What is Forex arbitrage and how to implement it in your strategy?

What is Forex arbitrage and how to implement it in your strategy?

Forex trading arbitrage refers to a strategy where traders take advantage of currency pair price differences. When using this strategy, traders are buying and selling several currency pairs at the same time. 

In the Forex trading market, there are three different arbitrage strategies. Depending on the number of currency pairs you are using, the Forex trading arbitrage strategy can be divided into different types. For example, triangular arbitrage refers to a strategy using three different currency pairs.

"The market gives you the opportunity to arbitrage what the emotional investor will pay or sell at versus the fundamental value of a company, but you've got to pull the trigger promptly without hesitating. We've disciplined ourselves mentally and prepared ourselves in terms of information, as well as relationships with brokers, to do that." - Richard Chandler

In today’s guide to arbitrage in Forex, we are going to discuss how this strategy works and what the best ways of implementing it are.

4 Things You Should Know About Forex Arbitrage

  • Forex arbitrage is a low-risk trading strategy
  • Currency arbitrage is the process of taking advantage of price differences with different brokers
  • Typically, Forex traders use two-currency arbitrage, which means using the spread differences between two currencies
  • Triangular arbitrage is when traders use three-currency arbitrage, and is a bit more complex

Arbitrage in the Foreign Exchange Market - Definition & Meaning

Forex arbitrage is a very low-risk trading method, which aims to take advantage of the price inefficiencies in the market. Traders who use this strategy are buying and selling several currency pairs simultaneously, hoping that they can benefit from the price differences in the market.

Even though the Forex trading market has become more efficient over the past few years thanks to technological advancements and algorithmic trading, there are still many opportunities for arbitrage Forex trading techniques present in the market. 

However, it should also be noted that in most cases, the differences are very small, almost inconsequential.

But, if you look at the market, you can notice that such differences can be identified in the market several times a day. This means that people who use this strategy can find many opportunities to make profits during the trading day. When these opportunities add up, those using arbitrage strategies can actually make some good profits.

Types of Arbitrage in the Foreign Exchange Market

Arbitrage in the foreign exchange market can be divided into two general types. This division is based on the number of currency pairs you are using for arbitrage. Let’s say that you are using only two currency pairs. It means that you are using a two-currency arbitrage. 

On the other hand, if you are using three currency pairs, this means that you are using a three-currency arbitrage, also known as triangular arbitrage. 

There is also another type of arbitrage available in Forex, called statistical Forex arbitrage. This type of arbitrage uses underperforming or undervalued currencies against overperforming or overvalued currencies. 

Let’s discover how they work one by one below.

Two-currency arbitrage

One of the simplest ways of Forex trading arbitrage is the two-currency arbitrage. This is also sometimes called a covered interest arbitrage. The main idea behind this strategy is to cover low-yielding currencies with higher-yielding currencies. 

The general idea behind this is that you are using low-yielding assets, which you are depositing to the saving accounts of higher-yielding currencies. Because the interest rates in higher-yielding accounts are higher, you will be making profits. 

However, you should not forget about one great problem, namely the exchange rate risk. On the other hand, you can simply open a short position of the low-yielding and high-yielding currency pairs, which will give you annual earnings thanks to the interest swaps. 

Let's discuss a specific currency arbitrage example to better understand how this works. Let's say that the USD is a low-yielding currency, and the Turkish lira is a high-yielding currency. Let's say that you want to use the above-mentioned strategy for this currency pair, and you have opened a $100,000 short position on the USD/TRY at 65, while you are also purchasing an option, which gives you the opportunity to close the trade at 65.50. 

If you decide to close the position when the price is at 62, for example, you would earn somewhere around $4,900 profit from the trade, and the money earned in interest swaps would be over $5,000. 

Three-currency arbitrage

Triangular arbitrage is one of the most popular types of this strategy. As the name suggests, traders using this strategy are focusing on three different currency pairs. Triangular arbitrage is used when the currency's exchange rates do not match up. 

While these opportunities are rare in the market, there are still enough of them to make some profits using this strategy. This strategy usually works when traders are using advanced computer equipment or programs to automate the process. 

To ensure that you make profits from this strategy, it is vital to perform activities very fast and on a large scale. The general idea behind this strategy is that if two currencies can be traded with another third currency, their exchange rates should be synchronized. 

However, there are some moments in the market when this does not happen, and it is used by some traders to make profits. But, it should be noted that such differences are very small, in most cases, fractions of a cent, and to be able to make profits from such a small difference, you should be using a large amount of capital. 

It is safe to say that the triangular arbitrage currency pairs trading strategy requires the use of automated trading software as it needs a very accurate and timely reaction on the trader's part. Without automated trading software, this strategy would be very hard to implement. 

Statistical arbitrage

Another very popular type of Forex arbitrage is statistical arbitrage. This strategy might sound a bit confusing and vague at first, but it is actually quite simple to use it. This trading strategy is performed by buying currencies that are underperforming or undervalued and trading them against those that are overvalued and overperforming. 

The general idea behind the statistical arbitrage strategy is to benefit from market corrections. This method is quite different from the ones that we have already covered in today's guide. 

This strategy fully focuses on the idea that in the Forex trading market, the major pairs mostly move in cycles. Basically, there is no single currency in the Forex trading market that is constantly enjoying an upward trend. Instead, all currencies in the market experience both bullish and bearish cycles.

Most of the traders who use this strategy are using purchasing power parities (PPPs), and the general idea behind this strategy is that after some time, currency exchange rates tend to converge toward the PPP level. This way, traders can understand where the prices of different currencies might be heading next.

Pros & Cons of Forex Arbitrage Strategy

As with everything else in the Forex trading market, currency arbitrage also comes with its own advantages and disadvantages that traders should know about. While this strategy is known for having very low risks, there are also some drawbacks that should be taken note of. 

There are many traders in the market who believe that the arbitrage strategy in Forex trading can be very beneficial for them, but, on the other hand, there are others who avoid using this strategy and prefer to go with other, more trading-focused strategies, such as scalping, for example.

Below, we will discuss the major advantages and disadvantages of the arbitrage trading strategy to help you decide if this is a good strategy for you or not.

Main advantages

​​As we have already noted in this guide, the biggest advantage of using an arbitrage strategy when trading Forex is that this strategy is a low-risk technique. This trading style entails making profits with very low exposure to risk, as buying and selling are done at the same time. 

Another very important part of this strategy is that the majority of traders are using reliable and sophisticated systems, which can perfectly manage trades. This strategy involves high speed, as well as huge volumes, which makes it vital to use automated trading programs that can find perfect opportunities for executing this strategy. 

Another advantage of arbitrage in the Forex market is the fact that the profits made with this strategy are treated as equity funds, and it creates a lot of tax benefits for traders. Because of this, traders using this strategy are paying the dividend distribution tax, which is calculated at a rate of 15% on the gross amount of dividends. 

Main disadvantages

While there are many advantages associated with this strategy, it should also be noted that it does come with several disadvantages. For example, one of the disadvantages of this strategy is that because the opportunities in the market don't stay for very long, there are a lot of chances for traders to miss out on some of these trades. 

Due to the fast development of modern technology and software, large investors around the world are using this strategy in an easier manner, which ends up correcting the differences very fast. 

This makes this strategy quite hard for retail traders to follow, as they might not own as sophisticated a program or use tech that is as up-to-date as giant investors do. For this strategy, execution speed is crucial for success.

Now that you know what arbitrage trading is in Forex and how it works, it is time for you to decide whether this strategy is a good choice for your trading style. If you decide to use Forex arbitrage, make sure that you have the necessary equipment for this strategy to work well.

What Did We Learn From the Forex Arbitrage Trading Guide?

  • Arbitrage Forex trading is a strategy that takes advantage of price discrepancies in the market
  • All types of Forex trading arbitrage rely on unusual market circumstances that are present in the market for a short time
  • Forex arbitrage requires very fast execution and quick reaction to the opportunities found in the market
  • Most of the traders using Forex arbitrage trading strategies are using automated trading tools to react to these opportunities lightning fast
  • Forex arbitrage is a low-risk strategy, which, if successful, can be very rewarding for traders

FAQs on Arbitrage Forex

Is currency arbitrage profitable?

Yes, currency arbitrage is profitable. As long as price differences exist in the market, there are numerous opportunities for those who are using this strategy. In most cases, the price differences are very small, mostly just a small portion of a cent, which means that in order to make good profits, traders need to find many price differences in the market and use high initial capital to earn good profits.

It is also very important to use algorithmic programs that are able to automatically find opportunities for arbitrage, without using these, it can be very hard to make profits with this strategy.

How do you find Forex arbitrage opportunities?

The best way to find opportunities for the Forex arbitrage strategy is to use automated trading programs. There are many robots available in the market that are able to monitor the market 24/7 and look for the best opportunities for the FX arbitrage trading technique. 

These opportunities exist in the market for very short amounts of time, which means that those who are using this strategy are required to react very quickly to these market conditions to make substantial profits. 

Is Forex arbitrage illegal?

No, Forex arbitrage is completely legal in the Forex trading market. Arbitrage techniques are even encouraged by some people in the market, as they can resolve some of the price inefficiencies and make the Forex trading market more efficient. This strategy is performed and used by many traders as it is considered to be a very low-risk strategy and can be quite profitable as well.