Arbitraging is a technique of obtaining profits from a better and more profitable price difference of an underlying in different markets. People who trade by using the processes of arbitraging are known as arbitrageurs. They purchase assets at a lesser price and sell the ones simultaneously with a higher value in another market.
An arbitrageur can profit from the price differentiation in the diverse market scenario for market inefficiency, as they detect the results of the price difference between the markets due to market inefficiency. In the ideal case, arbitraging should not include any kind of capital and risk, but in reality, both factors are present.
Arbitrage in a nutshell
- Forex Arbitrage: Benefit from currency price differences on decentralized markets.
- Triangular Arbitrage: Taking advantage of negative spreads between three or more currencies.
- Interest Rate Arbitrage: Trade currencies to profit from interest rate differences.
- Spot-Future Arbitrage: Entering into positions on both the spot and futures markets for a currency.
- Binary Options Arbitrage: Buying and selling the same asset at the same time with the intention of making a profit.
Different types of arbitrage trading explained below:
What is Forex arbitrage?
Forex arbitrage is the method that exploits the price disparities in the forex markets. (Learn what the term “forex” means here.) This process is possible only for the decentralization of the market. As the price of a particular currency can be different in two diverse markets, the traders have the opportunity to purchase trades at a low price and sell it at a higher price range.
Therefore, negative spread-related situations come under the circumstances.
Example of forex arbitrage
Let’s clear the concept of arbitrage with an easy example.
Suppose a bank quoted EUR/JPY forex pair in London at 122.500. But the same pair was quoted by another bank in Tokyo at 122.540. The trader who has access to both the quotes will be able to buy it at London price and sell it at Tokyo price. During the market convergence, let’s say prices would be 122.550.
For that instance, the trader will have to close both the trades. In Tokyo, he will lose one pip, but in London, he would gain a profit of 5 pips. So, in the end, the trader would gain a transaction that costs less than 4 pips.
Forex arbitrage strategies are varied for enhancing the chances of profits. The traders look for price differences in various combinations of trading instruments. Some effective forex arbitrage strategies are given as follows.
What is triangular arbitrage?
Triangular arbitrage is a change in negative spread strategies involving three or more foreign currencies due to discrepancies among them when exchange rates do not match.
A typical example of a triangular negative spread is EUR/USD, USD/JPY, and EUR/JPY.
What is interest rate arbitrage?
Interest rate arbitrage is also known as the carry trade. Traders sell the currencies with a lower interest rate and buy the currencies with higher interest rates. When the person reserves the currencies with a higher interest rate, he will profit from the interest rate difference. (See the definition & examples of an interest rate here)
The strategy includes the inherent risk of time, as, during a certain time period, traders can reverse their position, the rate of the currencies, and ever the interest rate as well.
What is spot-future arbitrage?
Spot-future arbitrage involves occupying the positions for a particular currency in the spot and futures market. Forex traders use this strategy to short in the spot market and widen the long position for the future market.
Arbitraging arises opportunities in the forex markets by exploiting market discrepancies. When the number of players is increased, the profitability erodes. Therefore, one should have the fastest technological support and time-accurate market updates to gain profit by involving arbitrage.
How do you do arbitrage trading with Binary Options?
Arbitrage with binary options refers to a trading strategy in which the same asset is bought and sold simultaneously in order to profit from price differences. Unlike shares, where different markets may be required for arbitrage, combinations of options offer the opportunity to realise arbitrage on the same market. It is considered a relatively low-risk technique due to its simplicity and how both positions are covered.
Benefits and risks of Binary Options Arbitrage Trading
- Arbitrage offers a relatively low risk form of trading through the simultaneous execution of binary options.
- Strategies for arbitrage can be automated by using trading algorithms and bots.
- Numerous binary options can be traded outside regular market hours, which creates arbitrage opportunities.
- Arbitrage opportunities can be challenging to identify.
- Slow trade executions can result in losses.
- Broker fees can reduce profits.
- Arbitrage strategies rely on inefficient markets, which limits the chances of identifying price differences.
