Did you know there is a market-neutral forex strategy designed to offer profit without having to predict the price direction? Analysts constantly look for loopholes to make money with little risk and effort in any financial market.
This has led a legion of people to learn how to do arbitrage trading, which also exists in FX. Arbi-what? Is this a secret strategy? Arbitrage is a slick and clever way to exploit ‘errors’ in market prices, an intriguing approach with several layers to it.
As a beginner, we will explore this in more detail and break it down in the simplest way possible.
What is arbitrage trading in Forex?
In financial trading, arbitrage is a practice where you capitalise on price variances of one market provided by two separate institutions. The idea is that an arbitrageur buys a lower-priced instrument (like a forex pair) from one broker and quickly sells it at a higher price with another broker.
Let’s demonstrate with a simple example. Imagine the pair was EUR/USD, and one broker had a slightly higher exchange rate than another. Here, you would convert your USD to receive EUR from one broker.
Afterwards, you would sell the same EUR to the broker with the greater EUR/USD rate to receive USD. By this time, you should have more USD than you did previously.
Let us first understand how arbitrage forex trading is possible in the first place. We refer to FX as a decentralized market, meaning we aren’t trading from a single source where we all receive the same prices.
Generally, forex dealers receive their quotes from the interbank market. Alternatively, they will make their own if they process client orders internally. This is why the price of each forex pair across brokers will almost be exact, but not entirely.
Due to decentralization, everyone is getting slightly different values. The disparities are very short-lived (often lasting a few seconds) and infrequent. However, with forex arbitrage trading software, it is possible to exploit these events, which often arise from pricing delays between brokers.
When a broker connects to a liquidity provider through a ‘bridge,’ the quotes may lag for tiny fractions of time. This can typically happen during high-volatility events like certain news announcements or random technical glitches.
So, one broker is processing quotes faster than another one. The thinking is that by the time everything is aligned, you’ll have already made a small profit after the simultaneous buying and selling.
Much of the literature around arbitrage suggests that it’s risk-free, which is not true. It poses many challenges, making it a less-than-viable strategy for the average person. Traders who learn arbitrage trading and profit from it have sophisticated software or bots to do the job.
How does forex arbitrage trading software work?
It is not possible to be an arbitrageur with manual execution. Timing and agility is everything. So, automated trading is the only way to stand a chance (rather than using trade alert programs) because a slight delay can lead to unwanted losses.
Also, it is vital to have ultra-fast internet to run the software. So, how does it work? An arbitrage trading bot is designed to instantly detect and execute arbitrage moments according to preset parameters.
This software will connect to your trading platform and scan various markets across a plethora of providers. Of course, you will run two brokerage accounts at the same time. You implement the program on a broker that receives the fastest quotes possible.
Even a few hundred milliseconds in difference is a huge deal. The ‘slow’ broker is where the software would execute your position once it has identified the right moment.
Types of arbitrage trading strategies
Let’s look at the main kinds of arbitrage in forex.
This is the simplest form of forex trading arbitrage. Here, the aim is to buy a FX pair from one broker at a lower price and then sell the same market with another broker for a slightly higher price.
Let’s go over a simple example with GBP/USD. Imagine that the exchange rate for this pair was 1.11400 with broker A and 1.11450 with broker B. With $1 000 000, you would receive £897 666.
With the same £897 666 on the other brokerage account, you would sell with an exchange rate of 1.11450. The final amount is now $1 000 448, a $448 profit, excluding the spread (which we’ll get to later).
This arbitrage forex trading strategy is more complex because it involves three different pair combinations (hence ‘triangular’) across multiple brokers. Let’s look at an example using EUR/USD, GBP/EUR, and USD/GBP.
- With $1 000 000 at a EUR/USD exchange rate of 1.1500, you would have €1 150 000 at broker A ($1 million X1.15).
- With broker B, you would swap the €1 150 000 for British pounds (GBP) at a GBP/EUR rate of 1.20. This would leave you with £958 333.
- Lastly, with broker C, you would exchange the £958 333 for US dollars at a USD/GBP rate of 1.25, resulting in $1 197 916.
Once you subtract the $1 197 916 from your initial $1 000 000, your profit is $197 916.
Interest rate arbitrage
Of all the arbitrage forex trading systems we’ve covered, this one is the simplest despite having substantial risk. Interest rate arbitrage doesn’t involve ultra-fast execution or fancy software. It’s an approach called the ‘carry trade’ (learn more about it here) a strategy capitalising on positive swaps or interest rates where you buy a high-yield pair against a low-field pair.
When the differential between the two markets is positive, you gain interest every day you hold this position overnight. The aim is that the longer this is performed, the greater the swap accumulation.
Let’s explore how interest rates play a role in FX. As we know, this market is leveraged. Technically, leverage is borrowing money from a broker, and like any lending, interest is involved. However, interest is only applied when you hold a position overnight.
Each currency has a specific interest rate attached to it. Here’s an example with South Africa (ZAR) and America (USD). Presently, the interest rates for each country are 6.25% and 3.25%, respectively. So, you could convert your US dollars and save them into SA rands to earn interest.
With this arbitrage strategy, you pair the countries with the highest interest rate against those with the lowest. Generally, the so-called emerging nations like Turkey, South Africa, and Mexico maintain higher rates to attract foreign investments.
On the other hand, developed countries like the United States, Switzerland, and Japan have lower interest rates, sometimes negative.
Secondly, you will want to look for brokers with the highest swap offerings because they vary across the board. For instance, with IC Markets, you would receive $6.76 each night if you sold a standard lot (100 000 units) of USD/ZAR.
Like most arbitrage trading strategies, you would have to allocate a lot of money for a small daily profit. The other risk is that you may end up with a huge floating losing position if the exchange rate goes against you the longer it is held.
The swaps you gain may be too small to cover the ongoing losses. So, the key is performing technical analysis and finding the optimal time to trade a pair with this strategy. Also, the carry trade is best for long-term traders with substantial capital to make reasonable gains.
This is one of the most complicated arbitrage trading strategies. This approach is also called the ‘cash and carry trade’ or covered interest arbitrage. It is similar to the carry trade because the investor looks to exploit interest rate differences.
The main difference is that it uses futures or a futures contract by ‘locking in’ prices, as opposed to the previously discussed version where the exchange rates fluctuate. Also, investors perform this strategy over the long term (at least a year).
Let’s quickly cover what a future is in forex. Here, you trade a specific pair at a price locked in for the future. For instance, suppose you had $1000 and expected to receive euros in a month. If the EUR/USD exchange rate were 0.98, you would receive €1020 by exchanging your $1000.
When a month has passed, this will ensure that your €1020 is intact even if the EUR/USD price was different from the original 0.98.
For the spot-future arbitrage strategy, the investor looks to buy a currency with a higher interest rate against one with a lower interest rate. After identifying the pairs, they would have to perform two deals simultaneously: a spot (or normal) and a futures-based transaction.
Let’s imagine that the Eurozone had a rate of 5% while the United States had a figure of 2%. Having identified this difference, this is how you would perform forex arbitrage trading here.
Let’s imagine you had $1 000 000, and the current EUR/USD price was 0.98. You would have to enter into a futures contract with a higher exchange rate (let’s say 1.2) to hedge against fluctuations in the meanwhile.
- After converting the $1 million into euros, you would have €1 020 408 ($1 000 000 / 0.98).
- You can take a futures contract with a EUR/USD exchange rate of 1.2.
- Investing €1 020 408 at 5% yearly interest would net you €51 020 (1 020 408 X 5 / 100), resulting in a total €1 071 248.
- Finally, you would convert the €1 071 248 into the guaranteed 1.2 price (1 071 248 X 1.2), totaling $1 285 497. This is $285 497 more than the initial $1 million. Also, it is higher than if you invested this amount with the 2% interest rate.
While the futures contract hedges against fluctuations, this strategy doesn’t consider the trading costs. It also doesn’t guarantee that the interest rate differential will remain positive in the year.
Advantages of forex trading arbitrage
The main attraction for people to learn arbitrage trading is that you can profit from the markets without any predictive analysis. In ordinary trading, your success depends on how well you can forecast the depth of exchange rate changes.
However, this doesn’t matter with arbitrage because the trading event lasts for a few seconds. This also significantly reduces your positional exposure by shielding you from adverse price action.
Also, with software, you would spend far less time on the charts looking for opportunities.
Limitations of forex trading arbitrage
While we know about arbitrage trading forex, it is usually reserved for well-capitalised institutional traders for a few reasons. Firstly, this is because acquiring the best arbitrage trading software is expensive.
Also, the average trader is not privy to insider information on these opportunities. Besides, this trading style is only worthwhile if you have a large account.
Capital requirements and transaction costs
In the example with the two-currency forex arbitrage trading, you saw that making $448 would need one to have $1 000 000. This is an amount that very few retail traders could afford to have.
You can derive that much profit with other methods and less capital. The overwhelming drawback is that all arbitrage strategies yield little profit on a unit base and need vast unleveraged volume.
Regardless of how you trade forex, a spread will always apply. Therefore, if the spread is too high, you may end up with less money than intended after completing your arbitrage.
With a $1 000 000 position (10 lots), the spread on GBP/USD with most brokers is, on average, one pip. So, the cost would be $100 (1 X 10), meaning that your final profit would actually be $348.
This is only the best-case scenario for the amount. Even when you have identified an arbitrage forex trading opportunity, the spread may be higher than usual, affecting your profits. So, it’s best to find brokers with the lowest possible spreads.
Arbitrage requires advanced computing power and market connectivity that can exploit the latency between prices. These assets are not available to your everyday participant.
We mentioned that arbitrage might exist during news events. In financial markets, we have something called information symmetry. This simply means that certain participants have better knowledge of events before they happen.
Some parties have insider details about factors that can influence the outcomes of news announcements, like internal central bank dialogue. The general public will not be aware of the result until after the news.
This is just one example of secret knowledge which allows some traders to act on data before everyone else. This quality is what makes arbitrage moments rare for the ordinary trader.
Some brokerages forbid the practice of any high-frequency or scalping-like strategies such as forex trading arbitrage. This is usually with dealing desk or ‘market maker’ brokers that process your orders internally instead of connecting them to an external liquidity provider.
Because the profits are small with arbitrage, most strategies would require the trader to open as many orders as possible. This causes logistical issues with some brokers.
The super efficiency of pricing has diminished the number of arbitrage forex scenarios. It is like looking for a needle in a haystack.
Also, with technological advancements, arbitrage is less risk-free than it once was. Most arbitrage scenarios are not worthwhile endeavours if you don’t have a large account and the most advanced tools.