Arbitrage is a trading strategy whereby traders, as well as automated trading systems, seek to benefit from discrepancies in the pricing of identical forex trading instruments. The discrepancies occur when a security such as gold, Twitter stock, or EUR/USD is being offered at a different price point in multiple markets.
Amidst the discrepancies, a trader or a forex robot would buy a security in one market and sell it instantly in another market, to profit from pricing differences. This is a risk-free trading strategy as trades are carried out with speed. However, in fast-paced markets or low liquidity markets, the trading strategy can give rise to a substantial amount of risk.
How Arbitrage Works
Unlike scalping, trend trading or news trading where traders or forex expert advisors seek to benefit from price changes, traders in arbitrage trading seek to profit from market inefficiencies. A drastic change in supply and demand in the market often gives rise to discrepancies resulting in two different prices for the same item.
Therefore, arbitrage traders seek to take advantage of the momentary glitches while focusing on the difference in prices that occur when there are discrepancies in the levels of supply and demand between two exchanges or markets.
Let’s look at two currency arbitrage. Consider Bank A is buying one British Pound at $1.2500 and selling at 1.2700. Bank B, on the other hand, buys the same Pounds at $1.2700 and ell as $1.2900
In this case, a trader looking to benefit from price discrepancies between the two banks would leverage a two currency arbitrage trading strategy.
Likewise, the trader could use $100,000 to purchase the British pound from bank A and sell the same to Bank B immediately. If this was to happen, then the trader is likely to end up with a profit of $1,000
Arbitrage Trade calculators
Arbitrage trade calculations were initially done manually largely by hand or handheld calculators. However, advancement in technology in the recent past has seen an emergence of software programs as well as trading platforms able to identify such discrepancies in the market.
Automated FX trading systems have so far proved to be highly reliable and effective in arbitrage trading. Such systems rely on algorithms to spot price discrepancies, therefore, allowing traders or forex expert advisors to jump on an opportunity and exploit the marker before markets adjust.
The proliferation of trading systems, as well as automated FX trading systems designed to detect price discrepancies, has, to some extent, led to more market efficiency. Likewise, it is becoming increasingly difficult for retail traders to identify and take advantage of arbitrage opportunities in the forex market.
Arbitrage Trading Techniques
Traders, as well as forex expert advisors, deploy a number of techniques when it comes to arbitrage trading. One simple technique involves the buying and selling of spot currencies against corresponding futures contracts whenever prices are not rhyming.
Another popular arbitrage technique involves the use of a triangular arbitrage technique to exploit price inefficiencies in the forex market… Professional traders do, at times combine currency options as well as futures and spot as part of arbitrage trading. However, this type of trading requires a significant margin deposit
Arbitrage Trading Advantages
One of the reasons why arbitrage trading stands out is that the risk element associated with the trading strategy is almost zero. As long as there is a price discrepancy, traders would look to profit from it, and when it is not there, they will not trade, as is the case with other trading strategies.
Arbitrage trading plays an important role in ensuring security prices across all markets are more or less the same. Conversely, the various arbitrage techniques help in better price discovery while also putting an end to price variances in securities across markets.
In addition, arbitrage helps in making markets more efficient as securities end up trading with the same price on various markets
Arbitrage Trading Disadvantages
Increased transaction costs should never be ignored with arbitrage trading as they can take a toll on profits. Transaction costs, as well as taxes, are always sure to come about with the buying and selling of securities in the market.
Markets have become highly efficient in the recent past, given the advancement in trading technologies. Likewise, it can be extremely difficult to identify market discrepancies in the forex or stock market to take advantage of. In addition, one might need to have the latest technology, such as the algorithm FX Trading, to exploit price inefficiencies quickly.
Likewise, one needs lots of money to profit from arbitrage trading.
Arbitrage is a risk-free trading strategy that allows traders to exploit market efficiencies when it comes to the pricing of various securities. However, the market inefficiencies don’t last for long as such opportunities are usually short-lived. The market would most of the time, balance itself once traders or automated trading systems take advantage of the inefficiencies.