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What Is Currency Arbitrage?

Oftentimes if you have been investing in currency market for an extended time, you might be on the lookout for new instruments to boost your investment further. Most are looking for a strategy with the minimum risk, least amount of exposure yet maximum returns. Are you wondering if that’s more like a dream strategy, unreal wondering in the realms of imagination? Well, think twice! The currency market offers a complete platter of this type of opportunity. All you need to do is look out and grab them, and you would be surprised to see the amount of easy money floating around.

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What Is Currency Arbitrage?

First and foremost we need to understand this concept before trying to use it to boost our returns. As the name in itself signifies, arbitrage means a process where there are simultaneous buying and selling of the asset in a way that the trader profits from the price difference between the two products. An arbitrage trade is a direct fallout of the market inefficiencies and it facilitates a mechanism that ensures that prices stay close to their fair value for maximum times and chances of any significant divergence narrow down significantly.

Thus, traders use currency arbitrage strategy to take advantage of the price difference between the various spreads. Different brokers offer different rate for a specific currency pair. What an intelligent and alert trader would want to do is take advantage of this price difference between the different spreads in a way that it brings maximum benefit for the trader. Difference in spread signifies the difference in the bid and ask price for the same currency pair and making it work to your advantage. Alternatively a trader could also use a different exchange rate for three different pairs of currency and simultaneously and prompt buying and selling of these would create neat profit in every individual trade.

Let me use an illustration at this juncture to bring forth the true merit of this currency arbitrage strategy. First and foremost, select the currency pairs you want to trade in. Let us say we use the following:

EUR/USD
EUR/GBP
GBP/USD

The trade that you are about to execute is essentially a part of triangular arbitrage strategy, the most commonly used. Now let us consider the rate at which the various currencies are trading at any given point of time. I am using some imaginary values to explain the process. Assume that

1 euro=1.183 US dollar, meaning you need to spend roughly 1.183 US dollar to get 1 euro
1 GBP= 0.723 euro, meaning 1 Great Britain pound is available for 0.72 euro
1GBP= 1.683 US dollar signals you can buy about 1.64 US dollar with 1 Great Britain pound.

Once the exchange rate is decided it is now time for executing the arbitrage trade. Essentially by arbitrage, I mean that traders should buy and sell correlating currencies against one another by trading them simultaneously. Remember that currency pairs are traded in lots. One lot comprises of 100,000 units while mini lots have 10,000 units. This is how your trade would proceed then:

Buy 100,000 euro for 118,370 US dollar
Now sell these euros for 72,310 Great Britain pound
Now sell this pound for 118,500 US dollar

The difference between the original purchase and the last sale price is what you earn as currency arbitrage. Tracking this price difference is not simple. It is best to use a special technology provided by brokers to facilitate easy sighting of these easy money pockets, and these require high-speed trading. Quick movement is the key to succeeding in most of these trades.

But in case you are wondering how nubile you need to be to identify the potential targets and then execute this trade in matter of seconds, well technology is there to help you with suitable platforms and programs for trading & arbitrages by retail investors. Most brokers will provide the software, or you can even go out and buy it if you operate independently. You also have the option of trying out multiple programs before zeroing on what would be the best option for you. If you are a MT4 user, you can ask a MQ4 programmer to program a currency arbitrage EA.

Advantages of Currency Arbitrage in Trading

Well, this is the most important consideration. Unless you are confident about some obvious advantages, the point of trying out or experimenting with a new financial instrument is totally lost. The big positives with arbitrage include:

1. You have got nearly zero risk in this trade. So whatever profit you earn is practically risk less and fear of losing out huge investment is fairly minimal. For example, let’s assume two banks, Bank A and Bank B offer different quotes for the EUR/USD pair and you want to arbitrage on this difference. Supposing Bank A’s rate is 3/2 dollars per euro, and Bank B sets its 4/3 dollars per euro, when you arbitrage it, you take 1 euro, convert into dollars with Bank A and then go to Bank B and convert back to euro & end up with 9/8 euro. In simple terms, your profit is 1/8 euro.

2. Another great advantage of currency arbitrage is that price discovery is the way fairer now given the fear or the prospects of possible arbitrage. The price of securities is more or less uniform to create a level playing field for all kinds of players, and traders get a more realistic value of the asset class they invest their money in.

There is another advantage, and this is more in the interest of the bigger market space. Imagine the mayhem and chaos there would have been in the absence of arbitrageurs. Different brokers would have charged differently, and the scope for speculators would have grown manifold. But thanks to currency arbitrage, there is a check on prices across markets and speculators too have been reined in.

Disadvantages of Currency Arbitrage in Trading

Well, there are two sides of every coin and arbitrage is nit completely without any negatives:

1. Certain times when retail traders try their hands on it, they forget about periphery costs like transaction costs and taxes. This can severely dent the profit margins and eat into your gains if not accounted for in the right perspective. It can even result in losses if the trade goes bad.

2. Technology is a very important tool to get the most out of a currency arbitrage trade. So if you do not have sufficient tech back up, think twice before investing in this instrument. Essentially it is about speed and expertise and if you do not have the required back-up support it is best to avoid this option.

3. Currency arbitrage though risk-free, need heavy capital investment. So if you are operating with a limited budget, this is not the right avenue to park your money.

Conclusion

Thus to conclude, currency  arbitrage is neither for the weak hearted nor the novice. If you are new to the market or not good at multitasking, if quick thinking is not your forte or you are unable to act swiftly, it is best to avoid arbitrage. This is a great way to make money for those traders who have been investing over a significant point of time and have learnt the trick of seeing through the market moves. It is a tool for the veterans who understand not just the face value of entities, but can also read between the lines.

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"Whether you think you can, or you think you cannot, you are right." - Henry Ford

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One thought on “What Is Currency Arbitrage?
  1. Bob says:

    Hi Peter,

    I have read your article through a number of times and tried to calculate out how this would actually work on a trading platform, and I must be missing something because I can’t make it work.

    I can see how it would work in other situations, but not with an trading platform because when you open a position on a currency pair it stays open until you close it again, and even if it was opened and closed before the price altered, you would always lose by the spread amount.
    If I took US$100K to a bank, I could buy Euro with it, then I have Euro. Then I could sell the Euro to buy GBP, so I then have GBP etc.
    But on a trading platform if I buy EUR/USD, then where is the EUR? How can I then use this EUR that I have supposedly bought to buy GBP?. Ok so I open a EUR/GBP position to buy GBP, and what then? I have 2 positions open that need to be closed don’t I?

    I know that this no doubt a very stupid question and no doubt there is a very simple answer.
    I will be glad of your help in understanding this.

    Regards,
    Bob.

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