How to Use Forex Arbitrage Strategy?

Sep 28, 2021 07:32 PM ET
How to Use Forex Arbitrage Strategy?

Arbitrage is a trading strategy in which traders try to benefit from price differences between related assets. Arbitrageurs are profit-driven traders that participate in this kind of trading.

Traders use arbitrage to profit from discrepancies in fx rates by taking advantage of short-term fluctuations that occur in various markets. They take advantage of pricing differences between two markets in order to profit from the often short-lived favorable circumstances.

How arbitrage trading works

In order to make a quick profit, arbitrage traders aim to find financial market mistakes and exploit them. They are on the lookout for price variances, which could occur due to variations in levels of supply and demand across different exchanges. With that in mind, traders are given a simple, quick opportunity to make a significant reward without a big risk.

By incorporating the automated trading system, traders are better equipped to get the most out of their arbitrage trading.

Automated trading systems use algorithms to detect price variations. A trader can capitalize on a profitable opportunity before it becomes widely known, and the markets respond.

Types of arbitrage

Forex arbitrage can be divided into three categories:

  • Two-currency: This is the practice of leveraging the differences in quotations between two currency pairs rather than the price variations between individual currencies

  • Covered interest: This is a trading strategy in which a trader takes advantage of the differential in interest rates between two countries while simultaneously using a forward contract to hedge against exchange rate risk to make a profit.

  • Triangular: In this instance, as the name suggests, the transaction is three-stepped. First of all, you have to convert your original currency into two different currencies. This means that you will have to decide how much of your capital will go towards purchasing each currency. Secondly, you have to convert the first currency back to the original currency. And thirdly, you will convert the second currency you bought back to the original. Again, remember that exchange rate differentials in markets play a critical role.

Two-currency arbitrage

This is a form of arbitrage in which two currencies are traded against one another.

A popular form of 2 currency arbitrage is when two different brokers are used for trading the same two currencies, allowing the trader to profit from any price discrepancies that may exist between the brokers.

As an illustration of currency arbitrage, consider the following scenario: two different banks have set different rates on the EURUSD currency pair: In this transaction, bank X buys one euro at 1.7400 and sells it at 1.7500. Bank Y is purchasing one euro at 1.7600 dollars and selling it at 1.7700 dollars.

An example would be for a trader to purchase euros from bank X, which is selling them for 1.7500, and then immediately sell those euros to bank A, which is purchasing them for 1.7600. If the trader makes this move with a 10,000 capital, they stand to make a 100 profit in a short period of time.

If the trader notices a discrepancy in pricing, he or she must act quickly because the forces of supply and demand will cause the banks to adjust their pricings as soon as a few traders become aware of it, and the chances for arbitrage diminish.

Covered interest arbitrage

Covered interest arbitrage enables a trader to profit on the difference between two currencies' interest rates. They engage in a forward contract to help minimize their risk.

A forward contract allows a trader to secure a future exchange rate while also buying currency at the current spot rate.

A trader who uses this strategy for the EURUSD could do the following:

  • Open a starting account with a specific amount of USD. Establish that eurozone interest rates are better than interest rates in the United States. 
  • Convert the USD to EUR at the current exchange rate and invest in the eurozone. 
  • Create a forward contract on EUR USD with a fixed exchange rate to protect yourself against any fluctuations in the exchange rate over the course of the investment period at the same time. 
  • Execute euro-denominated interest rate payments
  • The forward contract guarantees that your euros will be converted back into US dollars at a specific exchange rate.

Triangular arbitrage

Forex triangular arbitrage is a trading technique aimed at making a profit by implementing compensatory forex transactions from price fluctuations on different markets. To understand how arbitrage currency pairings operate, we must first comprehend currency pairs.

You essentially take two positions when you trade a currency pair: to buy one currency in the pair and to sell the other.

A currency cross is a forex pair in which the USD is not included. The exchange rates of the currencies in question vs the USD imply a theoretical, or synthetic, value for a cross.

Let's take an example of some of the most common pairs: EURUSD, EURGBP, and GBPUSD.

The EURUSD exchange rate at 'bank X' is now 1.3500, the EUR GBP exchange rate at 'bank Y' is 1.4000, and the GBP USD exchange rate at 'bank Z' is 1.4500.

A trader could take the following actions in this scenario:

  1. At 'bank X,' exchange €100,000 for USD to receive $135,000 (100,000 X the current exchange rate of 1.3500).
  2. At 'bank Y,' convert the $135,000 into GBP, and you will receive £96,428 (135,000 /1.4000 exchange rate).
  3. At 'bank Z,' exchange £ 96,428 for US dollars in order to receive $139,820 (£96,428 X the 1.4500 USDGBP exchange rate).

The resultant profit would be $9,820. Adding the initial capital of $135,000 means that the trader would walk away with $139,820 in cash. Note that the above breakdown does not incorporate transaction costs or any payments you may incur in the process.

In summary

Using the inefficiencies of the securities markets, arbitrage is a legal and potentially lucrative strategy that can generate significant profits. To identify trading opportunities, one must conduct thorough due diligence across a number of different markets. This trading strategy, on the other hand, can be extremely time-consuming.

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