Forex arbitrage: A simple guide to making profits

Arbitrage is a trading technique that involves taking advantage of temporary price differences between different financial assets. Essentially, you buy an asset and immediately sell it to take advantage of the price difference. The asset can also be sold in another market in a different form or using a different financial instrument depending on the price difference it fetches. Arbitrage opportunities exist in almost every financial instrument, from equities and derivatives to commodities and foreign exchange (Forex). In the Forex market, arbitrage can involve exploiting differences in exchange rates on different platforms or exchanges, allowing traders to profit from the smallest price fluctuations. We will take a detailed look at this practice used by arbitrageurs.

Principle of operation

Arbitrage allows you to make a positive or zero profit by taking advantage of the momentary difference in price between different financial assets. Essentially, this technique involves:

1. Selling an asset and then buying another that better matches the current market price and what the investor is looking for in terms of acceptable risk and return. This approach may involve selecting an asset with higher upside potential or less volatility.
2. Selling and buying the same asset, but in two different markets, between which there may be a price difference that allows the investor to make a profit. Such arbitrage is often seen in currency markets, where quotes may differ slightly between exchanges, creating an opportunity for a quick trade.

How is arbitrage practised?

Arbitrage strategies are predominantly used by professional arbitrageurs. These professionals are constantly looking for opportunities arising from differences in asset prices. Their job is to correct market distortions and they actively use arbitrage as long as it is profitable, which helps prices return to their fair levels. The more liquid and transparent the market, the fewer such opportunities are available, or they disappear more quickly. Arbitrageurs can employ a variety of tactics to profit from price imbalances:

• Market arbitrage: Many financial assets are listed in multiple markets, so transaction costs, commissions, and other factors must be considered;
• Yield curve arbitrage: You can compare rates on bonds, futures, credit rates, and so on. This strategy involves calculating 0-coupon rates, determining theoretical spreads and then comparing them to possible arbitrage on market spreads;
• Volatility arbitrage: If an asset is subject to volatility, we compare historical volatility/expected volatility, inter-term volatility, volatility of the basket versus the assets within it, etc.

Using arbitrage with CFDs

CFDs (contracts for difference) are derivative products that can be used to quickly open and close positions. The success of arbitrage depends on speed, so some traders prefer automated trading programmes and algorithms to implement their strategy faster. This allows the software to automatically detect arbitrage opportunities without the need for manual calculations and analysis.

Arbitrage between two bonds

Bond arbitrage involves exploiting price differences between two similar bonds to make a profit without taking any directional risk. For example, if one bond has a higher yield than another bond despite similar characteristics, a trader may sell the bond with the lower yield and buy the bond with the higher yield. The goal is to profit from temporary price fluctuations.

Arbitrage opportunity

An arbitrage opportunity occurs when the price difference between similar assets allows for a risk-free profit. For example, if a stock is undervalued on the London exchange compared to the New York exchange, a trader can buy it in London and sell it in New York, capitalising on the price imbalance. Such opportunities are often short-lived because the market reacts quickly to these imbalances. Therefore, arbitrage requires trades to be executed quickly and accurately in order to have time to capitalise on this temporary advantage.

Disadvantages and advantages of arbitrage

While arbitrage may seem advantageous, it has its disadvantages. Arbitrage opportunities can be rare and require sophisticated tools and skills to discover and execute quickly. In addition, transaction costs and fees can reduce potential profits, and market and counterparty risks make arbitration less predictable.

On the other hand, arbitrage allows for profits with minimal risk if opportunities are detected in a timely manner. It can generate stable returns in liquid and efficient markets where price imbalances are quickly resolved. In some cases, arbitrage also promotes market efficiency by helping to equalise prices in different markets.

Conclusion

Arbitrage is a trading strategy based on exploiting temporary price differences between assets such as stocks, currencies or derivatives. Traders can profit by buying and selling the same asset in different markets, or by applying yield curve and volatility arbitrage. This strategy allows for quick profits when used correctly and in a timely manner.