What is arbitrage?
Simply put, arbitrage is a trading strategy in which a currency or trading instrument, such as a stock, a security, or a commodity, is purchased by a trader in one market and then almost simultaneously sold at a higher price in another market.
The purpose of arbitrage is to generate profits from differences in the prices of identical or related financial instruments.
The speed at which transactions in arbitrage trading are executed implies relatively low risk. Although, there is always some risk present due to low liquidity in the markets or fast-moving prices.
The workings of arbitrage trading
Arbitrage trading is dependent on the inherent inefficiencies in the financial markets and dissimilarities between prices of financial instruments traded in the markets.
The law of supply and demand is the main driving force behind trading in the markets where a change in supply and demand of a financial instrument can affect its price. The aim of traders who utilize arbitrage, is to identify the discrepancies in prices due to changes in the levels of supply and demand across financial markets or exchanges, and to act quickly to generate low-risk profits.
These days, opportunities for arbitrage are usually brief and price discrepancies can be a matter of milliseconds. Furthermore, differences in prices can be extremely small.
Therefore, to be successful at arbitrage trading, the following aspects, among others, are important to scan markets and execute high volumes of orders quickly in order to generate profits before an arbitrage opportunity has disappeared.
- A substantial amount of money to trade with.
- The utilization of automated trading systems that rely on algorithms to identify price discrepancies.
- A fast computer and internet connection.
One of the most common ways a trader can generate profits through arbitrage is from buying and selling currencies (forex trading).
Types of arbitrage
Typically, there are three main types of arbitrage trading in forex:
Two-currency arbitrage
Implementing this type of arbitrage, a trader can capitalise on the different quotes of two currency pairs.
To illustrate, let us assume two banks, bank FDK and bank FKB, have set different exchange rates on the currency pair EUR/USD.
- Bank FDK is buying one euro at $1.1800 and selling at $1.1900,
while,
- Bank FKB is buying one euro at $1.2100 and selling at $1.2200
In this instance, a trader can buy euros from bank FDK at $1.1900, and then immediately sell it to bank FKB, which is buying euros at $1.2100. If the trader trades with an initial amount of $50 000, he or she could generate a quick profit of $1 000 ($50 000 x 0.02).
However, you have to act fast after noticing the differences in the quotation as other traders will soon spot the discrepancies as well, and will enter the market, causing the market forces of supply and demand to rectify the situation.
Triangular arbitrage
Triangular arbitrage, also referred to as cross currency arbitrage or three-point arbitrage, occurs when a forex trader exchanges three currency pairs at three different banks. The aim is to realise a profit through small discrepancies in the different exchange rates quoted.
This arbitrage strategy involves three steps of trading:
- Exchange the initial currency for a second currency.
- Exchange the second currency for a third.
- Exchange the third currency for the initial currency.
For example:
Assume the current exchange rates for the following currency pairs are EUR/USD = 1.1800, EUR/GBP = 0.9000 and USD/GBP = 0.7300.
- With $1 you buy euros EUR/USD at the exchange rate of 1.18. This means you now have €0.85 for $1.
- With the €0.85 you now buy British pounds EUR/GBP at the exchange rate 0.90. You now have £0.77 for €0.85.
- With the £0.77 you now purchase US dollars USD/GBP at the exchange rate of 0.73. This means for £0.77 you now have $1.05.
Your initial $1 has increased to $1.05. Thus, a gain of 5 cents. If, for instance, you traded with $50 000, you would generate a profit of $2 500.
Covered interest arbitrage
Covered interest arbitrage is a trading strategy in which a trader can make the most of the differences in interest rates between two countries when trading in foreign currencies. This is executed by using a forward contract to hedge the exchange rate risk.
The forward contract entitles a trader to specify an exchange rate in the future, while simultaneously buying a currency at the current market (spot) price.
Step-by-step explanation of how covered interest arbitrage works:
- Start with an amount of money, for instance $2 500 000.
- For illustration, assume that the interest rate in the eurozone is 3% and the USA 1.5%.
- Exchange the 2 500 000 US dollars for euros at the current exchange rate of 1.1850. That would give you €2 109 704.
- At the same time, to hedge your exchange risk, buy a forward contract at a predetermined exchange rate of 1.1800 for a period of one year.
- Invest the €2 109 704 at an interest rate of 3% in the eurozone for a year. That would give you a return of €63 291, giving you a total of €2 172 995 (€2 109 704 + €63 291).
- Convert the sum of €2 172 995 back to US dollars at the exchange rate of 1.1800 as guaranteed in your forward contract, giving you the sum of $2 564 134. This is $26 643 more than the $2 537 500 you would have if you had invested in the USA at 1.5% over the year instead.
Advantages of arbitrage trading in forex
- Low-risk profits: Arbitrage trading executed correctly can generate low-risk profits because the selling and buying price are known beforehand.
- No capital investment: If you simply exploit price discrepancies, you do not have to invest your own funds to profit from an arbitrage opportunity.
Disadvantages of arbitrage in forex trading
- Short-lived opportunities: The duration of arbitrage opportunities is often extremely short. Chances are good that other traders could also identify and utilize an opportunity, resulting in a self-correcting market.
- Potential price or rate fluctuations: Exchange rates and currency prices change frequently and quickly. Hence, there is always a possibility that you may execute a trade at a time you may incur a loss.
Frequently Asked Questions
Where can beginners find information on Arbitrage in trading?
Read our comprehensive guide on Arbitrage explained for Dummies.
Can you arbitrage Bitcoin?
Yes, some people take advantage of this and manage to make profits out of ‘thin air’.
Do people lose money with arbitrage trading?
Yes, there is a possibility of losing money with arbitrage trading.
Is Arbitrage trading legal?
Yes, just make sure you trade in countries where bitcoin is legal.
Are there fees involved in Bitcoin arbitrage trading?
Yes, Transaction fees that include fees for every trade you make and withdrawal fees when sending crypto to another exchange.
Top 4 Brokers
