What Is Forex Arbitrage?

Strategy, focused on currency mispricing across different brokers or global exchanges.

How does forex arbitrage work?

copy trading mechanism High-frequency arbitrage trading is effective even under unpredictable market conditions as it does not rely extensively on price trends; rather, it relies on currency mispricing through various foreign exchanges. Such opportunities are referred to as arbitration and may help to close market pricing gaps.

Trading arbitrage lets the investors know that there are price imbalances. When trading has started and an inflow of either buying or selling of assets has emerged in an exchange, a price gap may emerge. The strategy of arbitration not only helps private investors who profit from the broker or exchange. It also leads to adjusting trading prices across various financial markets, putting the currency pair levels into equilibrium. In turn, exchanges are informed of the mispricing and, as a response, adapt it to market prices, adding stability back to markets.

Types of arbitrage trading strategies

Different forms of arbitration techniques are utilized by traders and investors in the financial sector to benefit from fluctuations in exchange rates. Here is a list of the most popular and productive forms of arbitration.

  1. Triangular Arbitrage
  2. Statistical Arbitrage
  3. Latency Arbitrage
  4. Cryptocurrency Arbitrage
  5. Currency Arbitrage
  6. Futures Arbitrage
  7. Capital Structure Arbitrage
  8. Cash Carry Arbitrage
  9. Fixed Income Arbitrage
  10. Relative Value Arbitrage
  11. Swap Arbitrage
  12. Options Arbitrage
  13. Gold Arbitrage
  14. Rental Arbitrage
  15. Sports Arbitrage
  16. Credit Card Arbitrage
  17. Regulatory Arbitrage
  18. Volatility Arbitrage

Below you'll find brief explanation of top 3 ones.

Triangular arbitrage is a trading strategy which takes advantage of the price differences between three currencies in the forex market. It is also known as three-point arbitrage or cross currency arbitrage. The price discrepancies arise in situations where one market is undervalued and another is overvalued. Triangular arbitrage trading strategy is executed by converting first currency into second, then second currency into third and finally converting the third currency back to first. All these transactions are done by trading algorithms in a matter of seconds. Triangular arbitrage opportunities are very rare in real world as foreign exchange markets are highly sophisticated and competitive with large number of players. These transactions require large trading amounts as the price difference between currencies is limited to few cents. Due to this, such opportunities can only be exploited by high frequency traders with low transaction costs. Using high speed algorithms these traders can easily find the mispricing and immediately execute the necessary trades.

Statistical arbitrage is an algorithmic trading strategy used by many investment banks and hedge funds. It is not a high frequency trading strategy. It can be categorized as medium frequency where trading occurs over the course of a few hours up to few days. This type of arbitrage uses mean reversion to exploit the price movement across thousands of financial instruments by analyzing the price anomalies between these instruments. These algorithms are designed by using complex statistical methods and data mining. Statistical arbitrage is an advanced version of pairs trading where the stocks are traded in pairs based on some similarities. When the first stock outperforms the second stock in the pair, the second stock is bought and the entire position is hedged by shorting first stock.

Latency arbitrage is mostly associated with high frequency trading and it refers to the fact that different people or firms get market data at different times. These time differences are known as latencies. These differences can be as small as a nanosecond, but they are crucial in the world of high speed trading. Latency arbitrage occurs when the high frequency trading algorithms earn profit by making trades split second before other traders.

Example of arbitrage in financial markets

There is a very small gap in certain capital markets between the buying price and the selling price of an asset, which is called "spread". However, this specific instrument can be exchanged around the planet. Prices can fluctuate briefly, allowing an arbitrator the chance to make a profit by purchasing it in one market and selling in other markets.

Suppose the market for US dollar in the UK is: £1 = $1.4001 and in Japan £1 = $1.4001
If there was a sudden increase in demand for Sterling in the UK the £ would rise in the UK £1=$1.4190.
If markets are not perfectly competitive, there may be a lag effect so that £ is cheaper in Japan (stay at £1 = $1.4001).
Therefore, you could buy £ in Japan and then immediately sell them in UK markets. This would give you a small but guaranteed profit. As arbitrageurs do this it will help bring the two markets into line. The speed with which markets are brought into line depends upon how many market participants seek to do this.

Is forex arbitrage illegal?

While the normal practice of front-running sees the broker trade ahead of his or her client and is against the law, the latency arbitrage sees main investors take advantage of faster connections to exchanges, relative to other market participants, and it is not illegal.

Software used for arbitrage

Since arbitrage trading conditions tend to persist for traders for a rather short period of time (often just a few seconds), it is very time-consuming to make arbitrage calculations by hand. Traders therefore need advanced Forex arbitration tools that can immediately identify and, ultimately, quantify arbitrage opportunities. We can define three categories of software applications that are widely used for arbitrage trading within the FX community:

The first form of technology used in arbitration trading is algorithmic trading software. This sort of arbitration software is installed directly on a brokerage trading platform such as MetaTrader 4 or MetaTrader 5. Whenever the arbitrage trading program detects an arbitrage conditions, it shall immediately execute the necessary transactions on behalf of the trader.

Some traders tend to make the final FX trading decisions themselves, they may use market notification tools instead. Unlike automated Forex arbitrage trading applications, this category of software continuously checks different stocks, instruments or brokers for the purpose of arbitrage trading opportunities. If such an opening is found rather than the transaction being carried out automatically, the trader would be notified of the opportunity, who will then decide whether to place the trade.

There are a range of traders who, instead of operating their own software systems, rely on what is regarded as the "remote alert service". Access to such service allows them to receive an automatic trading opportunity notifications in the same manner as they would integrating their own software programs. The difference here is that alert signals are given by software running at another location, outside the trader's own network or computer which may expose privacy concerns and can lead to significant delays.

Does arbitrage opportunity still exists today?

Through the rise of different technologies and platforms, there’s an increasing number of high-frequency trading. These platforms use advanced technology and are dedicated to initiating trades automatically. As a result, the increase in the level of high-frequency activity has increased efficiency without harming the integrity of the market. However, possibilities still exist today for any type of arbitrage opportunity, if at least two of the below conditions is true:

  • The same asset is traded in different markets at different prices
  • Two assets with the same cash flow are traded at different prices
  • There is a considerable difference between the expected future price and the current price of an asset
  • Low or zero transactional costs in purchasing assets
  • Low or zero transaction costs in exchanging currency

When you buy an asset in a cheaper market, it increases the demand and the price of that asset. When you sell the same asset in an expensive market, it increases the supply and decreases the price of that asset. Doing this repeatedly will result in price convergence across the markets and eliminating different types of arbitrage opportunities.

How to profit from latency arbitrage strategy?

As a retail trader, you may notice that coming across brokers suitable for forex latency arbitrage is a bit tedious task. In order to gain consistent profits with this strategy, it is recommended to find a good combination of a Fast Price Feed Provider (Fast Broker) and a Slow Trading Broker. The account performance with the latency arbitrage expert advisor depends on the Internet speed, geographical standpoint of your PC system and the hardware on which MetaTrader terminal is run. The smaller the ping to the Fast Price Feed Provider (Fast Broker) and the greater the Ping to the Slow Broker, the better the performance of the Expert Advisor used for arbitrage will be.

Conclusion

The forex market is considered the largest financial market globally. Trading in pairs is one of the most common strategies some traders may shy away during times of volatility. Thankfully, specific strategies, such as high-frequency trading, can help whether such conditions and, at the same time, help close market gaps and increase efficiency.

Related article: Which are successful forex trading strategies?