What is arbitrage trading?
Arbitrage trading represents simultaneously buying and selling identical financial instruments in different markets or different forms to profit by exploiting the price differences. For example, if a trader can buy the stock of Company Y at $100 on the New York Stock Exchange (NYSE) while, at the same moment, sell at $100.06 on the London Stock Exchange (LSE), a trader can earn a profit of 6 cents per share.
Now let us see how the arbitrage process will look like in the forex trading market.
What is Arbitrage Trading in Forex?
Arbitrage trading in forex represents buying and selling identical or similar currency pairs in different markets or different forms to profit by exploiting exploit price discrepancy. For example, a trader can buy EURUSD and sell at the same time USDCHF (a highly correlated currency pair); or a trader can buy a sport currency EURUSD and at the same time sell EURUSD futures contract.
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 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 at varying prices due to differences in costs, profit margins, demand, supply, and other reasons.
Typically Arbitrage usually involves purchasing the organization’s asset, 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 a low risk for the trader. Yet, there is some risk involved in this type of trading if the prices fluctuate 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 profit 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 decrease or increase the asset’s price. The arbitrage traders try to 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 profit from the currency pairs’ differences in prices. 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 another bank B’s buying price, 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 an 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 exchanges the currency pairs in three banks, hoping to make a profit using the prices’ difference. Exchanging the same bank’s currencies will not 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 that the banks will charge for currency conversion, reducing the profit.
In Covered interest arbitrage, the trader exploits the differences in two currencies’ interest rates to make a profit. The trade will also use a forward contract to 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 the euro-zone. The trader should also arrange for a forward contract that specifies the exchange rate for EUR/USD to protect the investor against fluctuation in the exchange rate during the investment duration.
– 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 with the small differences in prices, it is almost impossible to profit from currency arbitrag because of spreadse.
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.