What Is Forex Arbitrage Trading?
Arbitrage Forex by Forex Signals FxPremiere on Arbitrage. Learn more below.
Arbitrage has been in practice since ancient times. Arbitrage is a speculative strategy, where someone attempts to profit from price differences of the same instrument either in the same market or in different markets. It involves buying and selling an asset at two different prices in order to profit from the difference.
Finding the right conditions and applying an arbitrage trading strategy is not easy because everyone is looking for a loophole in the market in order to make a profit. Therefore, by the time it comes to your attention, someone else may have already placed a trade and closed. So, arbitrage is mostly a strategy for market participants with the best and quickest information and technology systems.
What Is Forex Arbitrage Trading?
Financial arbitrage consists of buying and selling a product or financial instrument (or two very similar instruments) as quick as possible, profiting from the price difference. You buy the instrument when you see it costs less in a market and then sell it in another market or in the same market where it costs slightly more. The markets are not perfect and there are inefficiencies — these are what create arbitrage opportunities.
In fact, arbitrage minimizes market inefficiencies because if a product is undervalued, the arbitrage players will immediately jump to increase the demand for it, thus increasing the price. As the price of the product goes up, demand will decrease and the supply will increase until they reach a balance and the price of the product reaches the right value. In currency trading, forex arbitrage is accomplished through the buying and selling of currency pairs.
In theory, there are three conditions to be met for a trade to be considered ‘arbitrage’:
- The price of the same or similar products is different depending on the markets.
- The price of two or more products with identical cash flow is different depending on the markets.
- The actual price of a product is different from the future price discounted at the interest rate.
There are many types of arbitrage, such as labor arbitrage between one or two markets. The labor price and demand between the East and West European member states are different. That is why many Eastern Europeans take their labor to West Europe and close the arbitration gap. This is labor arbitration within one market. The difference between the EU and African labor markets is an arbitrage in different markets. This is just a simple example to help explain how arbitrage works.
Forex arbitrage, or “two currency arbitrage,” is achieved when you buy a currency pair in an exchange that offers a lower price, and then sell the same pair in another exchange at a higher price. For example, assume you have accounts with two different brokers and they offer a slightly different price for EUR/USD; broker X has an exchange rate of 1.1010 while broker Y has a rate of 1.10.
If you buy ten EUR/USD with the second broker you´d get 909,090 EUR for 1,000,000 USD. If you then sell the Euros to a second broker at a rate of 1.1010, you´d get $1,000,909. You just made $909 by forex arbitrage. If both of the brokers have a 1.5 pip spread for this pair, the transaction costs would be $300 for this amount, which would leave you with a $609 profit.
A 10 pip rate difference is not very common, but you can find 1-4 pip differences for the same pair amongst many brokers. I often see 1-3 pip rate differences between Oanda and ETX Capital for the same exotic currency pairs. However, since the spread for these pairs is often more than 5 pips, the arbitrage trading strategy is not feasible.