Arbitrage trading in forex
Arbitrage trading is widely used for making a profit in different sectors, so it is crucial to understand the definition of arbitrage.
Arbitrage is a trading method where the trader will try to make a profit after noticing the differences in the prices of identical, related, or similar financial instruments available from different brokers, organizations, and companies. Various organizations are selling and purchasing financial assets like currencies to varying prices due to differences in costs, profit margins, demand, supply, and other reasons.
Typically Arbitrage usually involves purchasing the asset from the organization selling at a low price, and almost immediately selling the asset to the organization purchasing at a high price for a profit.
The trader is taking advantage of the differences in the prices quoted by the financial organizations. Since the asset is sold almost immediately after it has been purchased, arbitrage is considered low risk for the trader. Yet there is some risk involved in this type of trading if the prices are fluctuating rapidly or the market liquidity levels are low. Many Forex traders would like to find out what is arbitrage trading in Forex, so a detailed explanation is provided below.
Understanding arbitrage trading
It is possible to make a profit with arbitrage trading because the financial markets are not perfect and efficient. The price of any asset in the financial market depends on the demand and supply of the asset. Hence any change in the supply or demand can result in a decrease or increase in the price of the asset. The arbitrage traders try to make a profit from the temporary glitches in the financial asset values in the markets. The traders will try to be the first to spot the differences in the asset prices, which may occur if there is any mismatch in the demand or supply levels in the exchanges dealing with these assets.
Once the trader notices the difference, he could quickly make a profit, without taking much risk. Traders may use a trading system that is automated as part of their strategy for arbitrage trading. These automated systems incorporate algorithms, which detect the price discrepancies immediately and alert the trader. Hence the trader can exploit the price differences to make a quick profit. After some time, other traders will also notice the difference, and the prices of the asset in the market will get adjusted accordingly.
Types of arbitrage – forex arbitrage opportunities
Forex arbitrage can be classified into three main categories
Two currency arbitrage involves making a profit from the differences in the prices quoted for the currency pairs; It does not consider the differences in the prices of the currencies in the pair which is considered.
Triangular arbitrage utilizes the differences in the prices of three different types of currencies. The asset in one currency is converted into two other currencies before it is converted back into the original currency to make a profit.
Covered-interest arbitrage involves making a profit from the differences in the interest rates in two countries. The trader will use a forward contract for hedging and reduce the risk caused by fluctuations in the exchange rate.
Two-currency arbitrage is the most popular form of forex arbitrage. The trader will trade the same currency pair with different forex brokers to make a profit from the differences in prices of the currency pairs. The EUR/USD currency pair is the most widely traded. The selling price and buying price of the different banks may be different. If the selling price for one bank A is lower than the buying price of another bank B, the trader can purchase Euro from bank A paying dollars and sell the Euro to Bank B for a dollar profit. However, the trader should act fast since other traders will also notice the difference in prices.
When many traders try to make a profit from the same difference in bank rates for a currency pair, due to the increase in demand, Bank A will increase its price, and Bank B will decrease in price due to increase in supply, till both the banks offer similar prices.
Banks are quoting different prices for currency pairs based on supply and demand. So in triangular arbitrage, the trader is exchanging the currency pairs in three banks, hoping to make a profit using the difference in the prices. Exchanging the currencies in the same bank will not result in a profit since banks have an efficient system for pricing currencies and do not allow the traders to make any profit using arbitrage. Usually, the commonly traded currency pairs are the USD/EUR, EUR/GBP and GBP/USD, and the trader should monitor the exchange rates offered by different banks. The trader should also consider the transaction costs which the banks will charge for currency conversion, which may reduce the profit.
In Covered interest arbitrage, the trader exploits the differences in the interest rate of two currencies to make a profit. The trade will also use a forward contract so that they can control the risk they are exposed to. The forward contract allows the trader to purchase currency at the market rate at present, and also fix the exchange rate at a future date. A detailed explanation of the strategy for interest arbitrage for EUR/USD is as follows:
– Determine how much higher the Eurozone interest rates are compared to the US interest rates
– Using the available amount of US dollars, the dollars are converted into euro at the spot price, and the euros are invested at a higher rate in euro-zone. The trader should also arrange for a forward contract that specifies the exchange rate for EUR/USD to protect the investor against any fluctuation in the exchange rate during the duration of the investment.
– The trader will receive an interest in euros
– the euros can be converted back into US dollars at the guaranteed exchange rate, ensuring that the trader makes a profit.
How to make money from currency arbitrage ?
This is very hard because these day’s brokers have the same prices across all currency pairs. Even the small differences in prices, because spreads, it is almost impossible to make a profit from currency arbitrage.
Arbitrage in forex trading involves exploiting the forex market inefficiencies to make a profit without taking much risk. Only high equity accounts with proper technology can do this.