Forex trading’s main reason is to make profits by anticipating the directions a currency pair will take. Forex traders use different trading analysis tools to help them with reading the trends. What if there is another way to profit from forex trading without using any tools to anticipate the currency pair trends?
Some people might think this is almost impossible, but there are actual situations where some traders use trading strategies called market neutral to make profits. Such strategies are many in the market, but one of the least risky is the arbitrage strategy.
What Is Arbitrage Strategy?
An arbitrage strategy is a trading pattern where traders take advantage of price discrepancies between similar instruments to make a profit. These traders, called arbitrageurs, buy a certain amount from one market while selling a similar amount to another unrelated market. Their reason for doing this is to take advantage of any price divergences between the two markets.
One of the most common questions that people ask about this trading style is whether it is legal. The answer is it is an entirely legitimate trading strategy, and it helps to improve the trading market’s efficiency. Another question that others ask is whether it is possible to use the arbitrage strategy in forex trading. The answer again is yes.
Forex Arbitrage Trading
Arbitrate forex traders do not do things any differently from the above description. The traders aim to purchase cheaper currency versions while at the same time selling expensive versions in other markets. The arbitrageurs then subtract their transaction costs, and the profit they make is the difference that remains from the two prices.
The basic arbitrate strategy is the same in forex trading, which is to make a profit by exploiting price anomalies. An arbitrage also occurs when two different forex brokers offer different quotes for similar currency pairs. However, since brokers in the retail forex market have uniform prices, the strategy works better in the institutional market.
Main Arbitrage Trading Strategies
There are mainly three arbitrage strategies.
1. Forex Triangular Arbitrage
One of the most popular arbitrage trading strategies is the forex triangular arbitrage that attempts to profit from price discrepancies by offsetting trades in the forex market. You need to be knowledgeable about how currency pairs work for you to understand the strategy.
You effectively take two positions when you trade a currency pair, i.e., you buy one currency while you sell the other in the pair. A forex pair currency cross does not include the US dollar. Instead, a cross value is the currencies in question exchange rates versus the US dollar.
2. Forex Statistical Arbitrage
While Forex statistical arbitrage is not a pure arbitrage trading strategy, it takes a different approach that seeks divergences in prices likely to be sadistically correct in the future. It puts both over-performing and under-performing currency pairs in separate baskets intending to purchase the underperforming currency pairs and short the over-performing ones.
The strategy assumption is that one basket’s relative value to the other will most likely revert to the mean after a while. Using the strategy requires a tight correlation between the two different baskets to ensure market neutrality.
3. Risk-free Profit Arbitrage
Even though the arbitrage-trading strategy is supposedly risk-free, the truth is it is not. If the implementation were half the battle, then you would consider it low risk. However, it would help if you executed your offsetting positions simultaneously or close to that to eliminate any risks, which is not always possible because the slightest slippage of a few pips erases profits.
Advantages and Disadvantages of Arbitrage Trading Strategies
- Low-risk element
- It helps in minimizing price variances by keeping them more or less the same across the trading markets
- It helps in making financial markets more efficient
- It might lead to losses in the case of minimal price differences
- Few arbitrage trading strategy opportunities in the trading market
- Requires a lot of money
Wrapping it up
The forex trading market is one of the most competitive globally, with traders looking for different strategies and techniques to make a profit. It is hard to say one trading strategy is right over the other because they are subject to certain risks that affect profitability.
Suppose many traders chase after only one type of strategy, opportunities to make profits dwindle, which is why there is diversity. Even though arbitrage is not as popular as many other strategies in the trading market, some traders that explore the option find the theories helpful, mainly because the risks are minimal.