Arbitrage: An all-time favorite strategy

  • By Author

  • September 14, 2018
  • 12:21 am BST

Trading strategies are a vital part of trading for profit. One strategy that has been in existence for many years is Arbitrage, which is a speculative strategy. This usually involves a trader attempting to make a profit using the same instrument in different markets or even the same market. Most scenarios see the trader selling and buying a certain asset at two or more different prices so they can benefit from the profits that result from the difference between them.

It isn’t easy to find the perfect opportunity to implement the Arbitrage trading system because everyone trading is seeking some way in the market to make a profit. The chances of the moment passing you by with you only realizing the opportunity when somebody has already placed a trade and closed it is a very real possibility. For this reason, the strategy is usually suited to those traders who have channels to the fastest information systems.

Arbitrage explained

Simply put, Arbitrage is the strategy wherein a trader buys and then sells an instrument or product in very quick succession, benefiting the profits that result from the difference between the two. It usually works when a trader buys an instrument at a low cost on a particular market and then resells it on another market where it is listed at a slightly higher price.

Inefficiencies in the market that present the opportunity to use the Arbitrage strategy are minimized by the strategy itself. If a product or instrument is undervalued in the market, traders using the strategy will rush to buy, which will increase the demand and price. Once the price begins to rise, the demand will decrease until the value is at the correct price.

In order for a trade to be considered Arbitrage, three criteria have to be met: the price of the same product or instrument must differ in different markets; the price of products with a cash flow that is the same must differ in different markets; and the future price that has been discounted at the rate of interest must differ from the actual price of the product or instrument.

Arbitrage types

Two-way Arbitrage in forex occurs when a trader buys a currency pair in a market and exchange that provides a lower price and then quickly sells the pair in another market or exchange where the price is set higher. Triangular Arbitrage will present itself when a rate difference is evident between a number of different pairs. Triangular Arbitrage requires a three-way movement where currency is bought and sold more than once to achieve maximum profits. Triangular Arbitrage requires fast calculation in order to capitalize and is not very common.

Risky business

Arbitrage is not as easy as it sounds. There are several risks and contraindications to the strategy. Opening and closing two trades has to be done simultaneously in order to reap the benefits. Forex prices change rapidly, and even a second-long delay could equate to a loss for the trader. The opportunities to make a profit are available, but they don’t come frequently for the average trader.

In addition, this kind of strategy requires a huge capital and leverage to capitalize on the available opportunities of even the smallest discrepancies between the same pair. There are many professionals offering trading tips that advise beginners to use strategies, but this isn’t a good one for those who are just starting out. This type of strategy is best left to companies that have electronic systems are in place that allow them to make the most of the opportunities presented.