What Is Forex Arbitrage?
Strategy, focused on assets mispricing across different brokers or global exchanges.
How does forex arbitrage work?
Arbitration is a trading strategy that involves taking advantage of differences in prices between slow and fast brokers. By knowing in advance how the market will react to these price differences, investors can make profitable trades by buying or selling assets in the right direction.
High-frequency arbitrage trading can be effective even in unpredictable market conditions, as it relies on mispricings between foreign exchanges rather than market trends. When there is an inflow of buying or selling in an exchange, price imbalances may occur, creating opportunities for arbitration to close these gaps.
Types of arbitrage trading strategies
This a technique used by financial traders and investors to profit from changes in exchange rates. There are several different types of arbitration, and the following list includes some of the most popular and effective ones.
- Triangular Arbitrage
- Statistical Arbitrage
- Latency Arbitrage
- Cryptocurrency Arbitrage
- Currency Arbitrage
- Futures Arbitrage
- Capital Structure Arbitrage
- Cash Carry Arbitrage
- Fixed Income Arbitrage
- Relative Value Arbitrage
- Swap Arbitrage
- Options Arbitrage
- Gold Arbitrage
- Rental Arbitrage
- Sports Arbitrage
- Credit Card Arbitrage
- Regulatory Arbitrage
- 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?
Front-running, which is when a broker trades ahead of their client, is illegal. However, latency arbitrage, which involves taking advantage of faster connections to exchanges relative to other market participants, is not illegal.
Software used for arbitrage
Arbitrage trading opportunities tend to only last for a short time, often just a few seconds. This makes it difficult for traders to manually calculate arbitrage opportunities. Instead, they need specialized software that can quickly identify and quantify these opportunities. There are three main categories of software that are commonly used for arbitrage trading in the foreign exchange market:
- Automatic Trading Software
- Notification Programs
- Remote Alert Services
The first type of technology used in arbitrage trading is algorithmic trading software. This software is installed on a brokerage platform, such as MetaTrader 4 or MetaTrader 5. When the software detects an arbitrage opportunity, it will automatically execute the necessary trades on behalf of the trader.
Some traders prefer to make their own trading decisions and may use market notification tools instead of automated software. These tools continuously check for arbitrage opportunities in different stocks, instruments, or brokers. If an opportunity is found, the trader is notified, and they can decide whether to place the trade. Unlike automated software, these tools do not automatically execute trades.
There are a range of traders who use a "remote alert service" instead of running their own software. This service allows them to receive notifications of trading opportunities in the same way as if they were using their own software. The difference is that the alerts come from software running on another network or computer, which can raise privacy concerns and cause 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, it can be difficult to find brokers suitable for forex latency arbitrage. To be consistently profitable with this strategy, it is recommended to find a combination of a fast price feed provider (fast broker) and a broker with a misconfigured or lagging trading server (slow broker). The success of your arbitrage strategy depends on your internet speed, the location of your computer, and the hardware on which you are running the MetaTrader terminal. The better the performance of the Expert Advisor used for arbitrage will be, the smaller the ping to the fast broker and to the slow broker.
The foreign exchange market is the largest financial market in the world. While some traders may avoid trading currency pairs during times of volatility, specific strategies such as high-frequency trading can help to navigate these market conditions and improve efficiency by closing market gaps.
Related article: Which are successful forex trading strategies?