Typically, investors hope to profit by purchasing securities at lower prices and selling them at higher prices. The trading of currencies also works on the same concept. The main goal of forex trading is to make money by predicting a currency pair’s price movement. But what if you could take advantage of the forex market without the need to do this? There is, in fact, one such strategy. It’s referred to as currency arbitrage or forex arbitrage. Traders profit from the difference in prices at which two transactions are completed when they purchase and sell simultaneously at separate prices. Forex arbitrage trading is one of the several ‘market-neutral’ forex trading techniques that are available. So, let’s learn about arbitrage in the foreign exchange market in this article.
Table of Contents
What is Arbitrage Trading?
The goal of arbitrage trading is to profit from price disparities between several marketplaces.
- Markets are usually efficient, and all prices should reflect the current market value. So, arbitrage should theoretically be impossible. However, there are still small differences because of technology and geography. For instance, there may be information delays when pricing data is sent across locations.
- A trader will locate a currency, commodity, or stock that is valued differently on two distinct exchanges in a pure arbitrage play. They would purchase at the lower prices and sell at the higher prices. Individuals purchase assets in one location (a shop) and immediately resell them in another (online markets) to make money. The key is to use the demand to your advantage.
Is Risk-Free Arbitrating Possible?
- Economic theory states that the ‘efficient markets hypothesis’ governs trading in financial markets. Economist Eugene Fama and a few others established this in the 1960s. It implies that all available information about asset values and prices will be processed quickly and efficiently by markets. There is very little scope for price discrepancies between markets. So, the prices move quickly toward equilibrium levels.
- However, this is not the truth.
- In fact, the market isn’t always effective. That is, not all regions of the world have immediate information flow. Consequently, an uneven spread of information takes place between buyers and sellers. This gives rise to chances for arbitrage. The securities may be purchased in one market at a lower price and sold in the other at a higher price. This can be done by the first individual who notices such a discrepancy.
- When there is a ‘negative spread’, or the seller’s asking price is lower than the buyer’s bid price, this is an example of market underperformance. Traders can profitably trade into it rapidly if it occurs at that time.
- This appears to be a risk-free scenario that allows for arbitrage. However, no transaction is completely risk-free. ‘Execution risk’ is a circumstance of slippage or price requote that arbitrageurs encounter and which has the potential to reduce the profits. It may also lead to losses.
Forex Arbitrage Explained
Let’s now look at the forex or currency arbitrage meaning. The practice of traders trying to buy a currency at a lower cost and selling it for a higher price is known as forex arbitrage.
- The market offers a wide range of trading approaches.
- Traders are always on the lookout for opportunities with lower risk.
- Forex currency arbitrage is regarded as a low-risk strategy in which traders take advantage of a currency’s fluctuating market values by simultaneously purchasing and selling several currency pairings.
- In forex trading, the primary goal of arbitrage is to buy a less costly currency while simultaneously selling the more expensive one. To put it simply, forex arbitrage is the practice of profiting from price disparities in the market.
- There are several varieties of forex arbitrage. Statistical forex arbitrage is a type of trading in which inexpensive currencies are purchased against overpriced ones. Traders are ultimately profiting financially from the market corrections.
- In a nutshell, arbitrage currency trading is the method by which a trader makes transactions to benefit from various spreads that brokers provide for a certain currency pair. It signifies the discrepancies between the ask and bid prices since various currency pairings have distinct spreads.
Example of Forex Arbitrage Trading
Assume that a Company is listed in both Australia and India. The shares rise from ₹60 to ₹60.10 on the National Stock Exchange (NSE). However, its stock price remains at ₹60 on the Australian Stock Exchange. A trader may make a 10 paise profit per share by purchasing on the ASE and selling it right away on the NSE.
Forex Arbitrage Strategies
Triangular Forex Arbitrage
Triangle arbitrage is one of the most often used arbitrage trading techniques in the forex market. This requires opening positions with three currency pairings. The traders who take advantage of these possibilities are generally well-equipped with sophisticated computers and automated software. These opportunities are recognised to be extremely uncommon.
In short, it is a type of profit-making carried out by currency traders in which investors utilise algorithmic transactions to profit from price disparities. Making these kinds of deals, meanwhile, is difficult since they need to be done rapidly and in large quantities.
Forex Statistical Arbitrage
Forex statistical arbitrage uses a quantitative approach to find price divergences that are statistically likely to be right in the future. It accomplishes this by putting together a basket of currency pairings that perform well and a basket of currency pairs that perform poorly. The purpose of this basket is to buy the underperformers and short the overperformers.
It is assumed that over time, the relative values of the two baskets will probably approach the mean. You would require a close historical relationship between the two baskets for this assumption to be true. Thus, while picking currency pairs, the arbitrator needs to consider this factor also. It is better to maintain as much market neutrality as you can.
Riskless Profit
Arbitrage is often referred to as riskless. However, it’s not entirely true. The risk of a well-executed forex arbitrage strategy would be minimal. Yet the execution is half the work. One major issue is execution risk. You must execute your offsetting positions at the same time or almost at the same time. It becomes more challenging because arbitrage has a slight edge. Even the slippage of a few pips (the smallest whole unit price move) would wipe out your profit.
Conclusion
Through arbitrage, a trader can take advantage of market inefficiencies to make low-risk profits. Forex arbitrage is the process of buying a currency for a low price and selling it at higher prices. Arbitrage opportunities are typically short-lived. This is because once traders discover an inefficiency, the market tends to balance itself out in terms of buyers and sellers. A trader can profit from an arbitrage opportunity before it closes with the use of automated trading tools. Reputed financial firms like Share India offer excellent trading platforms that facilitate swift transactions. Currency arbitrage, covered interest arbitrage, and triangular arbitrage are common techniques for trading forex arbitrage.
