For decades, traders have always pursued methods to profit off forex with minimal downside. While using traditional strategies is one method for achieving this goal, it takes many years to perfect, and you are constantly dealing with risk in any given position.
Some turn this model on its head by capitalizing on what is known as arbitrage, a style of trading aiming to profit from ‘glitches’ in prices of identical markets from two providers.
What is arbitrage?
Arbitrage is a market-neutral trading approach when one looks to exploit price discrepancies by simultaneously buying and selling one asset offered by two different institutions.
Because forex is a decentralized market, dealers and brokers use quotes with very slight variances (this strategy is also possible with many other instruments). Even in centralized markets like stocks, in truth, no security operates in a totally efficient, error-free manner.
In forex, we have a multitude of ECNs (electronic communication networks), all dealing with astronomical data flow. For the most part, information is instantaneous, but not in all cases. Such variance can occur from a few causes like time and software delays, positioning, etc.
Though these differences seem minute, with highly-skilled observations, an arbitrageur can exploit such gaps.
The common types of arbitrage in forex
As with any methodology, there are several ways (primarily three) to achieve arbitrage potentially.
For the first two methods, computer software is imperative as only they can scan various markets to look for these opportunities. The last approach is a slower, investing-like process because one has to hold the position for at least a few months.
Two-currency or locational
This is the simplest form to understand by taking advantage of the same currency pair offered by two different financial institutions (typically banks).
For example, if the instrument was USD/JPY, the trader converts yen (JPY) by buying USD from one bank and then sells the same USD to another with a higher USD/JPY rate. By selling dollars for yen, they hopefully will have more yen than they initially did.
This technique is a little more complex because it involves three different pair combinations of the equivalent number of currencies (hence, ‘triangular’).
So, assuming they’ve spotted a chance, if an investor had Swiss francs, they would sell those for British pounds (EUR/GBP), and then British pounds for the yen (GBP/JPY), and finally the yen back to Swiss francs (JPY/CHF).
This is the most interesting and complex of them all. The advantage, though, is it relies on a long-term horizon rather than trading within seconds.
Covered interest is similar to carry trading in looking to capitalize on interest rate differentials between two currencies. The only distinction is, unlike the latter, an investor employs a future contract to shield themselves from exchange rate risk by locking in a specific price.
Let’s imagine an American investor has identified the interest rates of Switzerland and America are 6% and 2%, respectively (4% differential). Their first step would be to buy Swiss francs at the spot price using their dollars.
Then they will invest the CHF at the 6% interest rate. Now they enter into a one-year (or at least three months because this is the minimum length for a futures contract) CHF/USD futures contract that locks in a rate lower than the spot price.
They do this so that after a year (or however long), when they sell the CHF back to USD, the price is favorable enough to provide them with more dollars than they started with.
In the first two strategies, the main risk is the speed at which pricing will go back to equilibrium. In the last one, it’s more about the hope the exchange rate will be at least equal or lower than what they’ve locked in the contract.
Pros and cons of arbitrage trading
There are unique things that are both beneficial and detrimental about such a strategy. The following pros and cons mainly question the commonly-held belief that this trading style is largely risk-free.
Perhaps the biggest motivation for this approach is it doesn’t require using a time-consuming technical strategy to predict whether an exchange rate will increase or decrease.
This means these movements are insignificant, especially because when ‘arbing’ (except for covered interest), the trader performs fast execution without holding positions for long since the chance presents itself typically in a matter of seconds to a few minutes.
- As technology has advanced, arbitrage opportunities are now scarce because providers and financial institutions are becoming more uniform in their pricing. So, finding any decent opportunities is like looking for a needle in a haystack.
- We also have to consider that nowadays, it’s improbable for the average retail speculator to execute this strategy with limited resources successfully.
Arbitrage is probably primarily practiced by high net-worth institutional traders using high-frequency trading because of the capital and technology requirements.
- Most arbitrage is like picking pennies and is similar to scalping. A profit from one opportunity is small, meaning a trader needs to do it frequently and has to buy and sell large quantities of currencies to realize a substantial profit.
- The ‘enemy’ of this strategy is the transaction costs. Because this approach is all about speed, spreads are generally variable, meaning they can change on the fly.
- Multiple requotes can occur within milliseconds at any moment, which could make a once potential arbitrage trade quickly disappear. This is why this trading approach is not wholly devoid of risk.
Except for covered interest arbitrage (which is more of a traditional investment), the other two strategies in this realm are tricky. For the most part, there are efficient pricing systems in place that present very few arbitrage opportunities.
Unfortunately, trading using this tactic is primarily reserved for institutional guys with the necessary capital and technological resources to identify the rare moments and profit from them quickly.
Ultimately, there is no easy forex strategy with real money on the line where little or no risk is involved.