What is Arbitrage

What is Arbitrage
What is Arbitrage?

What is Arbitrage Trading About?

Arbitrage trading presents as a low-risk opportunity to generate a profit. It is a form of trading activity where you capitalise off discrepancies in the price of identical financial instruments such as AUD/USD, or AUD/CAD, etcetera.

The manner in which arbitrage trading can be beneficial is when different financial institutions price the same forex pairs differently. In forex arbitrage trading, slight differences can mean the difference between profits and losses, especially where leveraged trades are in effect.

Essentially, you buy one asset at a specific price from one financial institution and instantaneously sell it at a different price, profiting from the differentials. Given that these transactions take place at lightning speed, virtually no time elapses between the purchase order and the sale order.

The overall risk is minimal in absence of volatility. However, caution is strongly advised with low liquidity, or with rapidly moving prices.  Remember, with arbitrage trading a trader buys an asset cheaper in one market and sells it for a higher price in another market.

From a theoretical perspective, there is minimal risk and no capital required. In reality, risk and capital are involved when you engage in this form of trading.

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How to Source Arbitrage Trading Opportunities

In economic theory, the ‘Efficient Markets Hypothesis’ suggests that the financial markets and all the stakeholders process information with regards to financial instruments, prices, and asset values instantly and efficiently. In reality, the financial markets are imperfect and there are discrepancies within the markets.

It is helpful at this point to define arbitrage meaning as it relates to trading activity:

‘Arbitrage trading is the purchase and sale of financial instruments, such as forex, in different markets at almost the same time. Forex arbitrage is undertaken with the intent to profit from price discrepancies.’

Market inefficiency is the number one reason why asymmetrical information exists between buyers and sellers. Clear examples of this abound, such as the case of a seller’s asking price for a financial instrument being lower than the buyer’s bid price for that same financial instrument. In a case like this – a negative spread – arbitrage trading opportunities abound.

What is Forex Arbitrage?

Forex arbitrage works off the same concept as trading arbitrage. It occurs when price discrepancies exist within the markets. Currency traders are always scanning the financial markets for such discrepancies, since they present easy opportunities to profit from price differentials.

AUD/USD Example:

  • Financial institution ABC buys AU$1 at $0.7800 and sells at $0.7900
  • Financial institution DEF buys AU$1 at $0.8000 and sells at $0.8100

In the above example, a forex trader could buy Australian dollars from financial institution ABC for a price of $0.7900, and sell them to financial institution DEF which is buying at $0.8000. A forex order of $100,000 could yield a net profit of $1,000.

Interest rate arbitrage occurs when a forex trader sells a currency from a country with a low-interest rate, while simultaneously buying a currency from a country that pays a high-interest rate. The difference between the low interest-rate country and a high interest-rate country is what generates the trading profit for the interest-rate arbitrage trader. Another term for this is a ‘Carry Trade’.

Yet another option for generating profits with forex arbitrage is known as ‘Cash-And-Carry’. With this option, traders take positions on the same underlying financial instrument in the spot market (the current market) as well as the futures market, at the same time.

Using this strategy, a trader/investor will purchase a currency, and then short sell that currency in the futures market. The trader is taking advantage of different spreads (difference between buy and sell price) offered by different brokers for the same currency pair. This type of forex arbitrage is commonly engaged in, and can be profitable.

What is Statistical Arbitrage?

When statistical arbitrage is undertaken, traders utilise a combination of quantitative algorithmic investment strategies designed to take advantage of relative price movements across thousands of financial instruments in many different markets. By using technical analysis, traders can benefit from this and profit accordingly.

The objective of statistical arbitrage is to generate outsized trading profits for large-scale investors. It is worth pointing out that this particular method of trading is not conducive to high-frequency trading. Rather, it is best designed for medium-frequency trading, with trading periods ranging from several hours to a couple of days.

With respect to statistical arbitrage, currency traders would open long and short positions at the same time. This is done in order to take advantage of the inefficiencies in market pricing mechanisms. This is only applicable to correlated assets.

One might find that a trader is of the opinion that Amazon (NASDAQ: AMZN) stock is overvalued, and that Facebook (NASDAQ: FB) is undervalued. In this case, a long position on Amazon would be opened and a short position on Facebook would be opened.

What Is Triangular Arbitrage?

Remember, with all forms of arbitrage, the objective is to take advantage of market inefficiencies (price differences) however minuscule to benefit from near real-time trading opportunities. With triangular arbitrage, traders are also engaging in negative spreads. This particular strategy requires traders to engage in trading of 3+ currencies at the same time.

When triangular arbitrage is undertaken, traders attempt to find market situations where currencies are overvalued relative to one currency and undervalued relative to another currency. When viewed in perspective, there are three different currency options being traded.

As an example, consider the USD/AUD, EUR/AUD, and EUR/USD currency pairs. If the EUR is overvalued relative to the USD, but undervalued relative to the AUD, the trader could use these differentials to maximum advantage. For example, by using the USD to get more from the AUD and then converting AUD into EUR, and getting more USD out of the deal.

Trading FAQs

  • Under what conditions would arbitrage trading not work?

    In reality, there are many situations which present as potential trading opportunities. However, when price discrepancies are evident in quotes, by the time you try to use arbitrage trading techniques and strategies, these price discrepancies evaporate. There are several reasons why this occurs. Namely, when a price is quoted, it may be incorrect, or it may not be tradable.

    Another potential reason for price discrepancies is that the bid/offer spread wasn’t accounted for. In certain instances, arbitrage won’t work because the model you are using is inherently flawed. There may be other factors that haven’t been considered, leading to the failure of arbitrage opportunities.

     
  • Is arbitrage trading a boon, or a bane?

    Cannot be defined as good or bad – it’s simply a way of generating profits from price differentials in financial instruments. When market inefficiencies exist, and they do, opportunities for forex arbitrage may present.

    Some traders believe that arbitrage is beneficial to the financial markets since it guarantees market efficiency by removing those outliers in pricing discrepancies. Other forex arbitrage traders believe that arbitrage is bad since it takes advantage of situations that should not exist in the financial markets.

    Sometimes these discrepancies exist because of errors in specific systems. Ultimately, traders are in the financial markets to profit from their trading activity. If opportunities exist, they are part of the market process.

     
  • How many different forms of arbitrage trading are there?

    Recall that arbitrage meaning is about taking advantage of price differentials in different financial markets with the same financial instruments. These could be currency pairs, stocks, or any other asset that is traded in real time. There are different forms of arbitrage, notably:

    • Risk– buying stocks of companies that are engaged in mergers and acquisitions.
    • Retail – buying/selling physical products a.k.a. commodities are on Alibaba, Amazon, or eBay.
    • Convertible– buying convertible securities and then shorting the underlying stocks.
    • Statistical– arbitrage using complex mathematical formulae which trade the markets via preset programs to capitalise off minuscule price discrepancies.
     

Arbitrage Trading Summary

Arbitrage trading is all about profiting from price discrepancies in the financial markets, specifically, the prices of the individual assets involved in trades. It is a sophisticated process that requires powerful algorithms, rapid processing technology, and an eye for minutia.

The financial markets use powerful computing systems to standardise pricing on a global scale, across all markets. There is very little time difference between an error spotted, and an opportunity maximised. Speed, accuracy, and professionalism are required for effective trading.

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