A Simple Guide to Currency Arbitrage
Forex Blog Articles
A close look at a relatively safe yet potentially risky forex trading strategy
A big part of being a successful trader is eyeing the market and spotting opportunities before they fully develop. Catching a trend in its infancy gives you a head start on a good trade and potential windfall. One of the strategies that most heavily relies on a fine tuned eye is currency arbitrage.
What is Currency Arbitrage Trading?
In short, currency arbitrage is the method of trading in which traders search for and identify irregularities in prices and then buy and sell currencies in order to take advantage of missed price rates. These irregularities occur when multiple brokers offer different prices on the same currency pair. Though these irregularities are not very frequent, arbitrage traders are trained to recognize them and jump on the trading opportunity when they do occur.
Since this method of trading involves simultaneously buying and selling the same currency, it is regarded by many to be a very low risk trading strategy. This is true for the most part but only if the execution of trades is flawless. If there is a slight discrepancy between the moment a currency is sold and the moment it is bought (and vice versa), the difference between a few pips over time can wipe out profits. Slight slippage when arbitrage trading can negate any gains made.
How to Use Currency Arbitrage in Forex Trading
As forex trading is the buying and selling of currency pairs, an arbitrage forex trader’s strategy is to sell the same currency for a higher price while simultaneously purchasing it at a lower price. As we mentioned above, arbitrage trading is all about taking advantage of price discrepancies. In forex trading, this might mean exploiting differences between currency futures and spot rates, for example.
Examples of Arbitrage Strategies in Forex Trading
Here are two types of arbitrage strategies:
The most basic example of arbitrage trading in forex is referred to as statistical arbitrage. This type of trading relies on identifying price discrepancies (the core principle of arbitrage trading) which the trader believes will be corrected in the future. Once these price differences are noticed, the trader creates separate sets of over performing and under performing currency pairs. The strategy is then to short the over performing pairs while buying the under performing pair.
As the name implies, triangle arbitrage is the strategy of looking for price differences between three currency pairs, as opposed to two. The occurrence of this discrepancy is incredibly rare and is usually only found and capitalized on by traders who can afford the most advanced computing power. In short, the process is a trader exchanging a currency pair at one rate, converting it to another currency pair, and then converting it back to the original traded currency pair.
Since this technique requires such a fast recognition system, it is best used with an automated trading system. Triangle trading happens in such a small window because the market is always correcting itself from nanosecond to nanosecond. With automated systems, a trader can enter all of their preferred trade parameters and let the algorithm execute for them.
Risks in Arbitrage Trading
The risks, as mentioned before, are considered low but they are certainly there for traders who can’t manage to trade within the incredibly small window that arbitrage trading requires. If price discrepancies are positively identified and acted on, the risks for arbitrage traders is quite low. However, if there is even a slight second delay in the purchasing or sale of a currency, slippage can and will wipe out all gains. In currency arbitrage, the risk comes when a trader is too slow and can’t act on price differences before the market has a change to self correct.
we have a great article about Opportunity and Risk in Forex Currency Trading
Advantages of Arbitrage Trading
The big advantage to arbitrage trading is that it can eliminate or all but eliminate risk. When you’re able to execute trades in the timeframe required to capitalize on this strategy, your risk drops to essentially zero.
Disadvantages of Arbitrage Trading
Since you’re constantly buying and selling pairs based on slight discrepancies in price, the cost of doing business can often get too high for traders. With buying and selling come transaction costs and fees. This influx of taxes can lead some traders to miscalculate profit which may result in losses in the long run.
Another disadvantage is there simply aren’t that many arbitrage opportunities available in the market. Therefore it requires a lot of capital and time to wait and act on these opportunities. It’s an expensive strategy to trade with.
Forex Arbitrage Calculator
To help traders who want to trade arbitrage, calculators are available for funding real time arbitrage opportunities. Take note that not all platforms and calculators are the same and it’s necessary to demo before you proceed to make sure the tool is right for you. Here a sample arbitrage calculator – https://forexop.com/tools/arbitrage-calculator
Currency Arbitrage Bottom Line
Low risk if you can find and execute the right trades, arbitrage is a great strategy for traders who are patient and willing to let technology do a lot of the work. The opportunity is not often but can provide a nice win when properly done. However, if you don’t have the money to sit and wait for the rare opportunity to jump on price discrepancy, this strategy might not be for you. As with all strategies, it’s important to know exactly what your strengths and weaknesses are and how said strategy interacts with them. The good thing is that before you have to commit to anything, you can always demo a strategy or plan and see if it fits.
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