Arbitrages take advantage of the differences in the prices of currencies offered by the various brokers that deal with forex (the foreign currency market) to the advantage of those who carry out the trades. In practice, the investor takes advantage of situations where a certain currency has different prices in two markets. It is not recommended to use arbitrage as the only trading strategy in forex, just as this practice is not recommended for investors with little financial resources, which require large capital transactions.
Understanding Arbitrage and the Forex Market
Learn about the foreign currency market. Commonly known as forex, this international market deals with the trading of currencies. It allows investors (from the largest banks to small savers) to exchange one national currency for another. Each transaction is a trade, because one currency is sold to buy the other. This implies that the prices are expressed in other currencies. In other words, a euro is only priced in terms of British pounds, Japanese yen, US dollars or other currencies.
The forex market also facilitates the sale of financial instruments, including forwards, swaps, options and others. These are more complex transactions than simple currency exchanges that require many other trading strategies.
Learn about arbitrage. With this practice, you buy an asset in one market and sell it immediately afterwards on another at a slightly higher price. In theory, a currency should have the same price on all markets. However, system inefficiencies (which are often caused by communication difficulties) can generate price changes between different markets at the same time. Arbitrages exploit these errors for the benefit of the investor.
For example, if an investor notices that a currency can be bought in one market for less than it can be resold in another, they can leverage those transactions and profit from the difference.
Learn how to use arbitrage to make profitable trades. Those who invest in forex take advantage of the small differences in the prices of currencies, buying them where they are worth less and selling them where they have a higher price. This usually requires in practice to carry out multiple intermediate currency transactions. For example, you couldn’t just buy and sell US dollars. You may have to buy dollars with your euros, then sell them for pounds, which you will use to buy back the euros.
For a more specific example, imagine that you can buy a British pound (£) for € 2, then you can use that pound to buy $ 1.5, and finally you use dollars to buy € 2.5. Thanks to these transactions you would earn € 0.5, simply by exploiting the differences in the prices.
In the real world, price differences will never be this extreme. They are usually fractions of a cent. To get good returns and not see their margins completely lost in fees, investors need to trade large amounts of money.
Furthermore, investors must consider that arbitrage opportunities often disappear within seconds (because markets correct pricing errors very quickly). Professionals rely on computers and automated trading to buy and sell currencies fairly quickly.
Learn to read the current quotes. On the markets, prices are expressed in a very specific way. As mentioned earlier, currencies are quoted relative to other currencies. The US dollar is often used as the reference currency. For example, the value of the Japanese yen is expressed as a dollar / yen (USD / JPY) ratio.
Relative quotes of currencies are usually expressed up to the fourth decimal place. For example, the euro-dollar ratio can be expressed as 1.1156 EUR / USD. This means that at the time of listing it takes US $ 1.1156 to buy one euro.
Calculate the Arbitrages
Determine which currency to use. To perform triangular arbitrage, you need to compare the exchange rates of three “currency pairs ” that you can trade. An example is EUR / USD (euro / dollar), EUR / GBP, (euro / pound sterling) and GBP / USD (pound / dollar). As with any triangular transaction, three currencies are involved, each paired separately from the others.
Know the exchange rate of each pair. You can find the current quote on the forex broker program you are using (if you use a broker) or on websites that report this information. For our example, consider that the exchange rates for (EUR / €), British pound (GBP / £), and US dollar (USD / $) are as follows.
The EUR / USD exchange rate is 1.2238, which means you can buy 1 € for about 1.22 $
The GBP / EUR exchange rate is 1.1910, meaning you can buy £ 1 for around € 1.19
The GBP / USD exchange rate is 1.4650, i.e. with £ 1, you can buy around $ 1.47
Calculate arbitrage. To take advantage of arbitrage, you need to buy and sell multiple currencies, which are traded in units called “lots “. Standard lots are blocks of 100,000 units of currency, while mini-lots contain 10,000 units.
Imagine being able to carry out a trade with a leverage of $ 500,000. Leveraged transactions are carried out primarily with borrowed money.
Spend $ 500,000 to buy euros. Since the dollar is in the denominator of the exchange rate (EUR / USD), divide 500,000 by the quote: $ 500,000 / 1.2238 = € 408,560.
Sell Euros for British Pounds. Since euros are in the denominator of the exchange rate (GBP / EUR), divide them by the rate to get pounds: € 408,560 / 1.1910 = £ 343,040.
Sell British Pounds for US Dollars. In this case the pounds are in the numerator (GBP / USD), so multiply that by the rate to get the dollars: £ 343,040 x 1.4650 = $ 502,550.
Calculate the profit. You started with $ 500,000 and now have $ 502,550 after three transactions. The profit is $ 502,550 – $ 500,000 = $ 2,550.
Using Arbitrage as a Trading Strategy
Log into a forex trading platform or program. Brokers and investors looking to take advantage of arbitrages do not calculate them manually. They use programs that can identify market opportunities and recognize arbitrage in seconds. Additionally, these software can be configured to make trades automatically as these opportunities arise. Choose a service, create a profile and start trading in the forex market. Search the internet for “online forex trading ” to find out about the types of programs currently available.
Be aware that many platforms impose transaction fees. These fees reduce (or even cancel) your profits on each transaction, especially if you trade limited capital.
Beware of programs that don’t work well. On the internet you can find programs for sale that recognize forex arbitrage. Before using a real account, try them out on a demo one. This way you can be sure that the program does not lead you to lose money. Get advice on which trading software and platforms to use from more experienced arbitrage investors.
Look for arbitrage opportunities. Some internet forex trading platforms offer automatic calculators and programs that recognize these opportunities. Take advantage of this service if your platform offers it.
You can also use an independent calculation program to determine if an arbitrage opportunity exists. You can find them on the internet, in some cases for a fee, in others for free. Try searching for “arbitrage calculator “.
Do not hesitate. Markets correct mistakes very quickly when arbitrage opportunities arise. You will need to act quickly to complete the transactions before it is too late. When you notice an advantageous price difference, take advantage of it right away.
In fact, due to the current level of technology and the ease of communications globally, forex arbitrage is usually only profitable for large financial institutions with lightning-fast trading systems. In fact, arbitrage opportunities often last only a few seconds.