Arbitrage is the trading practice of buying and selling assets simultaneously in different markets to exploit their temporary price differences for a profit. Arbitrage is important in markets because it helps identify and resolve market inefficiencies.
Arbitrage forex traders buy a currency at a low price in one market, then sell it at a high price in the second market. The benefit of arbitrage is that it allows arbitrageurs to enjoy risk-free profits while enhancing market efficiency and price stabilization.
The drawback of arbitrage trading is that the profit margins can be small, and traders may require large capital to make decent profits.
To use arbitrage, traders should identify market inefficiencies and then calculate the potential profits minus the transaction costs to determine if the trade is worth the risk.
What is Arbitrage?
Arbitrage is a financial strategy that exploits price differences between the same asset but in different markets. Arbitrage traders buy low in one market and sell high in another market, generating profits from the price difference. Arbitrage aims to make markets more efficient by correcting price discrepancies between financial assets and preventing price discrimination in different countries.
Arbitrage traces its origin back to the ancient and medieval periods when merchants and traders engaged in primary forms of arbitrage by taking advantage of price differences for goods in different regions. After the rise in currency use, trade merchants would exchange money from one area to another to profit from differences in exchange rates.
Arbitrage today happens across various markets, including stocks, currencies, and commodities, where the asset’s listed price on exchanges differs in different countries.
Arbitrage opportunities are often small and short-lived, making them harder for newbies who want to learn forex trading to capitalize on them but still don’t understand the arbitrage definition.
What is Arbitrage Trading?
Arbitrage trading is the simultaneous buying and selling of an asset in two markets to profit from their price difference. Temporary price discrepancies are common in inefficient markets and enable experienced market participants to participate in arbitrage trading. Arbitrage trading is considered risk-free profit after transaction costs because all transactions are executed concurrently, minimizing exposure to market risk.
Arbitrage traders use mathematical and quantitative models to identify tiny price differences rapidly across markets and execute trades. The relatively high-frequency nature of arbitrage opportunities makes them unsuitable for arbitrage investing.
Arbitrage trading offers very profitable returns for traders who use large trading volumes or position sizes when opening small, short-lived positions.
What is the importance of Arbitrage?
Arbitrage plays a crucial role in the efficiency and stability of financial markets, including the forex, stock, and commodities markets. Arbitrageurs help push the prices towards fair value or equilibrium, enhancing market efficiency when they buy an asset (such as a commodity or a currency) at a low price in one market and sell it at a higher price in another market.
Arbitrage ensures that prices don’t deviate substantially from their fair value for long periods. The price alignment reduces market volatility by lowering the likelihood of excessive price fluctuations, leading to a stable market ideal for trading.
Arbitrage’s rapid buying and selling activities make it easier for market participants to complete trade transactions without causing large price movements. Arbitrage attracts more traders and investors, increasing trading activities and enhancing market liquidity.
Regulators and authorities seek to understand how arbitrage works because it helps them identify potential market weaknesses or inefficiencies.
How does Arbitrage work?
Arbitrage works under the ‘buy low, sell high’ principle and the ability to capitalize on price discrepancies for the same or similar assets in different markets. Traders look for a price discrepancy on an asset across various markets or platforms, then simultaneously buy the asset in the cheaper market and sell it in the market where it’s priced higher.
Market discrepancies arise from factors like market inefficiencies, technological delays in price updates, geographical disparities, or differences in supply and demand. Traders pocket the difference between buying and selling an asset with price discrepancies as profit (after deducting transaction costs).
Speed is key in arbitrage trading because opportunities disappear quickly, sometimes forcing traders to adopt algorithms and high-frequency trading (HFT) to capture trades.
An example of profitable arbitrage in the forex market is through triangular arbitrage, as shown below:
Suppose the direct exchange rates for EUR/USD is 1.2000, USD/GBP is 1.3500, and EUR/GBP is 1.5000. The calculated implied rate of EUR/GBP is obtained by multiplying EUR/USD and USD/GBP, i.e., 1.2000 * 1.3500 = 1.6200. A trader who buys EUR/GBP with $1,000 converts it to 833.33 euros (since 1.2 dollars equals 1 euro). The trader then converts the Euros to Pounds at the EUR/GBP rate of 1.5000, making it 1250 GBP. Finally, the trader gets $1,687.50 on converting the British Pounds to dollars at the USD/GBP rate of 1.3500. The arbitrage opportunity exists when the implied EUR/GBP rate differs from its direct exchange rate. In this case, the direct exchange rate is 1.5000 while the implied rate is 1.6200, giving a 0.12 price discrepancy. The trader therefore makes a profit of $1687.50 – $1,000 = $687.50. The total profit the trader receives could be slightly lower when the transaction fees, which are common in all types of arbitrages, are included.
What are the Different Types of Arbitrages?
The different types of arbitrages are listed below.
- Retail Arbitrage
- Merger or Risk
- Pure Arbitrage
- Convertible Arbitrage
- Dividend Arbitrage
- Futures Arbitrage
- Triangular Arbitrage
Triangular arbitrage is the most suitable type for trading in the Forex Exchange Markets.
1. Retail Arbitrage
Retail arbitrage involves purchasing goods or products from retail stores at lower prices and reselling them at higher prices. Retail arbitrageurs look for discounts, promotions, or clearance sales on goods like clothing or electronics and then use e-commerce platforms like Amazon, eBay, or Walmart to sell them at a higher price for a profit.
Retail arbitrage has a low barrier to entry and makes it easy for anyone to make quick profits. The downside to retail arbitrage is that having more people in the industry increases competition leading to market saturation.
2. Merger Arbitrage
Merger or risk arbitrage exploits the price difference between a company’s stock price and its announced acquisition price during a merger or takeover. Traders buy the shares of the company being acquired and short-sell the shares of the acquiring company, profiting from the spread.
Merger arbitrage offers traders predictable returns since the deal is usually agreed upon between companies. The main risk is the possibility of the deal falling through or taking longer than expected, tying up the trader’s capital.
3. Pure Arbitrage
Pure arbitrage is the most common arbitrage strategy in which a trader simultaneously buys and sells a financial security in different markets to profit from the price difference. An example of pure arbitrage is an investor buying a stock on the New York Stock Exchange (NYSE), where it’s priced lower, and selling it on the London Stock Exchange (LSE), where it’s priced higher.
Pure arbitrage is low risk, allowing traders to generate guaranteed profits, but it’s harder to execute since opportunities vanish quickly in modern, highly efficient markets.
4. Convertible Arbitrage
Convertible arbitrage involves opening simultaneous long positions in a company’s bonds and short positions in the same company’s stock. A convertible bond is a hybrid security that’s convertible into equity of the issuing company.
Convertible arbitrageurs look for situations where the convertible bond is undervalued relative to the stock price, then they open a long position on the bond and a short position on the stocks, profiting from their price discrepancies.
Convertible arbitrage entails lower potential risks than traditional stock investing, but the strategy is complex and incurs high transaction costs.
5. Dividend Arbitrage
Dividend arbitrage involves buying and selling dividend-paying stocks just before the ex-dividend date, hoping to capture the dividend payment. The ex-dividend date is the date after which a stock purchaser is not entitled to receive the upcoming dividend payout. Traders buy the stock before the ex-dividend date and then sell it right after.
Dividend arbitrage carries minimal risk and leads to decent profits, but it incurs high transaction costs, and the dividends could be subject to taxation.
6. Futures Arbitrage
Futures arbitrage takes advantage of the price difference between a futures contract and its underlying asset’s spot price. Traders buy the underlying asset, for instance, gold, in the foreign exchange markets (cash) while selling the asset’s futures contract instantaneously at a higher price to make a profit.
Futures arbitrage offers the potential for profits with minimal risk but requires precise timing and fast execution to capture price discrepancies.
7. Triangular Arbitrage
Triangular arbitrage exploits price discrepancies between three currencies in the FX market to make a profit. Arbitrageurs benefit when the indirect exchange rate between two currencies, calculated through a third currency, differs from the direct exchange rate quoted in the market.
Triangular arbitrage is theoretically a risk-free strategy that guarantees traders profits; however, traders require large capital to make meaningful profits. Overall, triangular arbitrage is the most suitable type of arbitrage for the forex markets.
How to use Arbitrage?
Using arbitrage involves several steps:
- Identify Opportunities: Look for price discrepancies for the same asset (e.g., currency pairs) across different markets or brokers.
- Calculate Profits: Calculate the price differential between the two markets to determine the potential profit from arbitrage.
- Calculate transaction costs: Find out the brokerage fees, exchange fees, and currency conversion fees. The potential profits should be higher than the transaction fees.
- Execute trades: Open simultaneous buy and sell orders on a fast and reliable trading platform.
- Monitor positions: Watch the trades keenly and close when you lock in profits or when market conditions change.
When to use Arbitrage in Forex Trading?
Forex traders use arbitrage when they identify market inefficiencies and price differences they can exploit on a currency pair. Arbitrage opportunities arise during times of high market volatility, low liquidity, major economic news, and geopolitical and natural events. Traders identify arbitrage opportunities using technical analysis, real-time market data, fundamental analysis, or market scanning software and use arbitrage to earn profit.
High market volatility often leads to large and frequent price discrepancies between different forex markets and currency pairs. The rapid price movements available during these periods create multiple arbitrage opportunities that traders capitalize on.
Arbitrage is used in FX trading during the release of major economic news, geopolitical events, or natural disasters, which result in temporary mispricings and provide arbitrage opportunities. A study by Yong Chen, Zhi Da, and Dayong Huang titled ‘Arbitrate Trading: The Long and the Short of It’ noted that arbitrage traders during the 2007-2009 financial crisis remained profitable despite their capital constraints.
How is Arbitrage utilized with Forex Brokers for High-Frequency Trading?
Traders use arbitrage in Forex markets by taking advantage of the differences in currency prices quoted by different brokers. High-frequency trading (HFT) algorithms are often employed to execute arbitrage strategies efficiently. HFT algorithms can rapidly analyze market data and execute trades within fractions of a second.
An arbitrage trading strategy, particularly when combined with high-frequency trading brokers, is predominantly utilized by institutional traders rather than retail traders. Institutional traders possess substantial resources, including advanced technology, sophisticated algorithms, and significant capital, which are essential for effectively executing high-frequency arbitrage strategies. Institutions can invest in low-latency infrastructure and colocation services to gain proximity to trading servers, thereby minimizing execution times.
When does Arbitrage occur?
Arbitrage opportunities occur when there are discrepancies in the pricing of the same asset, allowing traders to make risk-free profits by simultaneously buying and selling that asset. Arbitrage is caused by market inefficiencies arising during news events and market shocks when the price quotes aren’t perfectly reflected in asset prices across different markets.
An example of arbitrage occurring is when gold is priced at $1,800 per ounce in the London market and $1,805 in the New York market. An arbitrageur buys gold in London and sells it in New York, making a $5 profit.
Arbitrage occurrence is predicted to evolve as market participants embrace advancements in technology such as AI, quantum computing, blockchain, and innovations in high-frequency trading, which enhance efficiency and create new market opportunities.
Regulators are likely to introduce stricter rules in the future to identify and prevent manipulative practices that exploit market inefficiencies, leading to unfair advantages for some parties. The relationship between technological advancement and regulations is likely to reduce instances of market arbitrage.
What are the Benefits of Arbitrage?
The benefits of arbitrage are listed below.
- Potentially risk-free profits: Arbitrageurs aren’t exposed to significant market risk since the buying and selling price is known in advance.
- Improved market efficiency: Traders exploiting price discrepancies help correct imbalances and ensure better asset price discovery.
- Price stabilization: Arbitrageurs help stabilize asset prices by quickly correcting any deviations from the fair value.
- Increased market liquidity: The simultaneous buying and selling adds volume and depth to the market, making it easier for traders to enter and exit positions.
- Quick and easy profits: Traders make profits quickly from short-term arbitrage opportunities without having to predict market trends.
What are the Drawbacks of Arbitrage?
The drawbacks of arbitrage are listed below.
- Small profit margins: Arbitrage opportunities are often small price differentials, resulting in very small profit margins.
- High transaction costs: Transaction costs like trading fees, spreads, and currency exchange commissions eat into the arbitrage profits.
- Large capital requirements: Arbitrageurs need large sums of money to make meaningful profits from small price discrepancies.
- Execution challenges: Arbitrage opportunities require quick and precise execution before they disappear. Any execution delays erode profits.
- Technology dependence: Arbitrage relies heavily on advanced trading technology and infrastructure, which isn’t available to every trader.
Is Arbitrage illegal?
No, arbitrage is not illegal. Arbitrage is a legitimate trading strategy with relatively low risk recognized in most countries as a way to profit from price discrepancies between similar assets in different markets. Arbitrage trading is encouraged by regulators because it facilitates market efficiency by correcting price discrepancies and boosting market liquidity.
Some types of arbitrage activities like market manipulation, insider trading, front-running, or violating exchange rules are illegal and lead to severe legal consequences.
Many brokers and financial institutions restrict or prohibit arbitrage, even though it’s not illegal in their jurisdictions. They view arbitrage as a threat to their profits and hedging strategies.
What is the difference between Arbitrage and Hedging?
The difference between arbitrage and hedging lies in their primary objectives. Arbitrage involves exploiting price discrepancies between different markets or instruments to secure risk-free profits, while hedging involves taking multiple trade positions to offset potential losses in another investment.
Arbitrage seeks to make quick profits from short-term, temporary price imbalances between markets. Hedging vs. arbitrage aims to preserve capital and minimize losses rather than generate profit. Hedging is long-term, and trades are held for weeks to months, unlike arbitrage opportunities, which only last a few seconds.