Foreign Exchange traders employ a plethora of strategies in their trading, and Forex arbitrage trading is one. The basic concept is to profit from inefficiencies in the market that are present for only a short period of time. The nature of this kind of trading is complicated, especially for the beginner, and usually requires high levels of leverage to make any serious profit.
Forex arbitrage trading involves trading in at least 3 different currencies, and 3 different currency pair combinations that you can derive from these. You would normally begin with one currency, trade that for a second currency and then that for a third, and eventually buy back the original currency. So, if before you placed a trade you had USD, at the end of all the trades you will again have USD.
Lets look at an example using the pairings EUR/USD, GBP/EUR and USD/GBP. When an inefficiency in the markets is identified, it gives us an opportunity to buy EUR with USD, then buy GBP with EUR and then buy back our original USD with GBP and finish up with more than we started. While these opportunities do come up everyday, they are only ever around for a short time.
We will assume the following buying exchange rates for our example:
Now let's go through each trade in our example. We will begin with 0,000 and buy Euros: 500,000 / 1.533272 = 326,100 Euros. We take these Euros and by Pounds: 326100 / 1.3127 = ?248419.28. Lastly we take our pounds and buy back the Dollar: 248419.28 / 0.4967956 = 0043.23. So we have made a profit of .23.
When one of these opportunities to profit from the discrepancies between currencies arises, it is vital that an arbitrage trader executes their trades swiftly. There are literally hundreds of thousands of arbitrage traders around the world waiting to pounce on these opportunities, and when they all place the same currency orders within the same few seconds the markets compensate and the opportunity is gone.
You may be wondering then, how do traders actually identify these opportunities, given that the time frame they are available is so short and the calculations many and intricate. Forex arbitrage trading is made possible because software exists that is able to monitor the markets and make all the calculations. Because arbitrage trading involves taking advantage of an opportunity that is short-lived, you must ensure you have a live up to the second feed of FX rates and a good internet connection.
In our example we were able to make only .23 profit from 3 trades, many times you will find more than 3 trades is required. There is no real limit to the number of currency pairs and trades that can be involved in an equation. To actually make a profit using arbitrage, Forex margin trading strategies are important and you will need to leverage your account very heavily.
For the most part, forex arbitrage trading will generally only be a small part of an experienced traders dealings. For the inexperienced trader, arbitrage trading is not an ideal trading model to start with, and nor is it the best option to make a sustainable income from trading the Forex markets.