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An Introduction to Arbitrage Trading

BitForex Editor
Nov 25, 2020

Today technology and innovation have connected the global market in unbelievable ways than ever. While this is good, it has given room to making profits across trade borders seamlessly from your computer system.

As the currency market gets decentralized, prices fluctuate between brokers. These discrepancies are the gaps that traders leverage on to reap a reward while others wait to see the change. This causes spontaneous buying and selling between exchanges.

What is Arbitrage Trading?

The word arbitrage is to purchase and sell an asset to profit from the markets. Simply put, buying a commodity in one market of lower price and selling in another of a higher price is arbitrage. Traders who indulge in the gap are called arbitrageurs. Overall, it is profiting from the inefficiencies of the global trade market.

For example, assuming the price of a commodity on the NYSE is say $60.15, but the same commodity goes for $70.25 on the LSE upon investigating other markets. This is a profit of $10.10 just by shifting markets. 

This will continue until the company or commodity gains on the market to wipe out the huge gaps in these markets.

As a trader, it is paramount to understand that although arbitrage is trading at almost zero risks, it is highly speculative. It is not accepted by the new market where you want to sell it. Ordinary, arbitrage trading is seen as a trade that does not really involve any drastic or significant investment but one that money is made. For traders, it is a risk-free portfolio only for the daring.

Conditions For Arbitrage To Occur

While arbitrage is a juicy opportunity, the global trade market tries to eliminate any condition for such to happen. However, there is always that gap and lapses that traders are keenly watching to take hold of. And because arbitrage is a simultaneous affair, traders can get away with it immediately.

For arbitrage to occur, one or more of the following conditions must be present –

1.The same commodity is traded in two different markets at different prices.

2.Two commodities of the same price sources are traded at different prices.

3.There is a significant gap between the current price and the expected future price.

Types of Arbitrage

While there are lots of arbitrage types on the market, the three below are arbitrages that traders of currency should know. It is triangular arbitrage, funding rate arbitrage, and exchange arbitrage.

Triangular Arbitrage

This is also known as the three-point or cross-currency arbitrage. It is a trading process that sees a trading taking arbitrage advantage between the price differences of three currencies, especially in a Forex. This usually happens when there is a clear-cut discrepancy between the values of a currency compared to another.

In the triangular arbitrage, the trader sees a currency of the first currency as undervalued, which is then converted to another, then a third, and then back to the initial currency. These transactions are done in milliseconds to reap the profits at each stage. This type of arbitrage is scarce and rarely occurs due to the competitive nature of the global foreign exchange markets. Furthermore, it is super risky, and the yield is so marginal, but to the trader, very significant.

For example, assuming, you have one million dollars on a Forex trade and decide to take on the triangular between the Euro, GBP, and the USD. If the price of EUR/USD is 0.9324, EUR/GBP is 1.5600, and the USD/GBP is 1.7940.

This is the trade pattern.

1.Take the first trade, which is 1million by 0.9324 = 932,400 Euros.

2.Decide to trade with the second, which is 932,400 /1.5600 = 597, 692 pounds.

3.Finally, the pounds for dollar which is 597 692 by 1.7940 = 1,054,329

Profit is 1,054,329 – 1,000,000 = 54, 329 USD, a pretty good profit for a day’s trade. Traders exploit such opportunities by finding such loops and going through it.

Funding Rate Arbitrage

Also referred to as rate arbitrage is one that works to stabilize the price of perpetual contracts on futures exchanges. To properly understand how this arbitrage works, one needs to understand the longer a trader holds a position on the market, a fee is paid, and that fee is the funding fee. So the longer it is held, the more profitable and short periods are not.

Exchange Arbitrage

It is also referred to as currency arbitrage that is trading between trading points as a result of the price difference between the two currencies. The difference can be on the bidding or asking price of the currency. On the trading floor, currency prices are different according to the brokers. For example, a Forex/cryptocurrency trader can buy and sell for a short time. Exchange arbitrage commonly occurs in the price difference of assets of the same value on the market.

For example, if a currency pair is quoted in two different prices, say the USD/EUR for 5/4 and 4/3 in two markets. The trader will exchange euro for dollar with one market and then convert it to euro again on the next exchange platform. 

The result is a profit of 1/16 from an initial total of 15/16.

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