What is arbitrage and how can you use this strategy in Forex?

What is arbitrage and how can you use this strategy in Forex?

Updated: Aug 24, 2022
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Many people sometimes wonder, “What is Forex arbitrage?” and the answers they find on the internet tend to be pretty vague. For this reason, we have prepared this article to explain what Forex arbitrage is.

This is a strategy that does not carry any risk for traders. Forex arbitrage is a technique used by thousands of people around the world. However, it is worth mentioning that any arbitrage model brings unique risks, unavoidable challenges and costs that are not associated with common trading systems. Therefore, it is crucial that you consider the following 4 points:

  • You will need much more time;
  • Many of these arbitration systems require considerable investment in computers and network hardware;
  • It requires a great experience in trading, mathematics and computer science;
  • Arbitration is constantly evolving, so it is a good idea to check often for the latest developments in the field, as information on the internet can be out of date.

We also want to address potential ethical issues. Some people believe that certain forms of Forex arbitrage take unfair advantage of the market. Although this is up for debate, the main issue is that your personal perceptions may prevent you from withdrawing your winnings (we’ll look at this in more detail later).

I. Basic concepts to use this strategy

Basic concepts to use this arbitrage strategy

The first Forex arbitrage strategy, known as forex arbitrage, requires quickly searching for different opportunities (while they are available) generated by price inefficiencies. This involves buying and selling various currency pairs to take advantage of such inefficiencies. Traders generally practice bi-currency arbitrage, where they take advantage of the differences between the spreads of two currencies (there may be variations, which we will explain later). The spread is the effective distinction between two instruments that can provide FX arbitrage opportunities, therefore it is a fundamental concept in any Forex arbitrage system. To carry out this strategy, it is necessary:

  • access real-time price quotes;
  • Act immediately on opportunities.

There are arbitrage calculators that can help you quickly find opportunities. Such calculators are quite common on the internet, so you shouldn’t have any trouble finding a good option. You can also purchase Forex arbitrage calculators from many third-party websites and Forex brokers. In some cases, these calculators are offered for free or as trial software after opening an account.

II. Types of arbitrage strategies and their applications

It is important to talk about the triangular arbitrage strategy, which is a common practice in the forex market. The special thing about this type of arbitration is that its process is organized gradually. For this reason, even a single “irrelevant” discrepancy can cause the Forex triangle arbitrage process to fail. This is because this kind of arbitration can be understood as a susceptible or substantial phenomenon. The idea is that inefficiencies, which do occur occasionally, mean that you will end up choosing more units of currency than before. These inefficiencies occur daily in the markets, but as mentioned above, they are only available for a short period of time. You may be wondering, “What are the steps required to execute this kind of strategy?” Below we detail the steps to correctly carry out the Forex arbitrage strategy with a triangular approach:

  • Exchange the initial currency for the second;
  • Exchange the second currency for a third currency;
  • Then, exchange the third currency for the initial currency.

Below you will see a clear example. In this case, we will use the currencies USD, EUR and GBP. Here are the steps of triangle arbitrage in Forex:

  • Invest USD in EUR;
  • Invest EUR in GBP;
  • Finally, invest GBP in USD.

Here are the benefits that traders and investors can receive with this triangle arbitrage strategy:

  • Receive profits on large investments;
  • The risk is considered to be minimal, although investment operations present it at the lowest level;
  • It must be invested to generate profits. There are no problematic issues.

It is possible to adopt this strategy in uncertain market situations to generate profits. In these cases, it is highly recommended to make short-term trades, since it is possible to make profits anyway.

On the other hand, it is not necessary to have a capital of a million dollars or open accounts in several brokers. You can make money with Forex statistical arbitrage strategy even with micro and mini lots, and a single trading account. This pair trading arbitrage strategy (also called convergence trading), is based on statistics and what is known as mean reversion. Your goal is to find 2 historically correlated currency pairs with the help of a correlation calculator. Later, when the correlation between the 2 pairs diverges beyond a certain value, you will have to buy the weaker pair and sell the stronger one. In this case, when mean reversion is present, the number of pips from these two trades will be positive. Forex statistical arbitrage requires a good perception of leverage, solid risk control, skills in analyzing instruments with strong correlations across different asset classes, and a thorough understanding of spreads.

arbitrage strategy

It would be a mistake not to mention arbitrage with Forex brokers. For traders, it is possible to take advantage of certain price discrepancies between 2 brokers in the same market. For example, broker A may offer a price of 1.4542, while broker B shows a price of 1.4556. Arbitration with brokers is definitely fair, as the prices are offered by the brokers themselves. However, it is understandable that brokers with worse prices do not like traders who take advantage of their disadvantage. Some clients of large retail brokers in the United States explain that some brokers offer different prices according to their users. In these cases, arbitration with Forex brokers would be a very profitable strategy, although it is not certain that these brokers will allow you to keep your profits. Retail brokers offer unified and aggregated prices, so doing arbitrage of this type is simply not possible.

And finally it’s time to talk about latency arbitrage in Forex. In this case, the trader takes advantage of a network advantage over the markets. This can happen in a number of ways, although the general idea of this kind of arbitrage is that a network advantage (speed) allows you to see into the future. Latency arbitrage is practiced at both the institutional and retail levels, and it appeared in 2007. Unfortunately, this strategy is not as viable today due to the large number of people using it, the big IT companies, and the improvements in network infrastructure made by the largest market participants. The stance towards retail latency arbitration is divided and has caused much debate in different communities and forums. You can find various developers selling their software on these forums, which use one “fast” and one “slow” broker. However, this strategy involves the following dangers:

  • If the “slow broker” is too slow, your winnings may be so large that you may not be able to withdraw them;
  • Some network or software enhancements may allow the strategy to work for a while, but over time they lose their effectiveness.

III. conclusion

FX arbitrage is a good niche that can be profitable for experienced traders and of course, with great resources. There are also many unpredictable events when trading this class of systems. Even with a considerable investment of time and money, coupled with unsurpassed research, you would still not be guaranteed any profit, despite what Forex arbitrage systems imply. It is wise to examine various strategies carefully before applying them to a live account. Perhaps you will be lucky and the price will move in your favor, earning more than you expected. However, things can also go against you and cause you to lose in this “risk-free” method. Therefore, you have to try to trade Forex responsibly.

Sources & references
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Invezz is a place where people can find reliable, unbiased information about finance, trading, and investing – but we do not offer financial advice and users should always carry out their own research. The assets covered on this website, including stocks, cryptocurrencies, and commodities can be highly volatile and new investors often lose money. Success in the financial markets is not guaranteed, and users should never invest more than they can afford to lose. You should consider your own personal circumstances and take the time to explore all your options before making any investment. Read our risk disclaimer >

James Knight
Editor of Education
James is a lead content editor for Invezz. He's an avid trader and golfer, who spends an inordinate amount of time watching Leicester City and the… read more.

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a. What is arbitrage and how can you use this strategy in Forex?

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