What is a Forex arbitrage strategy?

There are many ways to profit on the Forex market. Anticipating the future price movements of currency pairs is one of them, and arguably the most widespread among retail Forex traders. Carry trades and accumulating rollover profits is also a popular trading approach, which is based on buying a higher-yielding currency and simultaneously selling a lower-yielding currency, making a profit on the interest rate differential. However, did you know that traders can also make profits with very low risk through Forex arbitrage? If you don’t know what Forex arbitrage is, then you're in the right place. In this article, we’ll cover everything you need to know about the Forex arbitrage strategy and give examples on how it works.

What is arbitrage in Forex?

Arbitrage is a well-known practice in financial markets that aims to take advantage of price discrepancies on the same asset, traded on different markets. An arbitrageur would simultaneously buy and sell the same asset or two similar assets which show a price imbalance on different markets, making a profit from the price difference. To make this concept crystal clear, let’s cover it with a hypothetical example. For instance, if the same car costs $30,000 in your country, but $35,000 in a neighbouring country, you could theoretically buy the car in your country and sell it in the other country, making a profit of $5,000. Of course, we didn’t take into account any import tariffs or gasoline costs to transport the car to the other country, as this is a simple example of an arbitrage opportunity.

Arbitrage example

Similar to our car example, arbitrage opportunities also exist on financial markets. Traders could buy commodities, currencies, or even stocks on one market, and sell them seconds later on another market on which the security trades at a higher price. Arbitrage is an important concept of today’s financial markets, as it helps to balance prices across different markets.

For example, a company could list its stocks on more than one stock exchange. If the price of the same stock differs on the New York Stock Exchange and the London Stock Exchange, one could buy the lower-priced stock on one exchange and simultaneously sell it at a higher price on the other exchange, making a profit from the price differential. Arbitrage on the Forex market is quite similar to that of the stock market, only the assets involved are not stocks, but currencies.

Triangular Forex arbitrage

Since arbitrage is a fairly low-risk strategy, arbitrage opportunities don’t last long on the market. The buying pressure on the lower-priced asset and the selling pressure on the higher-priced asset on different exchanges causes the prices to converge eventually. The advancement in technology and software helped large investors to continuously search for price discrepancies of the same assets traded on different markets, causing the arbitrage opportunity to disappear in a matter of seconds by increasing the demand for the lower-priced asset and increasing the supply for the higher-priced asset. Still, arbitrage opportunities arise from time to time and traders could make a profit with the help of certain arbitrage strategies, such as the triangular Forex arbitrage strategy.

The Forex market is an over-the-counter market without a centralised exchange. This means that currencies trade at the same prices most of the time. While a swap arbitrage Forex strategy looks for discrepancies in currency swaps, the triangular currency arbitrage on the spot market aims to exploit exchange rate anomalies between different currency pairs.

Let’s say that EUR/USD is trading at 1.1450, USD/CAD at 1.3110, and EUR/CAD at 1.5005. When buying a currency pair, you’re basically buying the base currency and selling the same amount of the counter currency at the current market rate. For example, if you buy one standard lot of EUR/USD, you’re buying 100,000 euros and selling US dollar in the amount of 100,000 euros, i.e., 114.500 USD.

Buying one lot of USD/CAD follows the same principle. You’re buying 100,000 US dollars, and selling 131,000 Canadian dollars at the same time, at the current market rate.

Since currency pairs are basically fractions with numerators and denominators, we’re able to calculate the intrinsic exchange rate of EUR/CAD by using the exchange rates of EUR/USD and USD/CAD. Simply multiply these two exchange rates to get the EUR/CAD exchange rate.

EUR/USD at 1.1450 x USD/CAD at 1.3110 = EUR/CAD at 1.5010

If you have 100,000 euros at your disposal, you could theoretically buy 114,500 USD, exchange it for CAD at 1.3110, which is equal to CAD 150,100, and exchange the Canadian dollar to euros again at the current market rate of 1.5005 to receive 100,033 euros. Starting with 100,000 euros, you now have 100,033 euros simply by exchanging them first to US dollars, then to Canadian dollars, and then to euros again, making a risk-free profit of 33 euros.

An example of another triangular Forex trade, which includes EUR/GBP, GBP/USD, and EUR/USD, is shown in the following graph.

Triangular arbitrage

Since the Forex market is a fairly efficient market, the difference in exchange rates between various currency pairs is usually very small or doesn’t exist at all. That’s why you need a larger position size to make a sizeable profit from the exchange rate discrepancies. In our example above, we were dealing with a position size of one standard lot to make a profit of 33 euros. If we increased that position size to 10 standard lots (1,000,000 euros), the potential profit would increase to 330 euros.

Statistical arbitrage on Forex

Another interesting Forex arbitrage trading system is statistical arbitrage. This strategy is based on shorting a basket of over-performing and buying a basket of under-performing currencies, with the idea that the over-performing currencies will eventually decrease in value, while under-performing currencies will increase in value. Most assets eventually revert to their mean value, and mean-reverting strategies aim to exploit this phenomenon.

Of course, tight historical correlation between the two baskets would be an advantage in this basket trading Forex strategy, in order to create a market-neutral portfolio.

Correlation is a statistical method that measures the interrelationship and interdependence between two (or more) variables. If one of the variables changes, correlation measures how the other variables will react to that change.

The most popular Forex correlation type is between currency pairs, which is often represented in the form of Forex correlation tables. These tables show the current correlation coefficient between various pairs, which can take a value of between -1 and +1. In general, a correlation coefficient of -1 reflects a perfectly negative correlation, i.e., if a currency pair goes up by 1 pip, the other pair goes down by 1 pip. Similarly, a correlation coefficient of +1 reflects perfectly positive correlation, i.e., if a currency pair goes up by 1 pip, the other pair will also gain 1 pip. A correlation coefficient of 0 shows that no significant relationship between the two currency pairs exists.

The following table shows a Forex correlation table, taking into account currency moves from November 2012 to September 2018.

Currency correlation table

As the table shows, the EUR/USD pair is highly correlated with the AUD/USD pair, with a high positive correlation of 0.9116. In other words, these two pairs will move in the same direction most of the time. On the other side, EUR/GBP exhibits a strong negative correlation with GBP/JPY, i.e., these two pairs will move in the opposite direction most of the time. The GBP/JPY pair has an almost non-existent correlation with the EUR/CHF pair, which is no wonder given that these pairs don’t include the same currencies.

If the euro is an over-performing currency, and the Australian dollar an under-performing currency, you could look to sell EUR/USD and buy AUD/USD to create a market-neutral arbitration portfolio.

Risks of arbitrage strategies

Now that you know what arbitrage trading is in Forex, let’s take a look at the risks involved.

While arbitrage usually carries very low risks and is often described as a risk-less way to make a profit, this is not always the case. Since the Forex market is a highly liquid and efficient financial market, arbitrage opportunities are rare, and even when they occur, the difference in the exchange rates tends to be very small. This is why we need significantly large position sizes to make a notable profit with arbitrage.

Slippage and transaction costs are also important points to consider given the small difference in exchange rates. Slippage can easily eat into the profits of an arbitrage opportunity, and transaction costs need to be taken into account when calculating the potential profit. Also, not all Forex brokers allow arbitrage trades. You need to open an account with arbitrage brokers Forex in order to trade on these strategies. Forex brokers that allow arbitrage usually state this feature on their website.

Finally, in the case of a triangular Forex arbitrage system, all trades should be executed almost instantly in order for the exchange rate to remain at the same levels. Remember, many traders are looking for arbitrage opportunities, which is why these setups quickly disappear from the market.

Conclusion

Arbitrage is a well-known technique that aims to exploit price differences of the same asset on different markets. Arbitrage opportunities can occur in all types of markets, even in your supermarket. While arbitrage is often considered risk-free, it’s important to calculate transaction costs and slippage into the equation since these costs can easily make an arbitrage opportunity worthless. In addition, since the differences in exchange rates on the Forex market are usually very small or don’t exist at all, position sizes need to be relatively large to make a notable profit from the arbitrage opportunity. When arbitrage trading Forex on leverage, pay attention to the required margin needed to open the positions in order to avoid a margin call.

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