Forex Arbitrage Trading System Explained

Forex Arbitrage Trading System Explained

Forex arbitrage trading systems have been around for a long time as they offer a low-risk profit opportunity if executed correctly. The main idea is to profit from price differences across exchanges by quickly identifying mispricings. A trader buys the underpriced instrument while immediately selling the overpriced instrument, keeping the difference in prices as a profit.

Let’s dig deeper into the main arbitrage strategies in the forex market and whether retail traders can use them to grow their trading account.

What is Arbitrage?

Arbitrage is a form of trading where a trader looks for short-term mispricing in an underlying instrument across different exchanges. Therefore, the trader purchases an instrument on an exchange where the price is low and at the same time sells the same instrument on an exchange where the price is high. This locks in immediate profit without any real exposure to the financial instrument.

Why is Arbitrage Possible?

Market pricing depends on the flow of information, which means that pricing is not instant and mispricing can occur here and there. Different brokers could offer different prices or different effective prices when traders look for arbitrage trading opportunities. This, however, usually lasts only for a short period of time as traders who spot the mispricing actively buy the underpriced instrument while selling the overpriced instrument, therefore, pushing the price back into equilibrium.

Types of Arbitrage in the Forex Market

Several types of arbitrage are possible when talking about the forex market specifically:

Two-Currency Arbitrage

This involves trading the same currency pair of two different brokers. A trader goes long with a broker that offers a low exchange rate while immediately taking a short position with a broker that offers a higher exchange rate. Therefore, you have no direct exposure to the currency and once the price difference is no longer there, a profit can be taken. Prices across brokers should eventually match.

For example, EUR/AUD is quoted at 1.8950 at broker A and 1.8955 at broker B. Therefore, you are able to make 5 pips of potential profit by buying at broker A while at the same time selling at broker B. If the price at broker A moves up 2 pips and the price at broker B moves down 3 pips, you effectively gain 5 pips. The price difference will eventually converge and you can close out both trades.

According to Fenn, Daniel J. et al (2009), “… a study examining exchange rate data provided by HSBC Bank for the Japanese yen (JPY) and the Swiss franc (CHF) found that although a limited number of arbitrage opportunities appeared to exist for as many as 100 seconds, 95% of them lasted for 5 seconds or less, and 60% lasted for 1 second or less. Further, most arbitrage opportunities were found to have small magnitudes, with 94% of JPY and CHF opportunities existing at a difference of 1 basis point, which translates into a potential arbitrage profit of $100 per $1 million transacted.”

This research paper shows that the majority of arbitrage opportunities between the Swiss franc and Japanese yen lasted for only 5 seconds or less, meaning that traders who follow a manual trading strategy are at a great disadvantage compared to trader with automated trading algorithms. For most manual traders, it would be almost impossible to place a trade, complete with SL and TP levels, in a timeframe of only 5 seconds (note that 60% of all arbitrage opportunities lasted for only 1 second or less!)

A successful arbitrage strategy requires an automated approach to trading price discrepancies in the markets. In addition, the required capital to make a sizeable profit is extremely high, since most discrepancies have very small magnitudes.

Triangular Arbitrage

This involves trading three different currencies at the same time. The basic idea is simple – the trader looks for a base currency that is overpriced against one currency but underpriced against another currency in the market.

An example of this would be a case where EUR/USD trades with a 1.1600 rate while GBP/USD trades with 1.33. By dividing these two rates we should get the price for EUR/GBP of 0.87218. Therefore, if the actual price of EUR/GBP differs from our calculated price – an arbitrage opportunity exists.

Let’s say the actual price of EUR/GBP is higher at 0.87318. A trader could take advantage of this arbitrage opportunity by selling EUR/GBP while at the same time placing two trades in EUR/USD and GBP/USD that have the same effective trade size in order to create a synthetic counter position. Once this is done, the trader effectively has no exposure in the market and lock-in the difference between prices.

Triangular Arbitrage Example

This might sound complicated at first, so let’s cover triangular arbitrage with another example. Let’s say EUR/USD trades at 1.1340, USD/CAD at 1.3000, and EUR/CAD at 1.4735. As you know, if you go long in a currency pair this involves buying the base currency and selling the counter-currency in an equal amount and at the current market exchange rate.

Being long one standard lot in USD/CAD, for example, means that you’re long 100,000 units of USD and short 130.000 units of CAD since the USD/CAD exchange rate is 1.3000.

Triangular arbitrage requires the calculation of the intrinsic value of a currency pair to identify mispricings. That’s quite simple, all you need to do get the intrinsic value of EUR/CAD is to multiply the exchange rate of EUR/USD by the exchange rate of USD/CAD.

Intrinsic exchange rate of EUR/CAD = EUR/USD at 1.1340 x USD/CAD at 1.3000 = 1.4742

So, the intrinsic exchange rate of EUR/CAD is 1.4742, while the actual exchange rate provided by the broker equals to 1.4735. This provides a nice arbitrage opportunity, as a trader could buy $113.400 for €100.000 (EUR/USD at 1.1340), exchange the $113.400 for C$ 147.420 (USD/CAD at 1.30), and finally exchange the C$ 147.420 to €100.048 (EUR/CAD at 1.4735).

Starting with €100.000, this arbitrage trade would return €100.048, or a total risk-free profit of €48 per each standard lot traded. Naturally, the easiest way to do so is to use an automated trading algorithm that performs all the required calculations for you.

Forex arbitrage opportunities require traders to act fast and trade on high leverage to make a sizeable trading profit. There are many currency arbitrage calculators available on the market that scan exchange rates for real-time arbitrage opportunities. Most of those calculators are sold by third-parties, which means that their real-time price quotes can differ from the quotes provided by your broker.

Also, if you decide to test arbitrage calculators on a real account, make sure that your broker supports automated trading (through EAs in MetaTrader, for example) and that your trading account allows for hedging.

Forex Statistical Arbitrage

Besides the two-currency and triangular arbitrage strategies, there’s also another interesting trading approach to exploit pricing discrepancies in the forex market – Statistical arbitrage.

Statistical arbitrage involves buying a basket of underperforming currencies and shorting a basket of overperforming currencies in an attempt to profit off the market’s mean-reverting nature. The idea behind statistical arbitrage is that currencies that have on average over-performed will eventually have to fall in value, while currencies that have on average underperformed will have to increase in value to reach their fair exchange rate. Unlike other arbitrage types, statistical arbitrage is not completely risk-free as traders anticipate that currency pairs will eventually revert to their fair value over time.

Statistical arbitrage takes advantage of currency correlations in the market in order to create a market-neutral portfolio. In addition, trades based on statistical arbitrage take quite long to perform, sometimes several months, which means that trades can be manually entered. While this is an advantage over two-currency and triangular arbitrage, statistical arbitrage still requires a relatively large trading account to withstand negative price developments over a long period of time. When trading on margin, traders need to make sure to maintain enough free margin in their trading account in order to avoid a margin call.

Interest Rate Arbitrage

Covered interest rate arbitrage refers to an arbitrage strategy in which traders look for interest rate differentials in the forex market to invest in a higher-yielding currency, while simultaneously hedging its exchange rate exposure with a forward contract.

Naturally, traders need to weigh the cost of hedging and the possible return of investing in the currency with a higher interest rate. If the cost of hedging is higher than the possible return, the strategy would actually generate a loss instead of a profit. Just like with other arbitrage strategies, returns of covered interest rate arbitrage tend to be relatively small and require a high capital investment.

Risks of Arbitrage Strategies

While arbitrage is often assumed to be a risk-less profit opportunity, in reality, it is not.

Executing arbitrage trades simultaneously is crucial as only small and short-term differences are seen in modern financial markets. Otherwise, if exchange rates change by the time you execute your second trade, any potential profit might be gone. In fact, you might lose money because of this.

Additionally, any broker fees, swaps, and spread differences can quickly reduce any potential for profit. A sudden increase in the spread during the time of execution can make all the difference as the arbitrage opportunities are usually very small. In arbitrage, every pip counts.

Therefore, make sure that your broker offers fast execution and that the exchange rate difference is indeed large enough to make a profit after all the additional trade costs are deducted.

Arbitrage Capital Requirements and Leverage

Arbitrage requires a large amount of capital and high leverage to produce a substantial profit. This is because the price differences are very small, and profits will be quite small without taking a sizeable.

Another risky situation arises if one of the brokers used during the trade experiences technical difficulties such as the inability to close a position. If the counter position has already been closed, this can quickly lead to huge losses.

Most traders who follow a successful forex triangular arbitrage strategy trade directly with banks that can provide the best exchange rates with the tightest spreads. Retail traders have the disadvantage of relatively small accounts, as millions of dollars are needed to make a small risk-free gain. While this can be somewhat mitigated with the use of leverage, bear in mind that leverage is a double-edged sword and can result in high losses if a trade doesn’t play out as expected.

Most large banks have developed complex trading algorithms that scan the market for pricing discrepancies and arbitrage opportunities. Once they identify a trading opportunity, the size of the trade quickly eliminates any profit opportunity for less-capitalized traders without a complex trading infrastructure.

Key Takeaways

  • In arbitrage strategies, a trader looks for short-term mispricing in underlying instruments by buying the undervalued one and selling the overvalued one both at the same time.
  • Immediate profit without any real exposure to the financial instrument can be made if executed properly.
  • Two-currency arbitrage and Triangular arbitrage are the most common forms of forex arbitrage.
  • Statistical arbitrage is also a popular arbitrage strategy as it can be done with manual trading. However, trades can often last for months.
  • The spread of mispricing is usually very small, therefore large capital and leverage is needed to produce profits.
  • Mispricing in the market usually does not last long, therefore, execution speed is crucial.
  • Broker fees, swaps, and spread differences can quickly reduce any potential for profit

Final Words

Arbitrage offers an almost risk-free profit opportunity in the markets by taking advantage of price discrepancies between different exchanges. The main problem for retail traders is that mispricings last only for a few seconds, making it almost mandatory to utilize an automated trading strategy. A notable difference is statistical arbitrage, which involves buying under-performing currencies and shorting over-performing currencies in order to take advantage of past correlations and the mean-reverting nature of markets. Trades based on statistical arbitrage can last for months.

Besides trading on high leverage and dealing with extremely short-lived mispricings, market liquidity, volatility and broker spreads/commissions should also be taken into account before getting your feet wet with arbitrage strategies.

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Fat Finger

Fat Finger

Hello everyone!

My name is Phat Fin Ge, but most people just call me Fat Finger or Mr. Finger.

Many years ago, I was a trader on the Hong Kong Stock Exchange. I became so successful that my company moved me to their offices on Wall Street. The bull market was strong, but my trading gains always outperformed market averages, until that fateful day.

On October 28th, 1929, I tried to take some profits after Charles Whitney had propped up the prices of US Steel. I was trying to sell 10,000 shares, but my fat finger pressed an extra key twice. My sell order ended up being for 1,290,000 shares. Before I could tell anyone it was an error, everyone panicked and the whole market starting heading down. The next day was the biggest stock market crash ever. In early 1930, I was banned from trading for 85 years.

I went back to Hong Kong to work at my family's goldfish store. Please come and visit us at Phat Goldfish in Kowloon, only a 3 minute walk from the C2 MTR entrance.

I thought everyone would forget about me and planned to quietly return to trading in 2015. To my horror, any error in quantity or price which cause a problem kept getting blamed on Fat Finger, even when it was a mix up and not an extra key being pressed. For example, an error by a seller on the Tokyo Stock Exchange was to sell 610,000 shares at ¥6 instead of 6 shares at ¥610,000. That had nothing to do with me or with how fat the trader's finger was, but everyone kept yelling, "Fat Finger! Fat Finger!" In 2016, people blamed a fat finger for a 6% drop in the GBP. It really was a combination of many things, none to do with me or anyone else who had a wider than average finger.

Now that I can trade again, I'm finding forex more interesting than stocks. I've been doing some research on trading forex and other instruments and I'll be sharing it here.

If you see any typing errors, you can blame those on my fat finmgert. If you see any strange changes in price, it's not my fault.

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