Arbitrage is a trading strategy that has made billions of dollars as well as being responsible for some of the biggest financial collapses of all time.
What is this important technique and how does it work? That is what I will attempt to explain in this piece. An Excel calculator is provided below so that you can try out the examples in this article.
Arbitrage is the technique of exploiting inefficiencies in asset pricing. When one market is undervalued and one overvalued, the arbitrageur creates a system of trades that will force a profit out of the anomaly. In understanding this strategy, it is essential to differentiate between arbitrage and trading on valuation. The keyword here is hope. This is not true arbitrage. Buying an undervalued asset or selling an overvalued one is value trading. The true arbitrage trader does not take any market risk.
He structures a set of trades that will guarantee a riskless profit, whatever the market does afterwards. Take this simple example. Suppose an identical security trades in two different places, London and Tokyo. The table below shows a snapshot of the price quotes from the two sources.
At each tick, we see a price quoted from each one. London is quoting a higher price, and Tokyo the lower price. The difference is 10 cents. At that time, the trader enters two orders, one to buy and one to sell.
He sells the high quote and buys the low quote. Because the arbitrageur has bought and sold the same amount of the same security, theoretically he does not have any market risk. He has locked-in a price discrepancy, which he hopes to unwind to realize a riskless profit. Now he will wait for the prices to come back into sync and close the two trades. This happens at 8: The opportunities are very small.
This is why you have either to do it big or do it often. Before the days of computerized markets and quoting, these kinds of arbitrage opportunities were very common. Arbitrage between broker-dealers is probably the easiest and most accessible form of arbitrage to retail FX traders. To use this technique you need at least two separate broker accounts, and ideally, some software to monitor the quotes and alert you when there is a discrepancy between your price feeds.
You can also use software to back-test your feeds for arbitrageable opportunities. Essential for anyone serious about making money by scalping. It shows by example how to scalp trends, retracements and candle patterns as well as how to manage risk. It shows how to avoid the mistakes that many new scalp traders fall into. A mainstream broker-dealer will always want to quote in step with the FX interbank market. In practice, this is not always going to happen.
Variances can come about for a few reasons: Timing differences, software, positioning, as well as different quotes between price makers. Remember, foreign exchange is a diverse, non-centralized market. There are always going to be differences between quotes depending on who is making that market. This will allow a risk free profit. In truth, there are challenges. More on that later. Having both quotes available, the arbitrager sees at He immediately buys the lower quote and sells the higher quote, in doing so locking in a profit.
When the quotes re-sync one second later, he closes out his trades, making a net profit of six pips after spreads. When arbitraging, it is critical to account for the spread or other trading costs. That is, you need to be able to buy high and sell low. In the example above, if Broker A had quoted 1. Buy 1 lot from A 1. Sell 1 lot to A 1. In fact, this is what many brokers do. In fast moving markets, when quotes are not in perfect sync, spreads will blow wide open.
Some brokers will even freeze trading, or trades will have to go through multiple requotes before execution takes place. By which time the market has moved the other way. Sometimes these are deliberate procedures to thwart arbitrage when quotes are off. The reason is simple. Brokers can run up massive losses if they are arbitraged in volume. Anywhere you have a financial asset derived from something else, you have the possibility of pricing discrepancies.
This would allow arbitrage. The FX futures market is one such example. A financial future is a contract to convert an amount of currency at a time in the future, at an agreed rate. Suppose the contract size is 1, units. The arbitrageur thinks the price of the futures contract is too high.
The cost today is USD 1, From this, he knows that the month futures price should really be 1. The market quote is too high. He does the following trade:. He makes a riskless profit of:. Notice that the arbitrageur did not take any market risk at all. There was no exchange rate risk, and there was no interest rate risk. The deal was independent of both and the trader knew the profit from the outset.
This is known as covered interest arbitrage. The cashflows are shown in the diagram below Figure 3. Seeing the futures contract was overvalued, a value trader could simply have sold a contract hoping for it to converge to fair value. However, this would not be an arbitrage. Without hedging , the trader has exchange rate risk. And given the mispricing was tiny compared to the month exchange rate volatility, the chance of being able to profit from it would be small.
As a hedge, the value trader could have bought one contract in the spot market. But this would be risky too because he would then be exposed to changes in interest rates because spot contracts are rolled-over nightly at the prevailing interest rates.
So the likelihood of the non-arb trader being able to profit from this discrepancy would have been down to luck rather than anything else, whereas the arbitrageur was able to lock-in a guaranteed profit on opening the deal. Trading text books always talk about cross-currency arbitrage, also called triangular arbitrage. Yet the chances of this type of opportunity coming up, much less being able to profit from it are remote. With triangular arbitrage, the aim is to exploit discrepancies in the cross rates of different currency pairs.
From the above the arbitrageur does the following trade:. Of course, in reality the arbitrageur could have increased his deal sizes. If he trades standard lots, his profit would have been , x.
In practice, most broker spreads would totally absorb any tiny anomalies in quotes. Secondly, the speed of execution on most platforms is too slow.
Arbitrage plays a crucial role in the efficiency of markets. The trades in themselves have the effect of converging prices. Over the years, financial markets have becoming increasingly efficient because of computerization and connectivity. As a result, arbitrage opportunities have become fewer and harder to exploit. At many banks, arbitrage trading is now entirely computer run. The software scours the markets continuously looking for pricing inefficiencies on which to trade. Nowadays, when they arise, arbitrage profit margins tend to be wafer thin.
You need to use high volumes or lots of leverage, both of which increase the risk of something getting out of control. The collapse of hedge fund, LTCM is a classic example of where arbitrage and leverage can go horribly wrong.
Some brokers forbid clients from arbitraging altogether, especially if it is against them. Always check their terms and conditions.More...