Last Updated: July 21, 2020
Foreign exchange is a marketplace where traders try to make profits by anticipating the future direction of the market.
This is a double-edged sword for the participants as it can swing both ways depending on the circumstances as well as the conditions of the market.
A right decision can make you a millionaire in mere weeks whereas a wrong decision can eat away at your investment capital.
However, there are a few market-neutral methods you can use to make money on the foreign exchange without the need for predicting the direction of any currency pair.
One such method is known as the forex arbitrage.
Forex arbitrage refers to the strategy which is often used by fx traders with the help of which they take advantage of the price disparity in the foreign exchange market to make short term profits.
The arbitraging style usually includes buying or selling divergent currency prices that also have a very high possibility of converging at a moment’s notice.
Forex arbitrage is also considered to be the least risky strategy of making money on the foreign exchange and the traders who make use of this strategy are known as arbitrageurs.
In this article, we will talk about forex arbitrage in more detail and find out how you can use it to make money on the foreign exchange market.
The fx arbitrage is a trading strategy that is known to have very few risks. Using this strategy, traders can make a good profit without running the risks of open currency exposure that forex traders have to face.
In simpler words, forex arbitraging is nothing more than simultaneously selling or purchasing similar forex instruments in two different markets for different prices that are advantageous to the arbitrageur trading them.
These arbitrageurs simply hunt around the market looking for price anomalies that give them cheaper versions of currencies to buy. The arbitrageurs then sell a more expensive version of that currency and pocket the difference.
Therefore, it can be said that the main aim of an arbitrageur is to identify price anomalies of currencies and exploit it to their advantage.
The reason for the rise of such price anomalies in the foreign exchange is the market’s enormous size. The fx market is huge and spread worldwide which is why the price of a currency may differ in different regions.
However. these gaps in prices do not stay open for too long which is why the arbitrageurs need to be quick on their feet and have a good response time.
It is common knowledge that the forex market is decentralized and huge, and as we mentioned before, the size of the market gives rise to price anomalies.
A currency might be quoted at different prices at different trading places even with the highly advanced automatic algorithms in place that exist to eliminate such discrepancies.
If an arbitrageur detects such anomalies then he can lock on to them and take advantage of it. Let us try to understand what arbitrageurs do with the help of an example.
Let us assume that the forex pair of USD/AUD was quoted 0.701 at a bank in Sydney and 0.597 at a bank situated in London.
The arbitrageur who detects this anomaly will immediately spring into action and buy this pair at the London price and sell it for the Sydney price.
Such opportunities arise multiple times a day so the more anomalies one can catch, the better their chance of making more profit without any risk.
Forex arbitrage requires traders to be highly responsive so having a notoriously slow trading platform is strictly forbidden.
Automated algorithmic trading also hinders a potential arbitrage situation from forming as computerized systems are incredibly fast and they can close up price anomalies within milliseconds.
Furthermore, certain circumstances may also affect market liquidity differences such as discounts or premiums.
Such conditions are not favorable for arbitrageurs and can make their strategy a bit difficult to implement successfully.
We mentioned the various challenges that come with arbitraging and now we will discuss the two most commonly used strategies used by arbitrageurs to maximize their profits.
This arbitrage strategy takes a quantitative approach to the problems of arbitraging and looks out for price divergences that will most likely be accurate in the future.
This accuracy is determined by a statistical analysis which works by combining a group of over-performing as well as under-performing currency pairs and comparing the two.
After comparing the two, the arbitrageur then selects the five most under-performing currencies to purchase and shorts the over-performing currencies.
This forex arbitrage strategy works by offsetting trades to take advantage of the price anomalies on the foreign exchange.
As the name suggests, the triangular strategy consists of three foreign currencies, and the discrepancy that arises between these three currencies is targeted by the arbitrageurs.
Traders should note that finding discrepancies between three different foreign currencies can be a difficult task which requires you to run advanced computer programs so that the detection process is completely automated and quick.
Forex arbitraging is a well-known strategy used by traders to take advantage of the price differences between various foreign currencies.
This strategy is considered to be the least risky one in forex trading although there are still a few things to keep in mind to eliminate any possibility of running a risk while using this strategy.
Since the chances of successfully exploiting a price difference in currencies are rather low and the difference between the prices is also quite small most of the time, traders who run into such anomalies go for large position sizes to maximize their profits.
This is where you run the risk of having a slippage and destroying your arbitraging opportunity.
To avoid that, always remember to calculate potential profit and keep a close eye on the transaction cost that you will have to pay while purchasing currencies.
Furthermore, traders should also note that not all forex brokers allow their clients to participate in forex arbitraging.
You may have to register with an arbitrager forex broker to become an arbitrageur if you are already trading forex.
Lastly, be sure to make good use of arbitrage forex trading and give extra attention to the margin that is required to open the positions and you will be able to squeeze out risk-free profits from your trades.