Forex market is not a centralized marketplace. As a result, currency prices in one location might be different from prices in another one. Arbitrage traders take advantage of these differences.
Arbitrage definition
Forex Arbitrage is called exploitation of price differences on the market. There are various ways traders achieve that goal. The main idea is to buy currency prices and sell currency prices which are currently divergent. And are very likely to quickly converge. A trader is expecting the price to return the means to close a trade.
Why is Arbitrage important for traders?
- Thanks to Arbitrage trading the markets become more efficient.
- Arbitrage is one more opportunity to increase earnings on the market.
- Arbitrage trading can be interesting for institutional traders that have lower spreads and access to the best infrastructure.
- Arbitrage trading might not be attractive for retail traders due to complexity and technical challenges.
Thorough Arbitrage Explanation
Arbitrage trading requires high speed internet, fast software, high speed algorithms and good management. Price differences usually occur in milliseconds and exploiting these differences is not an easy task. Arbitrage trading’s core idea makes the practice seem like its risk free, but risks are associated with upfront costs, spreads, competition and execution.
Execution happens in milliseconds. The Forex market is a fast and the most liquid one in the world. Therefore, Arbitrage trading can be damaged by slippage and high spreads. In addition, this kind of trading requires good management by the algorithm developers and high speed traders. Many retail traders do not have access to the infrastructure needed to execute Arbitrage trades.
Example of Arbitrage in Forex
Now let’s see a practical example. Suppose that the GBP/JPY is quoted at 161.600 by a liquidity provider from London. And at the same time it is quoted at 161.650 by a Japanese bank. A trader that has access to both markets can buy the UK price and sell the Japanese one. When the price later converges at let’s say 161.700, the trader closes both positions. The Japanese position would lose 5 pips but the UK position would have made 10 pips.
FAQs on Arbitrage in Trading
How profitable is arbitrage?
It depends who you ask. Arbitrage in Forex requires preparation through high speed computers, high speed internet and developing algorithms capable of spotting and trading price disparities. It’s difficult to say how profitable the practice is when we take into consideration the costs.
Is arbitrage risk-free?
Arbitrage is supposed to be risk free due to its mechanism. However, the risks still exist. Risks are mainly associated with execution. Forex market is fast moving and very competitive. Price disparities get filled by high speed trading algorithms and in order to do better than your competitors, you need to invest heavily in your trading hardware and software (algorithms).