Arbitrage trading involves profiting from price differences of the same asset in financial markets. True arbitrage can yield riskless profit, which traders aim for. When executed well, an arbitrage trading strategy may be profitable, but it does come with a few risks. So what is arbitrage trading, how is it used in the forex market and what are the pros and cons?
- How Does Arbitrage Work?
- Types of Arbitrage
- Merger Arbitrage
- See All 12 Items
How Does Arbitrage Work?
To execute an arbitrage, a trader typically buys an asset in one market and sells it in another. The underlying aim is to generate profits resulting from price discrepancies. If markets are fairly efficient, the potential profits an arbitrageur achieves may be small, but trading in higher volume can magnify returns.
The term arbitrage first appeared in the English language in the fifteenth century. Arbitrage trading dates back to ancient times and may have appeared in areas under Greek influence from the presence of overvalued coinage.
The use of arbitrage trading, as it’s known today, dates back to the securities and commodity markets of the 19th century. Traders look for arbitrage trading opportunities in all types of markets ranging from stock to commodity to foreign exchange markets.
Markets offer opportunities to buy and sell assets, but the quoted prices may not always be efficient — an asset may be overvalued or undervalued in different markets. An arbitrageur who finds an asset overpriced on one exchange and underpriced on another may try to simultaneously buy and sell the asset in each market and profit. Price discrepancies may occur because of error, incomplete information or a lag in information flow. An arbitrage opportunity may be difficult to discover because fluctuations in prices may be short-lived.
Types of Arbitrage
A few types of arbitrage strategies are commonly used to generate returns.
Merger Arbitrage
Merger arbitrage is an investing strategy where an arbitrageur seeks to profit from the merger of two publicly traded companies. A merger involves one company acquiring another. Stock prices of the companies involved usually change substantially before and after the merge, often because the likelihood of the merger is not guaranteed. In merger arbitrage, a trader simultaneously buys and sells stock in the two companies to bet on the merger event.
Pure Arbitrage
Pure arbitrage is the opportunity to buy and sell the same asset for riskless profit. This opportunity occurs because of a price difference in different markets. Using the pure arbitrage investment strategy means taking advantage of market inefficiencies. If different brokers quote different prices for the same forex, traders may be able to take advantage of a pure arbitrage.
Convertible Arbitrage
In convertible arbitrage, a trader typically buys a convertible bond and sells the underlying company stock to isolate the bond return and profit from price swings in the underlying stock. Convertible bonds are bonds that have the option to convert into stock. Convertible arbitrage generally involves higher risk-taking than the previously described forms of arbitrage. It is a common hedge fund investment strategy.
Understanding Arbitrage in Forex Markets
Arbitrage in the forex market means using the price difference in varying markets for potential profits. Forex arbitrage can occur because these markets are decentralized and prices are quoted over the counter instead of on a central exchange. An arbitrage trade could generate profits if different brokers offer varying quotes for the same currency pairs. An information lag or misinformation could lead to inefficiencies in price quoting that could potentially be exploited.
Trading in a Margin Account
A margin account is a type of brokerage account where the broker lends cash to the investor. Securing capital helps increase purchasing power so that traders can trade larger sizes. Equity value remaining in the account is used as collateral.
When placing a currency trade, traders are buying one currency and shorting the other in a currency pair. To place an arbitrage trade, traders generally will take two opposing positions on a currency pair, which requires trading on margin. Keep in mind that trading in a margin account may magnify gains and losses.
Triangular Arbitrage
Triangular arbitrage is a type of arbitrage trading strategy unique to the forex market and implies mispricing between the exchange rates of three currencies. Such an arbitrage opportunity may occur when price discrepancies exist in the exchange rates of the currency pairs. An arbitrageur in the forex market may need to identify the implied value of the currencies from each exchange rate.
After converting the exchange rates of each currency, traders try to exploit any discrepancy between the quoted price and the cross-exchange rate. Algorithmic trading programs usually try to spot these mispricings and take advantage of them quickly. Because the forex markets are highly liquid, triangular arbitrage may be difficult to find.
Benefits for Arbitrage Traders
An arbitrage opportunity in forex presents several potential benefits for traders.
- Potential for risk-free profits: Using an arbitrage strategy may help forex trades increase the likelihood of generating profits. Exploiting market inefficiencies implies that the actual trading risk is small.
- Diversification of portfolio: The arbitrage trading strategy is a different investment strategy that can add diversity to a portfolio. Adding riskless or near-riskless trades increases returns of the overall portfolio while minimizing added risk. This trait is an ideal characteristic for a diversified portfolio.
Risks for Arbitrage Traders
An arbitrage opportunity comes with risks that traders need to be aware of.
- Market volatility: The forex market may exhibit fleeting price discrepancies that disappear almost as soon as they appear. Identifying an arbitrage opportunity doesn’t necessarily mean you’ll have the ability to take advantage of it if market volatility removes the price discrepancy.
- Execution risk: Arbitrage trading relies on exploiting price discrepancies that may be short-lived, and an arbitrageur needs to execute the relevant trades quickly. Any delays or slippage will impact the profitability of the trade.
Aim for Riskless Profit with an Arbitrage Strategy
In the forex market, an arbitrage strategy refers to the buying and selling of currency pairs with the aim of profiting from price discrepancies without risk. An arbitrage strategy may help generate profits and diversify investment portfolios, but execution is key.
Frequently Asked Questions
What does arbitrage mean?
Arbitrage is the buying and selling of the same assets in different markets. The goal is to generate profit based on price discrepancies without taking risk.
Is arbitrage legal?
Yes, arbitrage trading in the United States is legal and encouraged. It contributes to market efficiency and leads to a convergence of prices.
What are arbitrage opportunities?
An arbitrage opportunity occurs when an asset is undervalued or overvalued and the inefficiency can be exploited with little or no risk.
About Anna Yen
Anna Yen, CFA is an investment writer with over two decades of professional finance and writing experience in roles within JPMorgan and UBS derivatives, asset management, crypto, and Family Money Map. She specializes in writing about investment topics ranging from traditional asset classes and derivatives to alternatives like cryptocurrency and real estate. Her work has been published on sites like Quicken and the crypto exchange Bybit.