This is a strategy that is used as what is called a market-neutral strategy, this means it is less risky than others but always means the lower reward of course.
Let's talk about what arbitrage trading is first: This is a means of trading by which the trader will look to buy in one market and at the same time sell in an interrelated market, the aim is to take advantage of the divergence in price between the two.
Forex Arbitrage Trading
We have briefly described it above but let’s look further into arbitrage. In forex what this means, is traders are buying a cheaper version of a currency and selling a more expensive version at the same time. Then by subtracting the transactions costs, their profit remains the difference between the two prices. Arbitrage traders may try to take advantage of differences in spot rates and currency futures.
Futures are contracts which agree to trade at a certain date in the future for a particular price, forex broker arbitrage can happen when two brokers offer different quotes for the same currency pair. In the retail forex sector, prices between brokers are normally uniform. Therefore, the occurrence of the strategy occurs more at the institutional level. But this isn’t the only type of arbitrage trading, let's discuss one using three different currency pairs.
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Forex Arbitrage Strategies
Triangular Arbitrage Strategy
This is a forex strategy used by counteracting trades to profit from price movements in the forex market. Let’s run through the basic of a currency pair to help you understand how this is going to work. When you take a trade in the forex market, you are effectively taking two positions, buying the first named currency and selling the second.
Currency crosses are pairs which do not include the US dollar. You can calculate the implied value of these pairs, let's look at the example. Take EUR/USD if it is trading at 1.1202 and the GBP/USD is trading at 1.3029. The implied value of EUR/GBP is 1.1202/1.3029 = 0.8597.
If there's a divergence from the major pairs in the traded value of EUR/GBP, then we are presented with an arbitrage opportunity. So, let’s say EUR/GBP is actually trading at 0.8599, it has a higher value than the implied value which means we want to sell it. We will also take trades on the related majors; this will create a EUR/GBP opposing position. This will help to reduce our risk and lock in a profit, but because the difference in price is so small, we have to trade with a large position size to make it a worthwhile profit.
Forex Statistical Arbitrage
This takes a look at the quantitative approach and looks to see future price divergences. This looks at bringing an overall collection of over-performing pairs and under-performing pairs, the view will be to sell the over-performers and buy the under-performers. The reason for doing this is that the currency pairs will revert to the mean over time, you want a tight historical correlation between the two sets of pairs being used.
Limitations of the Strategy
The strategy will require you to have the fastest price feeds available, as it will be too difficult to exploit small price changes without it. As execution speed is a large factor, ensuring you have the right arbitrage software is absolutely necessary to be successful using this strategy. Always ensure you try the strategy out on a demo before jumping into a live account with it.
Due to the number of people using the arbitrage system, overpriced pairs will be pushed down in price when selling and under-priced pairs will be pushed up when buying, therefore, decreasing the difference in price between the two. This will mean you will need to trade at a larger and larger position size to make the profit worthwhile. Money makes money, ensure you have plenty of capital and leverage in the account to make this work for you.
Conclusion
Like with any trading strategy, it is subject to risk. The competition in the market makes it hard to spot these opportunities in the market. You will find them but be prepared to use capital and take the time to watch the screen closely.
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Hopefully, you have enjoyed today’s article. Thanks for reading!
Have a fantastic day!
Nisha Patel
Live from the Platinum Trading Floor.