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We’ll break down what forex arbitrage is and how to use it to maximise your profits.

Forex Arbitrage - An Introduction

What is arbitrage?

Arbitrage is the profit that is made from the buying and selling of a particular financial asset in different markets. If a particular instrument is bought in one market at a specific price and then sold at a higher price in a separate market, the profit is then made from the difference in those price points.

Arbitrageurs, or those who use arbitrage trading strategies, exist in all forms of financial trading, including forex. Forex arbitrageurs seek to purchase currency pairs in one market as cheaply as possible to then on-sell in another market at a higher price.

Theoretically, there should be little to no risk or capital exposure in forex arbitrage trading but because not all trading is successfully executed, markets can be more or less efficient, and decisions can be made with improper information, actual arbitrageurs often experience both.

Market Efficiency and Why It Matters

According to standard, conventional understandings of market efficiency, markets should theoretically reflect the accurate value of financial instruments, such as commodities, stock prices or--in our case--foreign currencies. If all markets across the decentralised and unregulated forex market were completely efficient, the prices of each currency pair would be uniform across markets meaning that there is no opportunity for making money through forex arbitrage.

The degree to which markets are either inefficient or there is a latency in the movement of markets will determine how much arbitrage opportunity is available. The quicker and more efficient, the more difficult this sort of trading is.

In short, forex arbitrageurs are either attempting to find opportunities between markets that have either been missed or to move quick enough to take advantage of discrepancies between markets before they reach equilibrium once more.

Market Inefficiency

What causes markets to be inefficient? Asymmetric information is one of the major causes.

This means that the information available to each party is different. The buyers of a currency in one market may be better informed than the buyers in another market, and this will be reflected in the price in each market. If two financial institutions set their ask price and their bid price respectively at different levels based on different valuations of the same currency pair, an agile and savvy trader can take advantage of this inefficiency in the market to profit.

The difference between a seller’s low price (from whom the arbitrageur will buy) and the higher price offered by a buyer (to whom the arbitrageur will sell) is called a negative spread. Quick recognition and trading when a negative spread is identified is the key to successful forex arbitrage trading.

The Risks Arbitrage Trading

Arbitrage, whether in the forex market or not, seems like a pretty simple strategy and one that’s relatively easy to implement. Additionally, unlike many other trading strategies, forex arbitrage trading is both simultaneous and instantaneous in delivering a profit (when carried out successfully). Due to this fact, it is not dependent on positive market trends or increasing prices that need to be speculated to happen in the future.

So, why isn’t everyone doing this?

While theoretically risk free, arbitrage losses can occur. Often this is in the actual execution of the trade. Slippage, the difference between the trade entry and exit signals on a platform and the actual entering and exiting of clients in the market, can make attempts at forex arbitrage less profitable than anticipated, and in some cases even resulting in a loss instead.

As online technology develops and trading platforms along with it, the opportunity for successful, risk-free forex arbitrage is speedily decreasing. In the past, these opportunities may have been open for a few seconds. In modern day trading, the window can be as short as a single second. However, market discrepancies through volatile periods, errors in price quoting and various other factors can still cause market inefficiency and arbitrage opportunities.

Maximising Arbitrage Trading Profits

There are a number of strategies used to maximise arbitrage trading profits.

Arbitrage automated software

Automated software can be used by traders to attempt to identify and capitalise on brief yet profitable opportunities for arbitrage trading.

Covered interest arbitrage

This form of arbitrage trading is based on the capitalisation of interest rates differences when purchasing currencies in two different countries. Also called “interest rate arbitrage” or “carry trading” the investor uses a forward contract to cover the risk of changing exchange rates.

Triangular arbitrage

This form of arbitrage works on the same principle as regular arbitrage but involves three currency pairs, attempting to reduce the risk of loss by increasing the likelihood of price discrepancies between the three sets of prices.

Cash & carry arbitrage

Also known as spot future arbitrage, this form of trading uses the difference between the spot market and the futures market. In essence this strategy shorts the financial asset or instrument in the future market. It can also be done in reverse when the asset is bought long in the future market.

A final word on arbitrage trading

Arbitrage trading can offer traders a lot of potential to maximise profits. While not “risk-free” there are definitely many advantages to this form of trading, especially considering the diversity in market access provided by the increasingly sophisticated arbitrage automated software and general trading technology now available. Disciplined, patient, informed and attentive traders may very well be able to spot unique opportunities in the market to really maximise arbitrage trading profits.

If you’d like to find out more about forex arbitrage or this form of trading in general, don’t hesitate to get in touch with us through email, phone or on live chat.