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Wednesday, January 23, 2013

Arbitrage in Forex explained

Arbitrage in trading is a situation where a trader can take advantage of pricing inefficiencies and enter a position where there is a locked in profit and no risk at all. I slightly talked about arbitrage in options trading a while back in my article about the Box Spread. But I wanted to find out about it in Forex. There are a couple ways, but this one is the easiest to understand.

It's all based on price inefficiencies. For example, if EURUSD is trading at 1.3000 and GBPUSD at 1.5000 then you would expect EURGBP to be trading at 0.8667 (1.3000/1.5000). At that point if EURGBP is trading at a different value, then there is a chance to exploit a price inefficiency.

Consider the following prices:

EURUSD is trading at 1.3000/1.3001
GBPUSD is trading at 1.5001/1.5002
EURGBP is trading at 0.8668/0.8669

If you had 100 000 USD to invest, you could buy 76917.16 EUR (at the Ask price of 1.3001)
Then you sell those EUR in exchange for GBP. 76911.24 EUR = 66671.79 GBP (at the Bid price of 0.8668)
Finally you sell your GBP back into USD dollars. 66671.79 GBP = 100014.35 USD (at the Bid price of 1.50001)

You started with 100 000 USD, and finished with 100 014.35 USD. A small $14.35 risk free profit. Well, at least in theory.

Exploiting this inefficiency in reality is very difficult. Your trades would have to get filled at the same time. Otherwise you might complete one transaction, but then you might not get an immediate fill on your second transaction. By that point the price inefficiency could have been corrected and then you're screwed. Also, you need not two, but three transactions to get perfectly filled, without delays or re-quotes.

The second issue is that it is not easy to find this price inefficiency in one single broker. Brokers generally keep coherent prices in their pairs as they have software and tools monitoring these prices so they are not put at risk. Which means you are unlikely to find the inefficiency in the same broker  (Remember that Forex is not a regulated market so each broker can control the price of their offerings at a value generally around other brokers, but none holds the absolute truth). Then you would have to explore prices of currencies in other brokers. You can find a pricing inefficiency between two currency pairs in your first broker and a third currency pair in your second broker, and then you could do the triangle. Two transactions in one broker and the other in the other broker. Overall you would keep a profit in total. But as you can see this is even more challenging now, you are dealing with two trading platforms, two brokers and you need to have two properly funded accounts with each one.

Arbitrage opportunities like this one offer small rewards. So, if you want to have something meaningful you would obviously need a good amount of money, a good amount in two brokers. I believe these type of arbitrage opportunities are exploitable with the right software, speed of execution, liquidity and tight spreads. But I believe it is almost impossible for retail trades to successfully exploit. I've seen a couple Metatrader 4 Expert Advisors for Forex Arbitrage for sale to retail traders. My honest opinion is that, it is a very very challenging task for a retail trader to obtain any meaningful profit if at all, out of this.

Enlighten me if your experience has been different.

Hope you enjoyed the article.

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