Bet instead of trade the forex market is a trading strategy that has made billions of dollars as well as being responsible for some of the biggest financial collapses of all time. What is this important technique and how does it work? That is what I will attempt to explain in this piece.
An Excel calculator is provided below so that you can try out the examples in this article. Arbitrage and Value Trading Are Not the Same Arbitrage is the technique of exploiting inefficiencies in asset pricing. When one market is undervalued and one overvalued, the arbitrageur creates a system of trades that will force a profit out of the anomaly. In understanding this strategy, it is essential to differentiate between arbitrage and trading on valuation. Buying an undervalued asset or selling an overvalued one is value trading. The true arbitrage trader does not take any market risk.
He structures a set of trades that will guarantee a riskless profit, whatever the market does afterwards. Arbitrage Example Take this simple example. Suppose an identical security trades in two different places, London and Tokyo. For simplicity, let’s say it’s a stock, but it doesn’t really matter. The table below shows a snapshot of the price quotes from the two sources. At each tick, we see a price quoted from each one. At 8:05:02 the arbitrageur sees that there is a divergence between the two quotes.
London is quoting a higher price, and Tokyo the lower price. At that time, the trader enters two orders, one to buy and one to sell. He sells the high quote and buys the low quote. Because the arbitrageur has bought and sold the same amount of the same security, theoretically he does not have any market risk. He has locked-in a price discrepancy, which he hopes to unwind to realize a riskless profit. Now he will wait for the prices to come back into sync and close the two trades.
Not a huge profit, but it took just three seconds and did not involve any price risk. This is why you have either to do it big or do it often. Before the days of computerized markets and quoting, these kinds of arbitrage opportunities were very common. Cross-broker Arbitrage Arbitrage between broker-dealers is probably the easiest and most accessible form of arbitrage to retail FX traders. To use this technique you need at least two separate broker accounts, and ideally, some software to monitor the quotes and alert you when there is a discrepancy between your price feeds. You can also use software to back-test your feeds for arbitrageable opportunities. This ebook is a must read for anyone using a grid trading strategy or who’s planning to do so.
Grid trading is a powerful trading methodology but it’s full of traps for the unwary. This new edition includes brand new exclusive material and case studies with real examples. A mainstream broker-dealer will always want to quote in step with the FX interbank market. In practice, this is not always going to happen. Variances can come about for a few reasons: Timing differences, software, positioning, as well as different quotes between price makers. Remember, foreign exchange is a diverse, non-centralized market.
There are always going to be differences between quotes depending on who is making that market. Delayed quotes: When a broker’s quotes momentarily diverge from the broader market, a trader can arbitrage these events. This will allow a risk free profit. Having both quotes available, the arbitrager sees at 01:00:01 that there is a discrepancy. He immediately buys the lower quote and sells the higher quote, in doing so locking in a profit.
When the quotes re-sync one second later, he closes out his trades, making a net profit of six pips after spreads. Spreads When arbitraging, it is critical to account for the spread or other trading costs. That is, you need to be able to buy high and sell low. In the example above, if Broker A had quoted 1. 3048, widening the spread to 10 pips, this would have made the arbitrage unprofitable.
In fact, this is what many brokers do. In fast moving markets, when quotes are not in perfect sync, spreads will blow wide open. Some brokers will even freeze trading, or trades will have to go through multiple requotes before execution takes place. By which time the market has moved the other way. Sometimes these are deliberate procedures to thwart arbitrage when quotes are off.