Arbitrage is one of the most popular and most widely applied Forex trading techniques across all financial markets. It draws on a very fundamental and conventional trading method – namely profiting through the difference in prices when you buy and sell an asset.
The same strategy and idea can be applied to forex trading in the case of trading foreign currencies. Similar to all other markets, the use of arbitrage in the forex market requires you to be somewhat of an opportunist who can find out the most profitable areas where you would be able to apply this trading strategy. Still there are certain peculiarities when it comes to making money with arbitrage in the forex market. In this article we will take a look at arbitrage as a whole and its use in different markets especially the forex market.
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What Is Arbitrage in Forex Trading?
The idea behind arbitrage is actually quite elegant and straightforward. It is kind of similar to buying low and selling high. In arbitrage trading you would try to benefit from the price discrepancies that exist across different markets.
This means you can purchase an asset for a lower price in one market and sell it for a higher price on another market. The difference in prices that is offered for the same asset in these two different markets is how you would be able to profit from arbitrage.
On paper and in an ideal situation, arbitrage would be impossible. This is because you would normally assume that the price of a certain asset should be fixed across the world. Just like many commodities that have the same price no matter where.
But this is only the case for a limited number of assets. The reality is that for the majority of assets we have price discrepancy. And that is exactly what arbitrage is.
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How Does Arbitrage Function?
As we discussed in the last section, the main and key feature of arbitrage can be found in the price differences for the same asset. Different markets offer different prices for the same asset and thus create a spread that can be taken advantage of with the help of arbitrage trading techniques.
This spread is exactly where the profit for arbitrage is. You buy an asset for a lower price from one market and then sell it for a slightly higher price on another market. When you do this enough times, these marginal profits, though small and slight, will eventually accumulate and lead to something substantial.
This is where the idea of high frequency trading or HFT also enters the discussion. For a trading strategy and technique such as arbitrage, you would have to employ a high frequency trading approach in order for the trading strategy to be profitable. Otherwise, as we said, the profit that is gained through arbitrage is actually nominal and marginal.
Let’s see this through an example.
For instance you purchase the stock for company X at $9.12 but then you are able to sell the same stock for $9.14 at another market. Although there is only a spread of 2 cents, if you do this enough time or if you do this with a substantial amount of stocks, then profits can be substantial as well.
The key point about arbitrage is you can profit rather quickly and you see returns almost immediately.
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Arbitrage in Different Financial Markets
The technique of arbitrage is used in almost all financial markets. But perhaps it is most notably seen in the stock exchange market. And the reason for that is also related to the nature of stock trading itself. There are different ways that arbitrage can prove to be profitable in the stock market.
First of all, it can be profitable through the simple spread in prices across different markets. Secondly, and this is the peculiar point about the stock market, it can be profitable through the price differences that occur in the stock market. Such as an IPO or initial public offering where you would be able to purchase shares for a lower initial price which invariably goes higher after a while.
But the focus of this article is to use arbitrage to make money in the forex market. So let’s turn to the exchange of foreign currencies with arbitrage.
Arbitrage Trading in Forex
The use of arbitrage in the forex market is perhaps a little bit easier to understand than certain other markets. This is because we have notable and clear price discrepancies in the forex market.
This is because of the decentralized nature of forex which leads to two facts:
- The updating process for prices can have some lags and face some bottlenecks which would lead to discrepancies.
- The mere fact that this market is decentralized means there is no centralized entity in charge of prices, so different markets can quote different prices.
And this is exactly how you can make money with the help of the arbitrage strategy in the forex market. You would be able to purchase a pair for a bit lower price and then sell it for a bit higher.
But when you are engaging in arbitrage in the forex market, you need to remember one crucially important fact and that is to pay attention to fees and commissions or basically the spread of your broker.
The spread of your broker is the price they pay for a pair and the price they sell it to you. Although it is nominal, this is where brokers make most of their money. And in arbitrage trading, since we are also dealing with nominal and marginal profits, broker and exchange spreads can change the outcome greatly.
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Conclusion
Arbitrage is one of the most popular trading strategies across all financial markets, and also the foreign exchange market or forex. In this method of trading, an asset is bought for a lower price in one market and then sold at another market for a slightly higher price which constitutes the profit through arbitrage. In this article we discussed the use of arbitrage in different markets, especially the forex market.
