In a very simplified way of explaining arbitrage trading in Forex, it can be said that this strategy is where a trader takes advantage of different spreads (price quotes) offered by different brokers for a stated currency pair. This opportunity arises because different brokers price their currency pairs differently, meaning those savvy and eagle-eyed traders who are quick enough to compare them can capitalise on the momentary disparity.
Still confused? Let’s break it down
- Brokers offer quotes (prices) for their currency pairs
- Broker A and Broker B might have a discrepancy of 1% between their listed quotes
- Trader John can spot this difference in price and act fast to gain a quick 1% profit, buying from the cheaper broker and selling to the other one
There are two different strategies popularly applied to arbitrage trading – Two-currency Arbitrage (as above) and Three-currency Arbitrage. In the latter, also known as Triangular Arbitrade, usually with the aid of advanced computer software, a program will spot noticeable discrepancies between three different currencies pairs and will take action to make transactions and gain profits on each, however, this is quite rare and almost impossible for the human eye to spot.
How does arbitrage trading differ from other Forex trading strategies?
Let’s say that the simplest form of trading in Forex is Spot Trading. A Spot Trader buys a currency, waits for the price to go up, and then sells it. It can’t be much simpler than that – simply analyse the price movements in order to profit on the ups and downs of a currency.
An arbitrage trader, on the other hand, isn’t really looking at price movements in the market, because that’s not where they see their profits. Instead, computers and trading systems are used to spot and exploit the differences between price quotes from different brokers. Unfortunately though, these opportunities are become few and far between due to the sheer number of trading bots, automated systems, and arbitrage traders in place. The gaps are shut down almost as quickly as they open, as brokers are incentivised to put better systems in place to avoid being exploited.
The risk for a Spot Trader is that the currency they buy will lose value and they, in return, lose money. For an arbitrage trader, the risk is that their deal does not execute fast enough, and so the opportunity is lost and they lose on the trade because of how fast the market moves. This is why advanced systems are often required and human ability is not quite enough.
What is arbitrage?
We’ve talked about arbitrage trading in Forex, but it’s good to know about arbitrage in general, as it’s practiced in many other markets and in day to day life too. Think about things this way, why do you choose the supermarket that you shop in? As a whole, do you get more value for the same products in your chosen supermarket? If toilet paper, milk, bread, soap, and other essentials are cheaper in one store, you’re practicing a type of arbitrage, profiting on the discrepancies in price of identical products. Now, nobody is really going to call this arbitrage, because the term is applied to financial markets, but it serves as a good example of how this works, aside from the fact that groceries aren’t changing price constantly and you can spot the price discrepancies manually. Arbitrage is practiced in stocks, cryptocurrency, indexes, and many other markets.
How does an automated arbitrage trading system work?
If you’re opting to get into arbitrage trading as part of your Forex strategy, you’ll want to find an automated trading system that offers reliable algorithms that can quickly spot price discrepancies and act on them. The truth is that you want to leave as little room for human error as possible and delegate as much of the process to the algorithm as you can. These arbitrage opportunities open and close for such a small amount of time before the markets adjust that it’s very easy to miss them and wonder what could have been.
SOURCE Vestigo Finance