Arbitrage in trading is referred to the practice of taking advantage of price difference between two or more markets. Arbitrage based trading is often used in the currency markets. It is often known as a risk-free trading strategy. One of the biggest factors when using arbitrage is speed of execution. Therefore, in many cases, arbitrage based trading strategies often employ the use of automated trading such as expert advisors or bots.
Arbitrage is, in fact, a very broad term that refers to the price differences in the asset being traded. Often, the arbitrage opportunities can be spread across different markets and not just limited to one asset class. For example, arbitrage can be applied to the forex markets such as buying EURUSD, selling EURGBP and selling GBPUSD for a net exposure to the US dollar. Similarly, arbitrage can also be applied across the markets such as spot and futures markets or other derivates.
A trader using an arbitrage strategy is referred to as an arbitrageur. The arbitrageurs simply look for price discrepancies and then take advantage of the opportunities. Due to the very nature of arbitrage, these opportunities are very short-lived as prices often reach back to equilibrium.
Arbitrage is categorized into three forms:
- Pure arbitrage is where there is essentially no risk, but you can still walk out with profits
- Near arbitrage is where you have an asset trading at different prices (in different exchanges or in different markets), but there is no guarantee that prices will converge
- Speculative arbitrage is where a trader thinks/expects that the markets are mispriced and therefore sells the expensive asset for a cheaper one
Why does arbitrage exist?
The reason why arbitrage exists is due to the nature of the markets. As you might know, every instrument or asset is priced with a Bid and Ask price. When there is a mismatch between two or more entities quoting the bid/ask prices on the same instrument, an opportunity arises (albeit for a very short term) which can be taken advantage of. This discrepancy can be seen during high impact news releases with a broker that offers variable spreads.
The best way to understand arbitrage is to use a hypothetical example. Let’s say you want to exchange currencies and you are looking at two bank’s exchange rates. If one of the banks offers a better buying or selling rate, then you could take advantage of this so that you buy from one bank and sell it to the other. This is nothing but arbitrage. However, these opportunities last for a very small window of time as various arbitrageurs often come in and plug the discrepancy to bring prices back to equilibrium.
Triangular Arbitrage in currencies
One of the most commonly used arbitrage trading strategies in the forex markets is what is called a ‘Triangular Arbitrage.’ As the name suggests, triangular arbitrage looks at 3 currency pairs for price discrepancy.
The most commonly used instruments in a triangular arbitrage are:
EURUSD –> EURGBP –> GBPUSD
(Buy EUR and Sell USD) -> (Sell EUR and Buy GBP) -> (Sell GBP and Buy USD)
In this triangular arbitrage method, a trader sells USD to buy the EUR. The EUR is then sold to buy GBP, and finally, the GBP is sold to buy back USD. This triangular arbitrage works when a trader’s base equity is in US dollar and is employed to seek higher returns when the USD is bought back.
As one can see by the above example, the triangular arbitrage method is nothing but selling the USD only to buy it back again but by using a different currency or currencies. A profitable trade is possible only when there is a discrepancy in the market. Usually, these price discrepancies can be as little as 5 pips or sometimes more. However, with leverage and position management the small discrepancies can build up into profits quite quickly. Depending on your base currency you can look at multiple currency pairs to use in arbitrage trading. For example, if your trading account is based in EUR, then you would be looking at:
Sell EURGBP -> Sell GBPUSD -> Buy EURUSD which leaves you with back with the euros, or right where you started.
You could also include other currencies such as Buy EURUSD -> Sell EURAUD -> Sell AUDUSD and many other variations. The key here is, of course, the speed of execution.
Although arbitrage trading is often referred to as a risk-free approach, there are some risks involved. Most importantly, if the broker fails to fill your order at the specified bid or ask price, chances are that your arbitrage opportunity could have diminished. Furthermore, any transaction costs such as commissions could eat into any profits that you might intend to make. Due to the small window of opportunity, traders will have to keep a close eye on the markets to exploit these price inefficiencies.
