Forex Arbitrage: Taking Advantage of Pricing Inefficiencies
October 26, 2010 | In: Guest's Articles
Arbitrage trading has become common practice on Wall Street over the last 20 years. This risky style of trading aims to take advantage of asset price inefficiencies by simultaneously buying and selling the same asset in separate markets, and pocketing the difference. The difference is usually quite small; therefore, huge amounts of leverage and a large account are essential to finding success with an arbitrage strategy, and this combination is why arbitrage trading carries very significant risks of the loss of funds. Before we break down the specifics of arbitrage trading and how to develop a forex strategy, it is essential to understand the risks.
One of the most spectacular Wall Street failures of all time was Long-Term Capital Management. Ironically, before its fall, LTCM was hailed as one of the most powerful firms on Wall Street during its prime. Two economic Nobel Prize winners believed they had created a quantitative approach to the markets that could not fail. They partnered with John Merriweather, a former Solomon Brothers trader and executive, and formed LTCM. Due to the distinguished background of the three gentlemen, capital was easy to raise, and LTCM opened shop in 1994. During its early years, LTCM boasted compounded annual returns of over 40%, but in ’98, LTCM lost over $4 billion in under 4 months when Russia defaulted and the East Asian Crisis caused global unrest.
LTCM’s trading strategy was based on statistical arbitrage, and it sought to take advantage of arbitrage opportunities in the fixed-income markets. LTCM’s huge success in the early 90’s caused a revolution on Wall Street and firms began focusing on developing quantitative models, and arbitrage became the hottest new style of trading. LTCM’s collapse, however, served as a needed reminder to Wall Street and the investing public, that no trading strategy is ever without significant risks. Although arbitrage trading is purported to be risk free, there are always risks; in fact, the riskiest strategies of all are ones that people consider to be “risk free.” When traders believe a strategy is risk free they tend to dramatically over-leverage trading positions, and then when something goes wrong and the market turns, and it inevitably will at some point, then these accounts will suffer major drawdowns because no strategy is risk-free, and arbitrage trading is actually high-risk.
Breaking Down Forex Arbitrage
As stated, arbitrage trading essentially involves finding an asset that is priced differently in two separate markets. Then, once a price inefficiency is discovered, a trader can buy the financial asset in one market and sell it in the other, or he can sell it in one and buy it in another. He then pockets the price difference. Generally, this price difference, or profit, will be extremely small, so a very large account and heavy leverage are essential to developing a successful arbitrage strategy; consequently, this dangerous combination of a large account and heavy leverage significantly increases the risk of arbitrage trading.
Due to the nature of currencies trading in pairs in the fx trading, triangular arbitrage is the most common forex arbitrage strategy. The mathematical formula for this strategy is rather basic:
AAA/BBB x CCC/AAA = CCC/BBB
Whenever this formula breaks down, an arbitrage opportunity has arisen. Therefore, a trader will buy currency BBB by selling (or spending) currency AAA; then, he will buy currency CCC by spending currency BBB. Finally, he returns to currency AAA by selling currency CCC and he pockets a very small profit.
Let’s break down a real-life example. Assume EUR/USD = 0.6522, EUR/GBP = 1.3127, and USD/GBP = 2.0129. If a trader trades 1 standard lot, he has $100,000 of buying power and he can purchase 65220 Euros. Then, using those Euros he can buy 49683.85 pounds. Finally, he uses those pounds to convert back into dollars and has $100,008.62. With these 3 transactions, the trader has just earned $8.62.
Challenge of Retail Trader
It is very difficult for a small, retail trader to take advantage of arbitrage opportunities on a regular basis and generate enough money to build a profitable trading strategy; however, arbitrage trading can definitely be an additional strategy to support an overall portfolio of market approaches. Remember, no strategy is risk free and this article merely describes the basic concept! A forex course can help a trader discover and understand working strategies.
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