Skerdian Meta • 5 min read
Arbitrage has been in practice since ancient times. Arbitrage is a speculative strategy, where someone attempts to profit from price differences of the same instrument either in the same market or in different markets. It involves buying and selling an asset at two different prices in order to profit from the difference.
Finding the right conditions and applying an arbitrage strategy is not easy because everyone is looking for a loophole in the market in order to make a profit. Therefore, by the time it comes to your attention, someone else may have already placed a trade and closed. So, arbitrage trading is mostly a strategy for market participants with the best and quickest information and technology systems.
Arbitrage can be applied when the same product has two different prices.
What is forex arbitrage trading?
Financial arbitrage consists of buying and selling a product or financial instrument (or two very similar instruments) as quick as possible, profiting from the price difference. You buy the instrument when you see it costs less in a market and then sell it in another market or in the same market where it costs slightly more. The markets are not perfect and there are inefficiencies, and these are what create arbitrage opportunities.
In fact, arbitrage minimizes market inefficiencies because if a product is undervalued, the arbitrage players will immediately jump to increase the demand for it and increase the price. As the price of the product goes up, the demand will decrease and the supply will increase until they reach a balance and the price of the product reaches the right value.
In theory, there are three conditions to be met for a trade to be considered ‘arbitrage’ but in practice, they may be bent a little.
- The price of the same or similar products is different depending on the markets.
- The price of two or more products with identical cash flow is different depending on the markets.
- The actual price of a product is different from the future price discounted at the interest rate.
Arbitrage might occur as two-way or multiple ways, but for convenience and comprehension, the literature refers to multiple arbitrages as ‘three-way arbitrage’. We´ll refer to them as two-currency and three-currency arbitrage.
Arbitrage seems easy but it is often very difficult.
How arbitrage works
There are many types of arbitrage, such as labor arbitrage between one or two markets. The labor price and demand between the East and West European member states are different. That´s why many Eastern Europeans take their labor to West Europe and close the arbitration gap. This is labor arbitration within one market. The difference between the EU and African labor markets is an arbitrage in different markets. This is just a simple example to help explain how arbitrage works.
In forex trading, arbitration is considered when you buy a currency pair in an exchange that offers a lower price, and then sell the same pair again in another exchange, hence the term “two-currency arbitrage”. For example, you have accounts with two different brokers and they offer a slightly different price for EUR/USD; broker X has an exchange rate of 1.1010 while broker Y has a rate of 1.10.
If you buy ten EUR/USD with the second broker you´d get 909,090 EUR for 1,000,000 USD. If you then sell the Euros to a second broker at a rate of 1.1010, you´d get $1,000,909. You just made $909 by arbitrage. If both of the brokers have a 1.5 pip spread for this pair, the transaction costs would be $300 for this amount, which would leave you with a $609 profit.
A 10 pip rate difference is not very common, but you can find 1-4 pip differences for the same pair amongst many brokers. I often see 1-3 pip rate differences between Oanda and ETX Capital for the same exotic currency pairs, but since the spread for these pairs is often above 5 pips the arbitrage strategy is not feasible.
For more on currency trading strategy:
As we said above, arbitrage can be used even when there are rate differences between several pairs. To make it simple though, we´ll explain the triangular arbitrage. This is a bit more complicated than the two-way arbitrage but the logic is the same. For example, three different brokers have the following rates for the certain pairs:
The trader who is trying to apply arbitrage buys $1,000,000, which means selling 10 lots USD/CHF to broker X. Now he has 817,100 CHF. Then he sells 817.100 CHF in exchange for British Pound Sterling on the broker Y which would give him 686,062 CHF. As a final step to complete the triangular arbitrage, the trader changes the GBP back into USD, ending up with US$ 1,005,081 (686,062 x 1.465), which means a $4,631 profit if the brokers have a 1.5 pip spread for all these pairs.
This type of arbitrage is not easy because it requires fast calculations to understand if there´s profit to be made. However, the rates change all the time, and so it is impossible for a human to calculate.
Risks of forex arbitrage trading
Arbitrage sounds like an easy and very profitable trading plan, but it´s not very easy in real-life trading. There are certain downsides or risks when you try to do arbitrage. The biggest risk of arbitrage is the execution process. When you execute the opening, and, especially the closing of the two trades, you have to execute them instantly – otherwise, you risk carrying the price difference between the entrance or exit of both trades. If the sell trade closes above the buy trade then the difference is a loss for you.
For instance, you sell EUR/USD at 1.20 with one broker and buy at 1.1997 with another broker to profit from the price discrepancy. Then you try to close them when the price of both brokers has reached 1.1210, which means losing 10 pips from the first trade and winning 13 pips from the second. The problem is that sometimes the execution might take a few seconds. So, if the buy trade closes immediately at 1.2010 but the sell trade closes a few seconds later at 1.2015 you will lose 15 pips from the second trade, which means a 2 pip loss in total. Opening the trade faces the same risk.
Spread is another risk; many brokers have fluctuating spread which narrow and widen. The spread might be 1.5 pips on both brokers, meaning 3 pips in total for two trades. There is a 5 pip price discrepancy for the same pair between both brokers. This seems like a good deal, but when the spread widens to 3 pips when you are trying to close the trades you will pay 6 pips for the spread and win 5 pips from arbitrage, leaving you with a one pip loss.
Arbitrage offers nice winning opportunities, but they are very rare for the normal trader. It also requires large amounts of funds and high leverage to maximize the profit from small discrepancies of the same pair. High-frequency trading firms are the ones that take advantage of this and make the most profit. The high-speed trading systems can detect small price gaps and close them quickly. That adds liquidity and brings the market as close as possible to perfection.