Arbitrage, in financial terms is defined as the buying and selling of instruments across different markets and taking advantage of the differing prices for the same asset.
Arbitrage is commonly used in the financial markets including forex trading. There are various strategies involved in arbitrage and forex arbitrage is most commonly found in OTC trading. Due to the various major and cross currency pairs available and the fact that there is a possibility of differing price feeds, forex arbitrage can be used to make profits by simultaneously trading multiple (in most cases three) currency pairs at the same time, thus the name Triangular Arbitrage or Triarb in trading slang.
The window of profit when using forex arbitrage lasts usually for only a couple of seconds, if not milliseconds. The reasoning behind this is a simple concept of supply and demand. When there is a price discrepancy and if you engage in forex arbitrage, sooner than later, due to excessive buying on one end and excessive selling on the other, the prices would converge. This is also known as price convergence.
However when used correctly and with the right tools and leverage, forex arbitrage can help traders to take advantage of the difference in price feeds and thus make a profit. In this article, we explain the basic concept of forex arbitrage also referred to as triangular arbitrage (because it involves three currency pairs) and how traders exploit this loophole.
How does Forex Arbitrage Work
To best understand forex arbitrage, let’s first look at the following simple example:
In your city or town, you have two markets at either ends. Market A, sells a dozen oranges at a price of $10. Market B, sells a dozen oranges at a price of $15. If you notice the price discrepancy, using arbitrage, you can buy 10 dozen oranges from Market A. At this point you spent $100. Now if you sell these same 10 dozen oranges in Market B, you are making $150, giving you a profit of $50. However note that we mentioned earlier about Price Convergence. Now if you were to repeat this (buying from Market A and selling in Market B) at some point the supply to demand ratio changes.
So in Market A, you would end up with higher demand, thus pushing the prices higher and in Market B, due to increased supply, it would push the prices lower.
Arbitrage was a common practice in the sports betting industry and would usually entail the punters to look at multiple price feeds and take positions accordingly. However a lot has evolved and this includes the spreads from forex brokers as well, reiterating the fact that arbitrage in forex comes far and few between. Forex arbitrage happens when either of the following conditions are met:
- The particular asset is being traded at a different price in a market
- Two particular assets with identical cash flows is not being traded for the same amount or price
- An asset with a known future price is not trading currently at the future price
Example of triangular forex arbitrage
Lets assume you have a forex broker A, who offers:
EURUSD at a bid price of 1.25732
EURGBP at a ask price of 0.79209
GBPUSD at a bid price of 1.58765
Now if you were to trade a 0.1 lot, then you would buy 10,000 Euro for USD12,573. You would then use 10,000Euro to buy 7920 British Pounds. You would then use the 7920 GBP to buy USD for $12574.
At this point, your initial investment was $12,573 and your final figure was $12574. At this point your profit is just $1.
Now if you were to place the same trade but place 1 lot, then your profit is essentially $10.
While the above example might not show outstanding results, note that the above sample data is extracted in real time with a real ECN forex broker during off market hours. As mentioned earlier, forex arbitrage offers a small window of opportunity and the real task lies in identifying the right moment of discrepancy.
In the above example, if you look closely, you will notice that unlike the previous example on arbitrage, with triangular arbitrage, the positions must be opened simultaneously thus minimizing market risk such as the one short order cancels the previous long order. This is also know as true forex arbitrage.
Considering the above, forex arbitrage is most ideal with using an automated tool to place orders for you. There are many tools and specially, Arbitrage Calculators that are designed to spot such trading opportunities.
Important Notes about Forex Arbitrage
Forex arbitrage is usually prohibited with market maker forex brokers and could instantly result in banning your forex account as well as withholding any profits you might have made. If you are trading with an ECN broker or a similar no dealing desk broker, be sure to check their terms and conditions before you engage in any sort of forex arbitrage. The basic principle is that because the ECN forex broker basically charges commissions, forex arbitrage is usually “tolerated.” However this policy differs from one broker to another, so always be 100% sure. There are some instances though where arbitrage is tolerated, provided you guarantee a minimum trading volume. The bottomline is to check with your forex broker beforehand.