the prices adjust and the LSE prices go below your purchasing price in the NYSE, you will end up having a loss.
Currency arbitrage definition
Currency arbitrage represents buying and selling currency pairs from different brokers or different markets to take advantage of the miss-priced rates. Usually, currency arbitrage involves buying a given currency on one market and instantaneously selling it on another. For example, you purchase USD in the spot market and then sell the same in the futures market to make a profit.
Is arbitrage legal?
Arbitrage trading is legal. Arbitrage trading can be very profitable. For example, you can read articles such as ‘latency arbitrage’ trading maybe $3 billion as same as HFT trading problem is over.
Stock market example: ABC Bank is trading for CAD 74.50 on the Toronto Stock Exchange (TSX) and 56.50 on the New York Stock Exchange (NYSE). At the time, the exchange rate of CAD/USD is 0.77, meaning for every CAD 1, you have USD 0.77. Mathematically, it should mean that ABC Bank’s trade in the NYSE equivalent to USD 57.30. This means that you can purchase ABC’s share from the TSX at CAD 74.50 and sell it in the NYSE at 56.50, making CAD 0.8 profit per share. This is because the New York equivalent of CAD 74.50 is USD 57.30
Latency Arbitrage (High-Frequency Trading Arbitrage)
In this example, we have “slow broker” and “fast broker.” Using HFT trading, we can see future price (fast broker) (0.5 seconds faster, for example ), and then we can make a profit using “slow broker.”
Latency arbitrage is a complicated way of trading, and if you want to learn more, you can read the research paper Latency arbitrage in fragmented markets.
Concept of arbitrage in the foreign exchange market
What is arbitrage trading in forex?
You can read more in What is Arbitrage Trading in Forex?
Forex Triangular Arbitrage
Forex triangular arbitrage is a method involving offsetting trades to profit from differences in Forex markets’ prices. It is a more complicated arbitrage strategy than the ones above. Forex triangular Arbitrage involves a pair of currencies, such as EUR/GBP, the Euro, and the British Pound. When trading in these pairs, you buy the first-named currency while selling the second-named currency. In the example above, you will be buying the Euro and selling the British Pound. In triangular arbitrage, a trader converts one currency against another in three banks.
Forex triangular arbitrage example: you have $1,000. You will exchange the money in three banks’ situations based on the currency exchange values. Take these exchange rates for instance: €/ $ = 0.90; €/ £ = 1.25; and $/ £ = 1.5 respectively. You will convert the $1,000 to Euros, giving you €900. Next, you will convert the €900 to Pounds, and you will get £720. Finally, you will convert the £720 back to Dollars. You will end up with $1,080. You will have earned an extra $80 in the process, assuming there are no transaction costs or taxes.
Technological Advancements in Forex Trading and Arbitrage
In an ever-competitive market, technology has been used to ease the means of acquiring an arbitrage. Hundreds of trading companies, boasting of experts and excellent software, meant ease in the day-to-day trading activities. Traders are now able to perform risk-free transactions in a quicker and more agile manner. The arbitrage is still the same, although the strategies used could be different. It is also important to note that each trading software is subject to extra risk, and profitability could change, depending on the software you use. The high number of competitors in the Forex market could mean lower arbitrage. Ensure the software you use is correctly coded to avoid price quote errors and work with an old version of a program. These tiny errors can cause a lot.
Other Forms of Arbitrage:
Other than the triangular and the forex arbitrage in general, there are several other types of arbitrage. The item in question is the one that varies; however, the concept is still the same.
Interest Rate Arbitrage
This is a common form of arbitrage, also referred to as ‘carry trade.’ In this form, an investor sells currency from countries with low-interest rates and then purchases a currency paying higher interest rates. Later, the investor reverses the trade, meaning they sell the high-interest rate currencies and purchase low-interest-rate currencies. They get to pocket the difference. This type of arbitrage is carried over a period of time and therefore involves more risk, majorly due to the variation of currencies and/or interest rates.
As it is commonly referred to, the ‘cash and carry’ arbitrage involves choosing or taking positions on the spot and futures markets regarding an asset. The trader purchases a particular asset at a certain price and sells it in the futures market when it is much favorable. The reverse of this can also happen, where the trader sells an asset and buys the same asset in the futures market.
There also is dividend arbitrage, currency arbitrage, fixed-income arbitrage, political arbitrage, regulatory arbitrage, and municipal bond arbitrage. All these forms revolve around the term mentioned. For example, dividend arbitrage is where options are purchased out at an equivalent amount of the underlying stock before the ex-dividend date. They are then exercised, collecting dividends—fixed-income arbitrage profits a trader due to pricing differences in interest rate securities. An investor takes opposing positions in the markets to take advantage of price discrepancies, at the same time limiting the interest rate risks.
Problems and Risks in (Forex) Arbitrage
As earlier noted, an arbitrage exists because of the fluctuation in price differences. It is important to be fast about these differences to achieve the desired profit. However, others also recognize the price differences, and under the laws of supply and demand, the price differences shrink. The overpriced items are made to be cheaper, whereas the under-priced ones have their prices go up. The margin shrinks, and the arbitrage becomes no longer profitable. Your execution speeds are key because they can make a difference in what amount you will be taking home.
Even in the original example involving an avocado, prices fluctuate because of demand and supply laws. When the demand is high, the prices go down, whereas when the supply is too high, the prices go high. This will cause the cheaper-trading markets to sell their avocados at a higher price, while the other market, where they were being sold, will have their prices go down. The arbitrage margins will shrink, causing lower profit margins.
There is also the fact that a ‘negative spread’ can happen. A negative spread is when the seller’s asking price is lower than another buyer’s bid. For example, a bank can quote a particular price for a currency, or a seller can quote a certain price of a product or asset, while another seller or bank quotes a different selling price. Therefore, it applies that the arbitrageur will purchase from the seller and sell the asset to profit. Instead of the trader waiting for a favorable trend in the markets, they encounter one just like that. On the adverse hand, ‘execution risk’ can occur. When the price is quickly corrected, making the trade less profitable means the trader could lose.
Explain the concept of arbitrage in the foreign exchange market
Forex arbitrage between brokers
The arbitrage concept can be represented as the process of simultaneous buying and selling of currencies in two or more foreign exchange markets to make profits by capitalizing on the exchange-rate differentials in various markets.
It is a technique or strategy to place two separate trades at two different brokers and make money by the price discrepancies. The theory is elementary because each broker has its own platform and has a price difference. In other words, we can say that money can be put together by the difference between two currencies while making pairs of that. If the paired money has space to give something, then profit is minimal due to the opportunity window.
Using arbitrage strategy as a forex trader?
A strategy that involves no risk in trading in Forex is called arbitrage. It used to profit without currency exposure being open.
This particular strategy is based on aiming for inefficiencies in pricing at the time they are available.
For example, EUR/GBP, EUR/USD, GBP/USD exchange rates are 0,7231, 1,1837, 1.6388. this is the time when you can buy a Euro mini-lot worth 11,837 dollars. Then trade 10thousand euro for GBP and earn 7,231, sell that and get 11,850, thus making 13 bucks of profit per trade. Short positions for each currency are canceled by long positions when the exposure isn’t open.
The catch is to act fast, as the inefficiencies with pricing are being corrected quickly. To exploit these inefficiencies, you have to have quotes of pricing in real-time, and you have to be able to exploit the opportunity quickly. There are available calculators to get to these changes faster.
There is a special calculator that can be used to calculate these situations. It can be found all over the internet and other tools for making finding these inefficiencies easier. Usually, brokers provide these sorts of calculators, sometimes for free, and it can be on a free trial, but they are available.
However, before going for this sort of profiting, you should practice. Demo accounts are good for that job, as always.
Due to less risk than other forex techniques or strategies, traders normally prefer to make a transaction. When the risk is too high, the trader will obviously hesitate to put money into the trade or business deal.
Forex arbitrage is the process of profitable trading between two dissimilar forex dealers. Forex (Foreign Exchange) is converting one country’s currency to another country’s currency, and ‘arbitrage’ is the term used for increasing profits with a better price difference amongst different country markets. A forex broker is a person who mediates the transactions between two different country persons.
Forex arbitrage involves a currency pair to trade, as one currency is to sell and the other is to purchase. The profits are always in four decimals, such as 0.0001$, and as the profits are so minimal, they are called Pips (Percentage in Points). The PIPs may look small, but they value more. Forex arbitrage software, released by Jason Fielder with Anthony Trister and his squad at forex collision, is used to place the trades.
How to arbitrage forex?
Forex Arbitrage is a strategy used for making money due to the inefficiency in the two currencies. This is done very fast because when the inefficiency is correct, then there is no opportunity to trade-off makes a profit. Real-time currency rates are significant for this because international market prices change in minutes and even seconds.
The most popular trades used in Forex Arbitrage are two currency trades. Now the trader will trade with two different brokers, each with its own pricing spreads. You can make a profit from each transaction by keeping in mind the difference between each broker’s prices for the same currencies in a single quote while keeping an understanding of the currency exchange rate of the two currencies. The exchange rate of the currencies has a smaller ratio than the prices, well also checked by the fluctuation of the currency rates.
There are many techniques used to speed up profits, but the simplest way to do it is with the Forex Arbitrage calculator’s help. The only problem is that they are costly, so be sure that the calculator is working properly before purchasing. The best way to save your money on a Forex Arbitrage calculator is to learn techniques from experienced traders.
The idea behind a Forex Arbitrage calculator is the same, but it only automates transactions from different brokers trading in different pairs. Some big investors have their own advisory board for huge transactions, but normally two brokers with a single Forex fair. With this software, you can keep track of 5 brokers’ pricing feeds along with each currency arbs they are working on.
Forex Arbitrage normally calculated costs from $2000 to $3000, but it also depends on the software’s quality. If it is a high-end product, then the price will be more than the standard edition. As advised earlier, before purchasing a calculator, it is better to check the demo version to give you an idea of what to expect.
Let’s take an example of how it works theoretically with three related currencies paired by the formula.
AAA/BBB x CCC/AAA = CCC/BBB
BBB = USD (US Dollar)
AAA = EUR (Euro)
CCC = GBP (Pound Sterling)
You can make profits from purchasing US Dollars and spend it but buying Euros, then once again buying Pounds Sterling by spending US Dollars and at the end by selling CCC with the pair of Euro; by making all this process a small amount of profit will be earned. You can also increase the profit by trading higher amounts for different brokers with a margin of prices.
You will probably have noticed that this technique is simple in theory but sophisticated in application. If you have patience and have complex software that can formulate huge amounts and exchange rates, then you have a little opportunity to make money because there are so many traders extracting similar information. Forex Arbitrage only supports your income, but it can not run your expenses.
Markets are dynamic, and they change every second. A trader can potentially lose or gain from any change in the markets. Executing arbitrage measures can be potentially profitable, but in certain situations, it can lead to losses. The advancement in technology has made it easier for traders to generate profits in Forex trading circles. However, caution should be exercised since the increasing number of players in the markets makes the arbitrage margins fluctuate. Such fluctuation can lead to losses exceeding the amounts deposited. Therefore, traders must check the news, prices, research, analysis, and other information about general market trends. However, they should stay away from investment advice as it may be clouded or wrong.