What is Arbitrage - Arbitrage Trading

The essence of arbitrage is to obtain a risk-free or almost risk-free profit. In classical trading, a trader predicts the behavior of an asset and opens long or short positions accordingly. Arbitrage strategies, on the other hand, are aimed at generating profit regardless of the direction of the price movement.

Arbitrage on the stock exchange can be profitable, but it is a highly specific trading tactic that is not suitable for all traders without exception. Below is a detailed explanation of this method and an overview of its varieties.

What is Arbitrage Trading

Arbitrage, in simple terms, is a low-risk trading method in which a trader earns profit regardless of the direction of the price movement. Profit is generated by taking advantage of price discrepancies for the same asset on different trading platforms. This is just one of the subtypes of this tactic, which uses derivative instruments (futures and options) and time factor in various modifications.

This approach is not a ready-made strategy, but rather an idea, a foundation, upon which both manual and automated trading systems are created. The main challenge in developing a trading system is the algorithm for selecting assets for arbitrage, as well as automating the opening and closing of positions. Market inefficiencies usually disappear quickly, and it is not always possible to manually catch them.

The essence of arbitrage trading on exchanges is that traders have found a way to make money on arbitrage - the idea of exploiting the differences in quotes for the same asset on different trading platforms. The difference can be due to a simple delay in one broker receiving quotes relative to another. This inefficiency can be exploited by compensating for small profits with large volumes.

With the advent of tools such as futures and options, arbitrage opportunities have expanded. Modified methodologies appeared in which the underlying asset and derivatives on it were used. This approach is called long-term arbitrage, and such strategies can be traded manually.

Regardless of the chosen asset and trading platforms, inter-exchange arbitrage boils down to finding a significant divergence in quotes for one asset or assets with high direct/inverse correlation. It is possible to limit oneself to one platform, hedging a position on one asset with a synthetic asset on another. This and other approaches we will discuss below, after checking out some features of arbitrage trading.

Here we go:

• Ability to work within one platform or on 2-3. Inter-exchange arbitrage is actively used in the stock market. At the initial stage of computerization of the Forex market, inter-broker arbitrage was used, due to the insufficient speed of receiving quotes, significant price discrepancies were observed. By the end of the 2000s, this method became practically unviable.
• Strategies can use both spot market instruments and futures/options. There is always a high correlation between the underlying asset and its futures, which allows for the implementation of these types of strategies.
• Both aggressive high-intensity trading and long-term work with holding open positions for several weeks are possible.
• This method is suitable for liquid assets, including cryptocurrencies. Trading on stocks of 2-3 tiers, for example, is not the best idea.
• Profit can be made both by taking advantage of the price difference of one asset on different trading platforms and by making a profit from changes in price over time on one exchange. Arbitrage is one of the most flexible trading strategies.
• Ability to build a market-neutral strategy. This means that to make a profit, it is not necessary to accurately predict the behavior of the chart. For example, when working with a calendar spread, it is enough for the difference in the price of contracts with different expiration dates to change.
• Arbitrage may seem too complicated for beginners, but this is a deceptive impression. Trading may be slightly more complex, but only because it will be necessary to conclude several transactions instead of one.

What is Currency Arbitrage

Currency arbitrage is a forex strategy in which a currency trader takes advantage of the different spreads offered by brokers for a particular currency pair by making trades. Different spreads for a currency pair imply a mismatch between buying and selling prices.

Currency arbitrage involves buying and selling currency pairs from different brokers to take advantage of incorrectly evaluated exchange rates. The most important risk that forex traders must deal with during currency arbitrage is execution risk.

This risk refers to the possibility that the desired currency quote may be lost due to the fast-paced nature of the currency markets.

Example of currency arbitrage:

For example, two different banks (Bank A and Bank B) offer quotes for the USD/EUR currency pair. Bank A sets the rate at 3/2 dollars per euro, while Bank B sets the rate at 4/3 dollars per euro. In currency arbitrage, a trader takes one euro, converts it into dollars using Bank A, and then back into euros using Bank B.

As a result, the trader who started with one euro now has 9/8 euros. If you don't consider trading commissions, the trader made a profit of 1/8 euro.

By definition, currency arbitrage requires the purchase and sale of two or more currencies to occur instantaneously, because arbitrage must be risk-free. With the advent of online portals and algorithmic trading, arbitrage has become much less common. When prices are high, the opportunity to profit from arbitrage decreases.

You can start trading using strategies you prefer on MetaTrader 4 trading platform right now.

Statistical Arbitrage

Statistical arbitrage is a group of trading strategies that use large and diverse portfolios traded on a very short-term basis. Statistical arbitrage strategies are market-neutral, as they involve simultaneously opening both long and short positions to take advantage of inefficient pricing in correlated securities.

For example, if a hedge fund manager believes that Coca-Cola is undervalued and Pepsi is overvalued, they would open a long position in Coca-Cola and a short position in Pepsi at the same time. Investors often refer to statistical arbitrage as "pair trading."

Statistical arbitrage is not strictly limited to two securities. Investors can apply this concept to a group of correlated securities. Moreover, just because two stocks operate in different industries does not mean they cannot be correlated.

Statistical arbitrage example

Suppose we have two stocks - Apple and Microsoft - that have a strong correlation. Let's say that as a result of some event, the price of Apple's stock suddenly increased, while the price of Microsoft's stock remained the same. This may indicate that the price of Microsoft's stock is undervalued, while the price of Apple's stock is overvalued.

A trader can use this information to create a statistical arbitrage strategy. They can open a short position in Apple's stock and simultaneously open a long position in Microsoft's stock to profit from the price difference between them.

If in the future the price of Apple's stock decreases and the price of Microsoft's stock increases, the trader can close their positions and earn a profit from the price difference.

However, it is important to note that statistical arbitrage can be complex and risky, as the correlation between stocks can change and unexpected price movements can occur. Additionally, transaction costs and market conditions must be taken into account, which can significantly impact the results of the trading strategy.

Triangular Arbitrage

Triangular arbitrage is a result of a discrepancy between three foreign currencies, arising when exchange rates between currencies do not precisely match. Such opportunities are rare, and traders who take advantage of them typically have sophisticated computer equipment and/or programs to automate the process.

A trader using triangular arbitrage exchanges an amount at one rate (EUR/USD), converts it again (EUR/GBP), and then finally converts it back to the original currency (USD/GBP), and assuming low transaction costs, generates a net profit.

This type of arbitrage represents a risk-free profit that arises when the quoted exchange rate does not equal the market cross-exchange rate. International banks, which create currency markets, use market inefficiency when one market is overvalued and the other undervalued.

The price difference between exchange rates is only fractions of a cent, and for this form of arbitrage to be profitable, a trader must trade a large volume of capital. This raises the question of using an automated trading platform.

An automated trading platform can be configured to identify opportunities and act on them before they disappear. However, the speed of algorithmic trading platforms and markets can also work against traders.

For example, there may be a risk of execution where traders are unable to capture a profitable price before it passes them by in seconds.

Example of triangular arbitrage:

Assume you have $1 million and the following exchange rates are available: EUR/USD = 0.8631, EUR/GBP = 1.4600, and USD/GBP = 1.6939.

There is an opportunity for arbitrage with these exchange rates:

Sell dollars for euros: $1 million x 0.8631 = 863,100 euros Sell euros for pounds: 863,100 euros ÷ 1.4600 = 591,164.40 pounds. Sell pounds for dollars: 591,164.40 pounds x 1.6939 = $1,001,373. Subtract initial investment from final amount: $1,001,373 - $1,000,000 = $1,373.

From these transactions, you would make an arbitrage profit of $1,373 (assuming no transaction costs or taxes).