What is Arbitrage Trading?

What Is Forex Arbitrage?

Forex arbitrage is defined as "the simultaneous purchase and sale of the same, or essentially similar, security in two different markets for advantageously different prices," according to the concept formalised by economists Sharpe and Alexander in the 1990s.^[1]

Given the popularity of forex trading, arbitrage strategies are implemented by thousands of participants around the world. Accordingly, someone who practices arbitrage is known as an "arbitrageur." Simply put, an arbitrageur buys cheaper assets and sells more expensive assets simultaneously to take a profit with no net cash flow. In theory, the practice of arbitrage should require no capital and involve no risk. In reality, attempts at arbitrage generally involve both.^[1]

Although the goal is the same, there are many types of arbitrage strategies. Examples include retail, convertible, negative and statistical. In some locales, markets and asset classes, such strategies are discouraged. However, on the forex, arbitrageurs are encouraged as their activities enhance market liquidity and efficiency.

"Risk-Free," Or Locational Arbitrage

According to economic theory, trading on financial markets is bound by the Efficient Markets Hypothesis, a concept developed by economist Eugene Fama and others from the 1960s onward. It suggests that markets (or more importantly all the active investors and participants in them) will process all available information about asset values and prices efficiently and quickly in such a way that there will be little, if any, room for price discrepancies across markets, and that prices will move quickly toward equilibrium levels.

Because of this natural tendency for prices to move toward equilibrium levels across markets at all times, traders may find it difficult to identify price discrepancies across markets that allow them to buy assets at "bargain rates." Or, in the words of renowned economist Milton Friedman, there's no such thing as a "free lunch."^[2]

Some market professionals question the validity of EMH. Stock investing legend Warren Buffett sums up his views on EMH with the following quote: "I'm convinced that there is much inefficiency in the market."^[5] Given the immense fortune Buffet has cultivated, there are legions of active traders that support his challenge to EMH and favor arbitrage strategies.

Arbitrage 101: Challenges For Retail Forex Traders

Despite the general acceptance of EMH, many people are fans of currency arbitrage. The reasons vary, but simultaneously buying and selling different currency pairs is often attractive due to limited liability and a reduced capital outlay.

However, retail arbitrageurs face a collection of challenges. While it is possible to make money implementing an arbitrage strategy, one must be as fast, informed, and connected as possible.

Latency

According to the Merriam Webster dictionary, latency is "a state of temporary inactivity."^[6] As it pertains to active trading, it is any factor that slows down strategic, order or trade execution.

Trade-related latencies play a major role in the success or failure of arbitrageurs. Real-time data lag, platform performance, and decision-making delays all undermine how quickly one can enter and exit the market. Unfortunately, institutional participants such as high-frequency traders (HFT) have the inside track on speed. Enhanced market connectivity and advanced computing power are assets typically only available to well-capitalised forex participants.

For any arbitrage trading strategy, speed is an integral aspect of success. Pricing discrepancies between forex pairs don't last very long. To cash in on inefficient exchange rates, one must be able to consistently avoid undue latencies.

Asymmetric Information

According to EMH, all available information is reflected in an asset's market price. This means that all publicly disseminated fundamental and technical data is "priced-in" to the market. However, the issue of asymmetric information persists.

In the realm of active trading, asymmetric information is another term for "privileged" or "inside" information. Essentially, it means that some parties are privy to market-related facts that others aren't. On the foreign exchange market, internal central bank dialogue, pre-release economic reports, or institutional order placement are examples of asymmetric information.

Asymmetric information has the potential to significantly influence exchange rates. And, the trading public doesn't become aware of the sensitive details until after pricing volatility ensues. Despite this disadvantage, savvy forex market arbitrageurs stay abreast of key economic, monetary policy and political developments as they unfold.

Market Access

To capitalise upon the inefficiencies in exchange rates, it's critical to have access to as many markets as possible. For retail forex traders, this involves maintaining multiple brokerage accounts in different locales. In doing so, one may be able to buy and sell different currency pairs at unique prices.

Securing a portfolio of trading accounts is typically a challenge for average retail participants. Posting the necessary margin money and adhering to local rules can stretch resources thin. For instance, assume that Broker A is offering a higher price for the GBP/USD than Broker B. If you sell the GBP/USD to Broker A (U.K.) and buy the GBP/USD from Broker B (U.S.), you can realise a risk-free arbitrage profit.

However, you must post margin money with both Broker A and Broker B. Also, you have to navigate regulations pertaining to the U.S. and the U.K. forex market trade. While overcoming these challenges is certainly feasible, doing so will require significant time, capital and expertise.

The Negative Spread: A Free Lunch?

While the efficient markets theory indeed works, in practice traders have found that markets have not shown themselves to be 100% efficient at all times due to asymmetric information between buyers and sellers.

One such occasion of market inefficiency is when one seller's ask price is lower than another buyer's bid price, also known as a "negative spread." For instance, this may happen when one bank quotes a particular price for a currency while another bank is referencing a different price. When a situation like this arises, an arbitrageur can make a quick profit by simultaneously executing a purchase from the seller and a sale to the buyer. In essence, the trader begins the trade in a situation of profit, rather than having to wait for a favourable evolution of market trends.

As an example, assume that Broker A and Broker B are offering different rates on the GBP. For the GBP/USD, Broker A has an ask of 1.3750, while Broker B lists an bid of 1.3752. Through instantly buying the ask from Broker A and selling the bid to Broker B, a 2 pip profit is realised.

However, while risk-free trading may sound like a great deal in theory, once again, in practice, traders should be aware that losses can occur. The most common risk identified by traders in arbitrage trading is "execution risk." This is the risk that price slippage or requotes can occur, making the trade less profitable or turning it into a loss. ^[2]

A Fast-Moving Market

With the rise of electronic trading platforms since the 1970s and the more recent growth of "high-frequency trading" using algorithms and dedicated computer networks to execute trades, some opportunities for so-called "risk-free" arbitrage have diminished. At the least, traders now must be much more agile and quick on the trigger finger to execute such trades. Whereas several years ago arbitrage trade opportunities may have lingered for several seconds, traders now report they may last for only a second or so before prices converge toward equilibrium levels.

However, market researchers have found that negative spread situations still do arise in particular circumstances. These tend to occur more often in periods of market volatility. They can also arise because of price quote errors, failure to update old quotes (stale quotes) in the trading system or situations where institutional market participants are seeking to cover their clients' outstanding positions.

Triangular Arbitrage

A variation on the negative spread strategy that may offer chances for gains is triangular arbitrage. Triangular arbitrage involves the trade of three (or more) different currencies, thus increasing the likelihood that market inefficiencies will present opportunities for profits. In this strategy, traders will look for situations where a specific currency is overvalued relative to one currency but undervalued relative to the other.

An example of triangular arbitrage would be to trade in three currency pairs, such as EUR/USD, USD/JPY and EUR/JPY. If in this case the euro is undervalued in relation to the yen, and overvalued in relation to the dollar, the trader can simultaneously use dollars to buy yen and use yen to buy euros, to subsequently convert the euros back into dollars at a profit.

Interest Rate Arbitrage

Another form of arbitrage that is common in currency trading is interest rate arbitrage, also known as "carry trade." This is when an investor sells currency from a country with low interest rates and buys and holds a currency from a country paying higher interest rates. When the investor reverses the operation at a later time, they will receive the net difference in interest paid on the two currencies. Because this operation is carried out over a period of time, the trader also may be subject to risks of variations in the levels of currencies or in interest rates.

Spot-Future Arbitrage: Cash And Carry

An additional form of arbitrage, known popularly as "cash and carry," involves taking positions in the same asset in both the spot and futures markets. With this technique, the trader buys an underlying asset and sells, or "shorts," the same asset in the futures market while the asset is purchased.

A similar strategy can also be taken in the other direction, and it's known as "reverse cash and carry." In this operation, the trader sells the underlying asset and buys, or "goes long," on the same asset in the futures market.

Summary

The use of arbitrage can potentially be a valuable strategy for traders to make timely profits although there is also a high level of risk of loss. Advances in trading technology and high-frequency trading in some cases have made true "risk-free" arbitrage opportunities less common for small-scale investors. But they have also widened access to diverse markets where asymmetric information and market inefficiencies may still present arbitrage opportunities.

Regardless of which market an arbitrageur chooses to operate in, what's most important is that they remain attentive to price levels and be on the lookout for when and where these opportunities may arise. Trading on margin carries a high level of risk and losses can exceed deposited funds.