forex-arbitrage-trading

There are different ways to make money in the Forex market, include the use of currency arbitrage strategies.

In Forex, people attempt to make profits by anticipating the future direction of a market.

But do you know that there is a way for you to profit from the Forex market without necessarily having to correctly pick the direction of a currency pair?

If you didn’t know, you should know that!

You will be shocked to realize that there are a many market-neutral strategies that you can use to benefit from the Forex market.

And, the least risky of all these strategies is currency arbitrage.

In this article, I will be taking you through Forex currency arbitrage strategies.

Let’s get started…

What are currency arbitrage strategies?

Arbitrate is the process of purchasing and selling two equivalent assets simultaneously for a risk-free profit.

Other than the forex market, this trading strategy is highly employed in other financial markets such as the stock market, commodity, and options market.

Basically, arbitrage works by taking advantage of irregularities or discrepancies in any financial market.

Traders look for market conditions that allow them to take small, risk-free profit when traded correctly.

Forex arbitrage, just like arbitrage strategies in other markets, depends on these discrepancies, which occur occasionally when markets trade inefficiently.

The aim of arbitrageurs is to buy in one market and sell an equivalent size in another interrelated market, to take advantage of the price difference between the two.

In most financial markets, similar products trade differently in different places.

The flow of information to different parts of the world is not perfectly instantaneous, and different markets don’t trade with complete efficiency.

So, there will always be price differences in different markets.

A trader who notices the difference in price of a commodity in different markets can buy the commodity on the market with the cheaper price and sell it on the market with the higher price.

The difference in the price of the commodity between the two markets will determine the amount of profit that the trader makes.

But why did I give you the above explanation?

Because traders seeking to arbitrage Forex prices do the same thing that I have described above.

Their goal is to purchase a cheaper version of a currency, while simultaneously selling a more expensive version.

Their profit is the difference between the two prices minus the transaction costs.

Different Forex arbitrage systems may operate differently, but the essence remains the same.

The goal is to exploit the anomalies in prices of currencies.

Initially, arbitrage trade calculations were done largely by hand or hand-held calculators.

Today, these are done in a number of ways including purpose made software programs, forex arbitrage calculators, and even on trading platforms.

Because of the increase in the number of such programs, the efficiency of financial markets has increased, reducing the number of arbitrage opportunities in the forex market.

Traders use different ways to arbitrage the forex market.

One of the common arbitrage techniques involves buying and selling spot currency against the corresponding futures contract.

Another technique employed by traders to arbitrage the Forex market is triangular arbitrage.

The technique takes advantage of discrepancies in exchange rate using three related currency pairs.

Other complicated ways to arbitrage forex market involve combining currency options, futures, and spot.

However, it requires a significant initial margin deposit to execute since it requires the selling of options.

You must also understand all the three markets in order to identify and execute the arbitrage when it sets up.

How to use the Forex Arbitrage System

Before the proliferation of computers, arbitrageurs working in financial institutions like banks used a pencil and a hand-held calculator to work out their numbers.

Nowadays, arbitrageurs use software programs to accurately identify and act on irregularities in the financial markets.

These software programs are capable of identifying and executing trades automatically.

When it comes to retail currency traders, this forex arbitrage program comes as an Expert Advisor (EA) that works within an advanced forex trading platform like MetaTrader 4 or 5.

The EA watches the forex market constantly, and when it identifies an opportunity for forex arbitrage, it automatically executes the trade.

This way, traders have high chances of locking in an arbitrage profit, and they are able to take advantage of a fleeting opportunity.

However, a good number of traders don’t feel comfortable with automatically executed trades, hence, they prefer making their own trading decisions.

Majority of such traders use trade alert or signal software.

The software, just like the EA, scans the market constantly to identify arbitrage opportunities.

However, after identifying a viable arbitrage opportunity, it doesn’t execute the trade automatically, but it alerts the trader.

The trader can then choose to execute the trade or not to.

Traders who use their own arbitrage software programs can also subscribe to remote signal alert services.

The remote signal alert services alert the trader’s software whenever an arbitrage opportunity arises in the market.

The trader’s software can then alert the trader regarding the arbitrage opportunity or execute the trade automatically.

Of course, this will depend on the kind of software that the trader is using.

Currency Futures Arbitrage Strategies

This is one of the available currency arbitrage strategies.

Because of differences in interest rates, currency futures tend to sell at a discount or at a premium.

This depends on how wide the interest rate differs between the currencies of the two countries involved.

For example…

Suppose a trader has a currency futures contract for the Sterling Pound quoted against the U.S dollar.

UK has a pertinent interest rate of two percent, while the U.S rates are at one percent.

This means that the Sterling would trade at a forward discount relative to the spot rate.

This is caused by the carrying cost differential of one percent since it will be better off for a trader to buy the Sterling spot and hold it until the value date compared to buying it forward against the Dollar.

We now need to use the above figures to demonstrate how a six-month futures contract for Sterling can be arbitraged against the spot market.

We will use the following contract and market parameters:

  • The spot rate for GBP/USD is trading at 1.2500.
  • The 6-month futures contract for GBP/USD is trading at 1.2400.
  • The GBP has a 6-month interest rate of two percent.
  • The USD has a 6-month interest rate of one percent.
  • The contract size is 1,000 currency units.

It’s possible to convert the futures contract at the option of the contract seller into physical currency at the stated exchange rate after the futures contract has matured in six months.

The trader who bought the GBP/USD futures contract will receive £1,000 then deliver $1,240 after the maturity of the contract in six months’ time.

The trader can then sell the Sterling forward against the U.S Dollar against the long futures contract.

Alternatively, a deposit of £990.00 could have been made at two percent for two months.

On the side of the U.S dollar, a trader would have borrowed $1,237 or the amount £990.0 would buy at a spot rate of 1.2500.

A synthetic future would have been created to convert £1,000 into $1,237 within six months with the current cost of $1,237.

To an arbitrageur, these numbers mean that the futures contract is trading a bit higher than it should be by three dollars per thousand.

The arbitrageur can then establish the arbitrage by selling the futures contract for 1.2400 and buying the spot with a net profit of $3.00 per thousand once the futures contract matures.

The $3.00 doesn’t seem to be a large profit on the trade.

The reason is because of the size of the amount.

It seems small when the size of the amount is small.

However, when you do the transaction in a large amount like $100,000,000, then you will get a much more respectable profit of $300,000.

Forex Triangular Arbitrage

The forex triangular arbitrage also belongs to the group of currency arbitrage strategies.

It is a common currency arbitrage technique among most market makers and professional traders who specialize in cross currency pairs.

These traders use triangular arbitrage as a way of locking in profits when the market driven cross rate deviates from the observed exchange rates for each component currency versus the U.S Dollar.

It is a popular currency arbitrage strategy that takes advantage of the fact that the exchange rate for the currency pair is mathematically connected to that of two other currency pairs.

Once the triangular arbitrage locks in the profit, there will be no further market risk.

However, the cross currency trader will still be facing the counterparty risk, which will manifest into a serious problem in case of a failure of delivery on any leg of the three part transaction.

However, it’s a very low risk among creditworthy and well-established professional counterparties.

Traders doing triangular arbitrage try to execute each leg of the three part transaction simultaneously as they can.

In addition to considering the costs of crossing any applicable bid off spreads to enter into the position of triangular arbitrage, the traders should also consider their transaction costs to ensure that they are locking in profits.

The less the transaction costs, the higher the profitability.

Higher transaction costs means less profits.

So, in a triangular arbitrage, three currencies are involved.

Traders use a mathematical formula in order to express the exchange rate for cross currency pair as a function of the exchange rates for the other two related currency pairs that have the U.S Dollar.

This is shown below…

CCY2/CCY3 = USD/CCY3 x CCY2/USD

In the example given above, the USD is the U.S Dollar, the CCY2 is the base currency in the cross currency pair, while the CCY3 is the counter currency in the cross currency pair.

Additionally, the term CCY2/CCY3 denotes the cross exchange rate for the counter currency CCY3 expressed in terms of base currency or CCY2.

The trader is allowed to include any relevant transaction costs that can be applied into computing an effective exchange rate.

The arbitrageur does the useful service of bringing the markets back in line, then locks in a modest profit at the same time for their trouble.

This is a rare opportunity for most retail forex traders, but it’s possible for them to sometimes perform triangular arbitrages between the rates that have been quoted by the different online forex brokers.

Statistical Arbitrage in Forex Trading

Currency arbitrage strategies take advantage of currency price discrepancies.

Statistical arbitrage in forex involves looking for profit opportunities that arise as a result of discrepancies in exchange rates as determined by predicted or historical norms.

Some traders choose to call it spread trading instead of arbitrage.

The reason is that technically, it does not involve locking in a risk-free profit the way other arbitrage strategies do.

Unlike other Forex market arbitrageurs, statistical arbitrage traders take risk with their positions because the spreads between the currency pairs that they are seeking to exploit may widen or narrow.

Majority of the forex statistical arbitrage traders rely on mathematical modelling techniques and historical statistics made up of normal spreads between different currency pairs to know the spreads that are out of line.

Such spreads should show narrowing over time.

The traders will then sell the overpriced currency pair and buy the underpriced currency pair.

If a trader chooses to do statistical arbitrage, he will need to take time to familiarize himself with the analytical and mathematical methods used to identify the arbitrage opportunities.

They may also have to learn how to use or develop some computer systems to help them in this process.

Those are some of the ways that traders can use to ensure that they succeed in statistical arbitrage.

Remember that forex is a competitive marketplace, hence, your goal should be to become the best trader.

This requires you to diversify your trading skills.

How to Choose the Best Currency Arbitrage Strategy

We have discussed a number of currency arbitrage strategies.

The best currency arbitrage strategy to use for your situation will be determined by the markets that you have access to, and whether or not you need to take risk as an arbitrage trader.

For example…

A market maker and a professional cross currency trader will almost certainly be doing triangular arbitrage between his cross currency pair and the other two currency pairs that have similar currencies quoted versus the U.S Dollar.

A trader who has access to the currency futures market on the other hand may instead choose to engage in futures arbitrage if they can handle large enough amounts, have small transaction costs, and be capable of identifying arbitrage opportunities virtually in real time.

Finally, a retail forex trader who doesn’t have access to the above opportunities for arbitrage may be in a position to arbitrage quotes at different forex brokers to do triangular arbitrage.

Without this, the traders will only be capable of statistical arbitrage since he will not have access to inter-bank pricing, futures markets, or clients who deal on their bid offer spreads.

It also means that their arbitrages will involve taking the risk of the spreads that they perceive to be widening instead of narrowing depending on their statistical analysis.

When deciding on whether to venture into arbitrage or when choosing the right arbitrage strategy from the various arbitrage strategies, you have to know that most arbitrages are done in a size that is large enough to maximize profits.

Also, if your transactions are small enough to perform arbitrages with, you only have the potential to make a modest amount of income, which may not interest you at all.

So, the size of an arbitrage is of great importance as it determines the amount of profit that you will make.

Types of Forex Arbitrage Calculators

The most popular example of triangular arbitrage is done by professional EUR/JPY cross traders when running their bread and butter business.

Once they spot a large trade go through in one of the three related currency pairs of EUR/JPY, EUR/USD and USD/JPY, the relationships between the markets gets sent briefly out of line.

The big trade is then assimilated into the exchange rates.

For example…

A trader who chooses the USD/JPY triangular arbitrage can feed the following transactions into an Excel Spreadsheet to help them in performing the following transactions in every currency pair to give a locked in profit…

  • Buy 1,000,000 EUR/USD at 1.2500

= Long 1,000,000 Euros, Short 1,250,000 U.S. Dollars

  • Sell 1,000,000 EUR/JPY at 140.00

= Short 1,000,000 Euros and Long 140,000,000 Japanese Yen

  • Buy 1,200,000 USD/JPY at 124.00

= Long 1,150,000 U.S. Dollars and Short 148,800,000 Yen

  • Net Position or Profit

= Long 100,000 Yen at a rate of 123.00 for USD/JPY = US$813.01

For a retail trader trying to do a triangular arbitrage between various online brokers, they can use an online arbitrage calculator.

A good example of a website from which you can get such a calculator is Forexop.

The website also provides an online calculator that helps traders determine whether there exist profitable futures versus spot arbitrage opportunities.

How to use an Arbitrage Trading Program

An arbitrage trading program can help you when trading any of the various currency arbitrage strategies.

The arbitrage trading software or ATP is made up of a computer software that forex traders can use to enter orders simultaneously for cross rate, spot, and currency futures contract.

It is mostly used by bank or institutional traders since it helps them execute large volume transactions in order to maximize arbitrage profits.

When dealing with a futures arbitrage, the arbitrage trading program will enter either a short or long trading position on an exchange traded futures contract, and the other order will involve taking an opposite position in the forex spot market, or with an online forex broker.

See the arbitrage trading program as a form of program or algorithmic trading in which automated computer programs take the responsibility of executing trades in the markets.

They play a significant role in relieving traders of the trading burden, making their work much easier.

The programs follow a predetermined set of algorithms or rules during the execution of trades, depending on an identified opportunity to profit from an existing arbitrage between markets.

Problems with Forex Arbitrage

The problems of forex arbitrage result from the number of people using the strategy.

Basically, arbitrage relies on price differentials, and these price differentials are determined by the actions of arbitrageurs.

So, what will happen when there are many participants in the arbitrage?

This is what will happen…

Instruments that are overpriced will be pushed down in price by selling.

The underpriced instruments will be pushed up in price by purchases.

This means that the price differential between the two will reduce.

Remember that the arbitrageurs rely on the price differential for profit.

When the price differential disappears or becomes too small, the arbitrage will no longer be profitable to the traders.

This means that the arbitrage opportunity will dwindle.

It is a good thing that there are many participants in the Forex market.

However, it also means that any arbitrage opportunities will be discovered quickly and exploited.

This means that only the quickest player will profit in Forex arbitrage.

If you want to profit, the fastest price feeds are essential.

This means that your goal should be to execute your trades at a very high speed.

Always remember that when doing Forex arbitrage, you will be competing with the fastest traders in the world.

And now that you know that the execution speed marks the difference between successful and failed arbitrageurs, you must do what it takes to ensure that you attain the right speed.

The best way to achieve this is by choosing the right arbitrage software.

This will ensure that you remain on the competitive edge, increasing your chances of running successful arbitrage trades.

Again, it will be good for you to try out different strategies before you can begin to trade with real money.

You will have chances of choosing the right strategy from the various arbitrage strategies.

Also, due to the speed of the modern markets, it means that you will be using an automated trading system to become a successful arbitrageur.

There are many arbitrage trading software out there.

It’s up to you to choose the one that meets your trading needs.

Ensure that you choose a feature-rich arbitrage system for your trades.

Conclusion:

This is what you’ve learned in this article…

  • Most people think that the only way to profit from the forex market is by anticipating the future direction of the market.
  • However, with Forex arbitrage, you don’t have to pick the correct direction of the forex market.
  • It involves buying a cheaper version of a currency and simultaneously selling it at an expensive price.
  • The difference between the prices minus the transaction costs marks the amount of profit that the arbitrageur earns.
  • The goal of any arbitrage system, including the forex arbitrage system is to exploit price anomalies in the market.
  • There are different forms of currency arbitrage strategies in forex.
  • Forex triangular arbitrage involves offsetting trades so as to profit from price discrepancies in the forex market.
  • The traders lock in profits once the market driven cross rate differs from the exchange rates observed for every component currency against the U.S. Dollar.
  • It takes advantage of the fact that the exchange rate for the currency pair is mathematically connected to that of two other currency pairs.
  • The traders try to execute every leg of the three part transaction simultaneously as they can.
  • To lock in profits, such traders must consider the transaction costs.
  • Forex statistical arbitrage follows a quantitative approach to find price differences that are statistically more likely to be correct in the future.
  • It compiles a list of over-performing pairs and a list of under-performing currency pairs.
  • The goal of the arbitrageur is to short the over-performers and purchase the under-performers.
  • The major problem associated with forex arbitrage is the number of people taking part in the arbitrage.
  • When the arbitrageurs become too many, the price of overpriced instruments will be pushed down by selling while the price of underpriced instruments will be pushed up by buying.
  • The price differential between the two will become too small, and the arbitrage will no longer be profitable.
  • The size of the arbitrage determines the amount of profit that you make.
  • To make a substantial amount of profit, make sure that you run transactions that involve a large amount of money.
  • Different arbitrage systems have been developed to aid your work as an arbitrageur by automating various tasks. Choose the one that suits your needs.
  • The systems relieve arbitrageurs of the many tasks involved in forex arbitrage.
  • They also facilitate a faster execution of transactions on the forex market.
  • Since speed is important in forex arbitrage, choose an arbitrage program that will help you increase your transaction execution speed.
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