What is Arbitrage in Currency Trading?

One of the forex strategies attracting interest among retail traders is currency arbitrage, mainly because it is assumed to be “risk-free”. Although that’s not the case (as we’re about to see in the following paragraphs), this is an effective method to take advantage of discrepancies between exchange rates from different market makers. If you are interested in arbitrage and you are looking to find some of the common strategies, this article will provide some of the basics.

Understanding currency arbitrage

When it comes to currency arbitrage, this is a strategy used by traders to take advantage of different spreads offered by different providers for any given currency pair. The disparity between the bid and ask is what makes this strategy viable, but it is important to note from the start that there are some risks involved, as well.

Basic currency arbitrage

The basic arbitrage involves buying contracts on a currency pair from broker A and selling it with broker B, considering the exchange rate is higher with the latter, due to spread differences or liquidity conditions. All seems to be easy so far, but any beginner’s guide to forex will tell you there are always risks when trading currencies, even though arbitrage means buying and selling during a short time frame.

One of the main risks comes from trade execution. Although traders can spot the difference among spreads, until they open and close both trades the market rate can change, erasing the profit. It is important to note that the spread differential is generally very small (1-2 pips maximum) and because of that, arbitrage traders are vulnerable to sudden price variations.

Triangular Forex arbitrage

Previously we’ve talked about the basic currency arbitrage strategy, but it is also possible to conduct triangular arbitrage. In this case, traders need to be specialized in cross currency pairs. Opportunities arise when the market-driven cross rate temporarily deviates from the exchange rate for each component currency versus the US dollar, Euro, or other major currency (because these currency pairs are the most liquid and spreads are tighter). This strategy takes advantage of the fact that the exchange rate for a cross currency is related to that of the two other currency pairs.

triangular forex arbitrage explained

How to choose the right arbitrage strategy?

Aside from the two strategies mentioned above, traders also get involved in statistical arbitrage or currency futures arbitrage. Each has its particularities and can perform well within certain market conditions. It is important to note that the risk is small when markets are not volatile. Usually, arbitrage traders are active when trading sessions are close to the end or during the night.

Also, technological advancement had enabled the development of arbitrage trading software. Keep in mind that this does not mean it is possible to simply install software and let the profits take care of themselves. Market developments must be constantly monitored, as well as the performance of the arbitrage strategy over any given time