Calculate Arbitrage in Forex
Arbitrage trading takes advantage of momentary differences in the price quotes of various forex (foreign exchange market) brokers and exploits those differences to the trader's advantage. Essentially, the trader is taking advantage of the same currency being priced differently in two different places. Trading forex arbitrage is not recommended as a sole trading strategy for trading forex. It is also ill-advised for traders with small equity accounts to trade arbitrage due to the high amount of capital needed.
Contents
Steps
Understanding Arbitrage and The Forex Market
- Understand the foreign exchange market. The foreign exchange market, commonly referred to as the forex market, is an international exchange for the trading of currencies. It allows investors, from large banks to individuals and everyone in between, to trade one currency for another. Each trade is both a purchase and a sale, as one currency is sold in order to buy another one. This duality means that currencies are not priced in any one currency, but in relation to other currencies.
- The forex market also allows the sale of financial instruments, including forwards, swaps, options, and others. These are more complicated than simple currency trades and allow for a multitude of other trading options.
- Learn about arbitrage. Arbitrage is the practice of buying an asset and selling it for a higher price in another market or area to take advantage of a difference in price. In theory, identical objects would be the same price in different markets. However, market inefficiencies, usually in communication, result in different prices. Arbitrage takes advantages of these inefficiencies to profit the trader.
- For example, if a trader can recognizes that a currency can be bought for less in one market and sold for more in another, he is able to make those trades and keep the difference between the two different currency values.
- Know how to use arbitrage to make profitable trades. Forex traders take advantage of price differences by buying currencies where they are less valuable and selling them where they are more valuable. In practices this usually involves multiple trades of intermediate currencies. Intermediate currencies are other currencies used to express the value of the currency you are trading. You wouldn't just buy and sell Dollars, for example. You would instead buy Euros with your dollars and sell them for Pounds, which you could then buy dollars with.
- For a more concrete example, imagine that you could buy 1 British Pound Sterling (£) for 2 American Dollars ($), that you could buy 1.50 Euros (€) for £1, and that you could buy $2.50 for €1.50. If you took your $2 and bought the £1, you could then sell your £1 for €1.50. Then, with your €1.50, you could buy $2.50. By trading this way you have gained $0.50, simply be exploiting price differences.
- In the real world, price differences would never be this extreme. In fact, they are usually fractions of a cent. Traders make money by trading in large volumes. Trading in large volumes also helps traders make enough profit to overcome transaction fees.
- In addition, traders must overcome the fact that arbitrage opportunities may disappear only a few seconds after coming into existence (as markets adjust to correct the difference in pricing). Institutional traders rely on computers and automated trading to overcome this obstacle.
- Know how to read currency prices. In the actual market, prices are expressed in a very specific way. As previously mentioned, currencies are not priced as a direct amount, but in relation to other currencies. That said, the US Dollar is generally used a base currency for determining value. For example, the value of the Japanese Yen (JPY) is expressed as (Number) USD/JPY.
- The relative values of currencies are generally expressed to four decimal places. For example, the Euro to US dollar rate could be expressed as 1.1156 EUR/USD. You can read this as "you need to spend 1.1156 USD to buy one EUR."
Calculating Arbitrage
- Determine what currencies to use. In order to have a triangular arbitrage, you must compare the exchange rate of three currency pairs that you can trade between. An example of this is the EUR/USD (Euro/U.S. Dollar), EUR/GBP, (Euro/Great Britain Pound) and GBP/USD (Great Britain Pound/U.S. Dollar). As in any such triangular arrangement, there are three currencies involved, and each currency is paired separately with each of the other two.
- Get the current exchange rate for each pair. You can find the current exchange rate in your forex broker software (if you have a forex broker) or on websites that have the current exchange rates listed. For illustration, assume the following exchange rates for the euro (EUR/€), the British pound (GBP/£), and the U.S. dollar (USD/$).
- Exchange rate of EUR/USD is 1.2238, which means that you will have to spend about $1.22 to buy €1.
- Exchange rate for GBP/EUR is 1.1910, which means that you can buy £1 for about €1.19
- Exchange rate for GBP/USD is 1.4650, which means that for £1, you can buy about $1.47.
- Calculate the arbitrage. The arbitrage is made by buying and selling the correlating currencies against each other. Currency is traded in units called lots. Standard lots are blocks of 100,000, and mini-lots are blocks of 10,000.
- Imagine you have the ability to make a leveraged trade with $500,000. A leveraged trade is one made mostly with debt.
- Spend your $500,000 to buy Euros. Because the USD is on the bottom of the exchange quote (EUR/USD), divide the $500,000 by the quoted amount. So $500,000/1.2238 would net you about €408,560.
- Sell the Euros for British Pounds. Again, because the Euro is on the bottom of this exchange rate (GBP/EUR), we divide the number of Euros by the exchange rate to get the number of pounds. So, dividing €408,560 by 1.1910, we get about £343,040.
- Sell the British pounds for U.S. dollars. Here, the GBP is on top of the quote (GBP/USD), so we multiply the number of pounds by the exchange rate to get the number of USD. So, £343,040*1.4650 yields roughly $502,550.
- Determine your profit. You started with $500,000, and you know have $502,550 after a few simple trades. Your profit is $502,550 - $500,000, or $2,550.
Using Arbitrage as a Trading Strategy
- Get access to a forex trading platform and software. Brokers and traders who trade arbitrage don't calculate arbitrage manually. They use software programs that can identify opportunities in the market and calculate the arbitrage in seconds. The software can be set up to buy and sell at the precise moment that the opportunity arises. You can access similar platforms online and trade in the forex market. Search for "online forex trading" to see what types of software are currently available.
- Be aware that many of these platforms charge a trading fee. If you're trading with small amount, this fee may erase or lessen your profit on each trade.
- Beware of faulty arbitrage programs. There are forex arbitrage software programs for sale online. Before using these programs on a real account, ensure that they work on a demonstration account first. This will prevent the loss of money through the use of faulty software. Have an experienced arbitrageur recommend software and trading platforms.
- Look for arbitrage opportunities. Some online forex trading platforms offer calculators or automated programs for finding arbitrage opportunities. Take advantage of this service if your trading platform offers it.
- You can also use an independent forex arbitrage calculator to determine if an arbitrage opportunity exists. These are available online, sometimes free and sometimes for a fee. Try searching for "arbitrage calculator" to find one.
- Make your trades quickly. The exchange rate will quickly correct itself out of the arbitrage opportunity, so you must act quickly to make the trade before your opportunity is lost. You can literally blink and lose an opportunity, so be sure to act immediately once you have determined that there is a price difference.
- The reality is that with the current level of technology and speed of worldwide communication, forex arbitrage is usually only profitable for large financial institutions with lightning-fast trading systems. This is because arbitrage opportunities usually close in a matter of seconds.
Warnings
- Never trade on an online platform that is not properly certified. If you're unsure, err on the side of caution and stay away.
- Assuming the software being used is working properly, forex arbitrage (whether in currency or in other assets) is commonly considered to be risk-free for the trader. Nonetheless, an investor is well advised to learn all he or she can about the process before committing money to it.
- If you use leverage (debt) to make forex trades, this can potentially magnify your losses to high degree. Be aware that you could lose a substantial amount of money this way if your trades go poorly.
