How to Use The Forex Arbitrage Trading Strategy
Forex arbitrage trading strategy allows you to profit from the difference in currency pair prices offered by different forex brokers. By leveraging price inefficiencies and allowing traders to buy and sell currency pairs that are currently diverging but expected to converge soon. In our article, let us learn more about what forex arbitrage trading strategy actually is.
What is forex arbitrage?
Forex arbitrage strategy leverages forex market price disparity and inefficiencies. In this strategy, a trader profits by opening different currency positions (of the same currency pair) with different brokers offering different prices. The traders open such positions with an expectation that the currency pair prices with both brokers will eventually converge, and before they do, traders can make a profit from the divergence. Hence, if one broker offers 1.2 for USD/EUR and another one offers 1.3 for USD/EUR, the trader opens a buy position with broker number 1 and a sell position with broker number 2 to make a profit of $0.1. When large positions are opened similarly, profits are also expanded.
How does forex arbitrage work?
The forex market is highly decentralised, but there is still some difference in how the currency pairs are quoted in different trading locations. If you are trading in a particular country, all forex brokers will offer you the same price. Hence, to use the arbitrage trading strategy, you need to open forex positions in entirely two different countries having a forex trading platform. The arbitrager spots the price difference in two locations and opens long positions at the lower of the two prices and short or sell positions at the higher of the two prices to lock in profits from the difference. For example, suppose that you are a British trader trading EUR/JPY in London. Here, the forex pair is quoted at 120.2 by a London-based bank, but the same pair is quoted at 120.4 by a Tokyo-based bank in Japan. Hence, if you have access to both quotes and forex markets in London and Tokyo, you will buy the pair in London and sell the pair at a Tokyo price in the Tokyo forex market. This will give you a profit of $0.2 per unit. When both prices converge to 120.5, you will close both positions and exit the trade. By doing this, you will lose 0.1 in Tokyo but gain 0.3 in London, reaping a total profit of 0.2 per unit of EUR/JPY.
Forex arbitrage trading strategies
Interest rate arbitrage
Interest rate arbitrage can either be on the spot or based on future contracts. When trading in the spot market, traders place a sell order for the currency pair having a low interest rate and a buy order for the currency pair having a high interest rate. After a while, he swaps the currency positions and sells the one with a higher interest rate, and buys the one with a lower interest rate. Hence, the trader makes a profit from the interest rate difference. In a forward market, traders plan to hedge the interest rate risk by tying it to a forward contract. They set a currency exchange rate in the future to avoid any losses that could be made due to an unexpected sharp movement in the currency pair prices. Locking the future exchange rate will protect traders from the markets moving against them.
The triangular arbitrage trading strategy refers to trading the price difference between three different foreign currency pairs. This strategy works on the fundamental that when two currencies are traded against a third currency where their exchange rates are not synchronised or the same, it results in a profit. For example, when trading with the triangular arbitrage strategy, let us assume a trader opens a position in EUR/USD for $10 and gets 10 units of the same. Next, the trader converts the same amount to EUR/GBP and gets 15 units of the currency pair in return. Finally, converting EUR/GBP again to the USD/GBP for a total of $10 gives traders 20 units of the currency pair, which, when sold off, reaps a higher gain than what 10 units of EUR/USD would.
Statistical arbitrage trading strategy aims to profit from the converging prices of the currency pairs. In this strategy, the trader combines overperforming currency pairs together as one portfolio and underperforming currency pairs together as the second portfolio. They then open a short position for the overperforming currency pairs and a long position for the underperforming currency pairs. This is done with an assumption that the value of the first portfolio (overperformers) with respect to the second portfolio (underperformers) has a high correlation. With time, the price of both baskets will converge towards the mean and help traders secure profits.
Spot future arbitrage
Spot future arbitrage trading strategy refers to opening positions in a currency pair in both spot and futures markets simultaneously. This is done with the expectation of making a profit from either of the markets. For example, if USD/EUR costs 1.2 in the spot market and 1.4 in the futures market, you will buy the currency pair in the spot market and sell it in the futures market to profit from the currency pair price difference. Since prices in the future market expire after some time, the price difference becomes risk-free.
Start arbitraging the currency pairs
Profiting from the price difference of the same currency pair is an uncomplicated way to start trading with the forex market. Start trading with Blueberry Markets to enter the forex market at different locations with price differentials. Sign up for a live trading account or try a risk-free demo account.
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