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Arbitrage Trading

One way to make money on market inefficiencies is to use a strategy called arbitrage trading. When you use this strategy, you capitalize on the price differences with the same asset. Arbitrage trading is a sophisticated strategy, and even though it deals with small differences in prices, the profits can be large when leveraged. Let’s take a look at how arbitrage trading works, and whether it makes sense to incorporate it into your strategy.

 

What is arbitrage trading?

Arbitrage trading is a strategy often employed by day traders. This investment strategy makes use of small differences in prices to take profits down the road. Basically, you buy an asset in one market while selling it in another market. The goal is to buy the asset — a stock, bond, currency, commodity, or cryptocurrency — at a lower price in one market and sell it for a slightly higher price in another market.

Arbitrage trading background

Market inefficiencies are part of the reality of investing. For example, a stock might be selling for $15.50 on one exchange and $15.60 on another exchange. The idea is that these small differences can lead to big profits in large amounts. 

Thanks to computer programs and other tools, it is possible to find market inefficiencies in pricing for assets and then exploit them. However, it works best when large amounts are involved. If you are working in large lots, like 100,000 shares, that small difference can result in a $10,000 profit.

When is arbitrage trading used?

For the most part, arbitrage trading is used by day traders who want to exploit small inefficiencies in the market to make a profit. Often, leverage is used with arbitrage trading so that traders can make large trades and reap profits

It often requires sophisticated algorithms and programs to find these differences in prices across markets and use them to make a profit. Arbitrage traders often need to be available at various hours, depending on the market and know when there are likely to be differences in prices.

How does arbitrage trading work?

Arbitrage trading requires knowing where to look

At its most basic, pure arbitrage works when you buy an asset at one price and sell it immediately for a higher price on a different market. Basically, there are assets that can be traded on multiple markets at once. When this happens, there is a chance that exchange rates and other factors can lead the asset prices on the different markets to be a little bit out of sync.

For example, if an asset is listed on the London Stock Exchange and on the Hong Kong exchange, the price might be slightly different for a short period of time. The pricing error exists until one of the exchanges fixes it, but in that window of time, an arbitrage trader can execute traders and benefit. 

It is important to note that the arbitrage window is smaller today than it used to be. Because of electronic trading, markets can identify the differences sooner and adjust accordingly.

 

The pros and cons of arbitrage trading vs normal trading

Before getting started, it is important to know the benefits and drawbacks of arbitrage trading. Realize that one of the biggest impediments to becoming a successful arbitrage trader is the level of sophistication you need to have as an investor

Let’s take a look at the pros and cons of arbitrage trading.

The pros

Profit off small pricing discrepancies in the markets — If you can find small pricing discrepancies, usually with the help of a computer program, you can earn profits from these small differences.

Low capital investment — Depending on the situation, you might be able to become an arbitrage trader without making a large capital investment. You might be able to use leverage to magnify your situation and put a small amount of money at risk.

The cons

Small window of opportunity — Your window of opportunity can be as small as milliseconds. If you do not have the trading infrastructure or access to the high-speed programs needed, you might not be able to capitalize using arbitrage trading.

Costs can be higher — Depending on your frequency of trading and price fluctuations, costs might be higher than expected. Trading fees, currency conversions across markets, and different tax treatments can reduce your profits.

 

Examples of arbitrage trading strategies with explanations

There are a few examples of arbitrage trading from recent years. Understanding how these strategies work and being able to take advantage of them could potentially lead to profits.

Kimchi premium

One of the most interesting opportunities for arbitrage trading is using the difference in price between cryptocurrencies on exchanges located in the west and other Asian countries and those on the exchanges in South Korea. This phenomenon is often called the kimchi premium.

Basically, by the end of 2017, some cryptocurrency traders noticed that there was a 30% difference between bitcoin prices in other exchanges and bitcoin prices on South Korean exchanges. By early 2018, the premium was at 50%. 

For example, if you could get one bitcoin for $8,000 in the United States on an exchange, it might be selling for $12,000 on an exchange in South Korea. It would be possible to make a profit of $4,000 by buying a bitcoin using U.S. dollars and then selling that same bitcoin minutes later using a South Korean exchange.

High frequency trading arbitrage

In high frequency trading arbitrage, the idea is to make trades quickly, getting them completed in a short period of time. Thousands of trades in a day, made using arbitrage, can add up to profits quickly. 

However, it is important to note that being able to make the most of these opportunities requires speed. High frequency arbitrage traders must be first to execute the trade in order to take advantage of the small period of time the window offers effective trading before the price inefficiency is corrected.

Two currency arbitrage

With two currency arbitrage, you take advantage of the difference in bid-ask spreads between two different banks. For example, perhaps one bank has an exchange rate that would require you to spend $1.15 to get one euro. However, another bank is offering a 1:1 exchange rate.

Basically, you’d take one euro to the first bank and receive $1.15. Then, you take that $1.15 to the bank offer a 1:1 exchange. Now, you’ve profited by $0.15. Every euro involved in the exchange has that profit. So, if you did this with 50,000 euros, you would end up making a simple profit of $7,500.

Covered interest arbitrage

Another type of arbitrage is known as covered interest arbitrage. In this approach, you try to benefit from the difference in interest rates between two countries. This type of arbitrage strategy involves purchasing a “forward contract,” which is an agreement to buy or sell a specific asset on a pre-determined day.

Perhaps the 90-day interest rate is higher on the U.K. pound than it is for the U.S. dollar. You start by borrowing money in dollars and then converting those dollars to pounds. Next, you deposit the pounds so they can earn interest at that higher rate. At the same time, you buy a 90-day contract designed to give you a set rate when you convert those pounds back to dollars. 

Now, because you have been able to earn interest at a higher rate in pounds when you convert your money back to dollars, you end up with a profit.

Triangular arbitrage

Triangular arbitrage is a little more complicated than some of the other types of arbitrage. This is because triangular arbitrage involves three assets rather than only two. Currencies offer another good way to look at arbitrage as an example. 

Let’s say you have $1 million. Your arbitrage depends on the Forex currency rates on the spot market:

  • EUR/USD = 0.852
  • EUR/GBP = 1.159
  • USD/GBP = 1.372

Your first step is to turn that $1 million into 852,000 euros. Next, you take those euros and turn them into approximately 735,117 pounds. Now that you have all of those pounds, you convert them back to dollars: $1,008,580. You have made a nice profit of $8,580 through these conversions.

Other types of arbitrage

There are other types of arbitrage that can be used in trading. Some of these include:

  • Merger arbitrage — Buying shares of a publicly-traded company ahead of a merger. The idea is that you can buy the shares at a lower price, and then when the merger is announced and is completed, you receive a higher price for your shares when the acquiring company completes the transaction.
  • Convertible arbitrage — Using convertible bonds, it is possible to turn a profit based on the difference between the conversion price of the bond and the price of the underlying shares of the company. It is a way of shorting the bond while going long on the stock price, or vice versa. 
  • Cryptocurrency liquidity pool arbitrage — On some decentralized exchanges, like Uniswap, smooth trading is accomplished with the help of liquidity pools. It is possible for arbitrage traders to take advantage of the difference created by price ratios in liquidity pools and the market price of a cryptocurrency. It’s also possible to make money using arbitrage by taking advantage of the price discrepancies between two decentralized exchanges.

 

How do you perform arbitrage trading?

When you get ready to become an arbitrage trader, it is important to understand the basics. First, you should understand how the markets work. Know which assets are likely to be affected by market inefficiencies, and have an idea of when you can most expect to see these differences. 

Trade entry

First, you need to know your trade entry point. You should have an idea of what you need to accomplish. The main goal of entering a trade is to buy at a relatively low price. Note you will rarely get the perfect price. Enter quickly to get the asset at the lower price. Now you have the asset and can hopefully sell it at a higher price on a different exchange.

Trade exit

Know when to exit a trade. In the case of arbitrage trading, you should be executing trades quickly, buying at a lower price and then immediately selling at a higher price. Some trades will have a longer time frame than others. For example, a high frequency arbitrage play happens in fractions of a second. However, with covered interest, you will not finish your arbitrage play until the expiration and execution of your forward contract.

Trading strategy

Figure out which arbitrage strategy works best for you. Depending on the situation, you might find a strategy that works better for you than another. Some brokers offer demo accounts, allowing you the chance to try different approaches and test out the availability of assets on various platforms. Use these tools to get a better idea of what to expect.

Focus on discipline and risk management

With any type of trading, you need to be prepared to stick with a trading strategy. Disciplined trading is an important part of successful arbitrage trading. You should understand when it makes sense to enter and exit a trade and take profits when they are available. Letting emotions rule your trades, rather than using a system, can lead to losses.

It is also important to manage your risk. Because any type of trading can be risky, it’s important to avoid risking too much on any one trade — even in an arbitrage situation when risks are considered somewhat low. A good rule of thumb is to avoid risking more than 1% to 2% of your account balance on any one trade. That way, if things do not work out or if you miss your window and lose, you will not be stuck.

This is especially important if you use leverage. Because leverage can magnify losses as well as gains, you need to be careful to manage your risk reward ratio anytime you are trading with leverage.

Educate yourself about the basics

Before you get involved heavily in arbitrage trading, it’s important to get to know the basics. Even though arbitrage trading can be profitable, the reality is that it’s more sophisticated than many other trading strategies, so it has more of a learning curve. 

Books

Consider purchasing books that can help you learn the fundamentals of trading before you look into arbitrage as a specific trading strategy. Two good books that can help you make the most of trading are Trade What You See: How to Benefit from Pattern Recognition by Larry Pesavento and Trading in the Zone by Mark Douglas. These books can help you understand trading and use the principles in your arbitrage strategy.

Trading courses

If you’re hoping to learn from people who have been successful, a good course can be helpful. Look for a reputable trading course on arbitrage. However, it’s important to watch out for fake gurus or those who overstate how much you make realistically. Do not be dazzled by unrealistic returns and end up paying more than a course is worth.

Blogs

There are hundreds of blogs on trading strategies, including arbitrage. Look for different blogs that offer insights into strategies and approaches. Again, you need to watch out for fake gurus who claim that you can make more than what is reasonable.

Forums

One of the best ways to learn from others is to join a forum. You can learn information from the posts made by successful arbitrage traders and get helpful pointers. You can also share what’s worked for you and get tips on when a good opportunity could be coming up.

Newsletters

Trading letters can be good resources for those hoping to learn more about strategies, as well as identify potential opportunities. Some of these newsletters can cost money, though. Make sure you’re careful about which newsletters you subscribe to.

Podcasts

Gain more insight into upcoming opportunities (like mergers and interest rate changes) by listening to podcasts. You can also learn about different assets that are compatible with arbitrage trading.

YouTube

With YouTube, you have the chance to learn visually. Many channels show successful trades and can walk you through exactly how to use a platform to complete an arbitrage trade. However, you do need to be on your guard. There are many fake gurus on YouTube, and they might try to get you to buy an expensive course by promising unrealistic returns.

Webinars

Depending on the webinar, you might be able to get more targeted information about making arbitrage trades. Some of these cost money, so be careful to vet your potential webinars before joining. Make sure that it is a live webinar and that you will be able to ask questions.

Establish whether arbitrage trading is for you

Before you get started, it is important to understand whether this is the right trading choice for you. You can use a demo account to try out different strategies and learn whether this approach is going to work with your situation, portfolio goals, and risk-adjusted return tolerance. 

What do you have to be prepared to do?

Arbitrage trading requires a lot of preparation ahead of time. One of the biggest things, especially if you plan to use pure arbitrage to profit off differences in stock exchange prices, is to get the right equipment and programs.

When you are using arbitrage trading, the window of time to execute a trade before the market brings prices back into alignment can be very small. You need to be able to buy an asset and then turn around and sell it in a matter of seconds — or less. In order to make this happen, you might need to invest in a software program or technology equipment that allows you to move fast. In some cases, you might need to pay for an automated system that can handle the trades on your behalf.

Additionally, depending on your strategy and the type of arbitrage, you might need to be ready to spend a lot of time at the computer, making sure that you are executing trades. Learning how to be successful at arbitrage trading takes time and effort, and you need to be very disciplined.

Manage your expectations

Too often, with any type of trading, it’s easy to become enamoured of the idea of massive profits in one day. However, as you get started with arbitrage trading, it is important to recognize that your profits are likely to be small at first. When you begin, make small trades to learn the ropes and become successful. Additionally, if you start without using leverage, you will see smaller profits at first. 

Recognize that building long-term wealth can take time. Consider looking into other methods of wealth creation over time. They might take longer, but they often come with less risk and less emotional distress.

Risk management

Understand your risk tolerance. Pay attention to how much you can afford to lose, and try not to take big risks. A good rule is to keep each trade to 1% to 2% of your account balance. So, if you have $50,000 in your trading account, you would risk no more than $500 to $1,000 on each trade. As you see success and your account grows, you could potentially begin risking more on each trade and seeing bigger profits.

Select a proven strategy with objective rules for entry and exit

Create rules for entering and exiting trades. This is a good approach, no matter what trading strategy you use. Having set rules can help you reduce your emotional involvement. Plus, you can limit risks when you have rules for stopping losses and ensuring that you take profits.

Keep a trade journal of the trades you take

Make a note of each trade you execute, including dates, entry and exit points, and amount of profit or loss. This can help you identify patterns, learn from trading mistakes, and become a better trader.

 

Which trading platform is best for arbitrage trading and has a demo account?

One of the best things you can do is look for a platform that offers a demo account. That way, you can try arbitrage trading and get used to the way trades are executed. Here are some of the best brokers:

IG Index

IG Index is mainly focused on Forex and offers spreads that are up to 20% lower than some others. You can use this platform to practice two-currency and triangular arbitrage. IG Index is U.S.-friendly.

eToro 

This platform was founded in 2006 and offers access more to more than 1,000 assets, including cryptocurrencies. For U.S.-based traders, only crypto is available. You can use eToro to trade across many markets and take advantage of market inefficiencies.

AvaTrade

AvaTrade came into being in 2006 and is part of the AVA Group of companies. It is compatible with MetaTrader 4 and MetaTrader 5, as well as the MetaTrader mobile app. Another nice touch for arbitrage traders is the fact that AvaTrade is compatible with API Trading and RoboX, which are automated tools.

XTB

With access to over 2,100 global markets and more than 15 years of experience, XTB makes it possible to take arbitrage trading to the next level. In addition to indices and Forex, XTB offers access to CFDs on cryptocurrencies and stocks. The platform is fully customisable and features fast execution, as well as performance stats and a trader’s calculator, making it easy for you to track your progress. 

FP Markets

Create your own trading system and get access to real-time stats with FP Markets. You can also use risk management tools to further improve your ability to trade using an arbitrage strategy. You can access Forex and CFDs and take comfort in the fact that the company is regulated by ASIC.

NAGA Markets

One of the most recent companies on the list, NAGA was founded in 2015 and offers access to financial markets and cryptocurrencies. You can set up a digital wallet with NAGA, allowing you to trade fiat and digital assets with ease. For arbitrage traders interested in cryptocurrency, this can be a good fit.

Forex.com

One of the oldest companies on our list, Forex.com has been offering access to Forex markets since 2001. Arbitrage traders can access transparent pricing and use the information for more effective two currency and triangular arbitrage strategies.

 

What are the risks of arbitrage trading?

Before you begin using any investing or trading strategy, it’s important to understand the risks involved. This can help you mitigate them, as well as help you decide whether it’s the right approach for you.

Execution risk

One of the biggest risks you run into with arbitrage trading is execution risk. This is the lag that occurs between when you actually place your order and when it settles. With a lot of arbitrage trades, timing is very important. So if you cannot execute the trades fast enough, you might not get the profits.

Mismatch

In some cases, you might assume that the assets in question are identical, but they are not. If you accidentally run the risk of mismatching and not getting the price and the profits you are looking for.

Counterparty risk

Depending on the type of strategy you are following, you could be stuck with counterparty risk, which is when someone on the other side does not fulfill their obligation. This is more likely if you are using arbitrage trading when forward contracts are involved, or other longer-term attempts to make arbitrage work in your favor.

Liquidity risk

This is what happens when there is not enough volume to find another side for your trade. You might be stuck with an asset and no place to trade it. This can happen with little-known stocks, lesser-traded currencies, and other assets that aren’t as popular, such as some cryptocurrencies.

 

8 pro tips for successfully performing arbitrage trading

  • Understand the assets that are best for arbitrage trading — Consider the assets that you know best, and that you’re most interested in. Understand those assets so that you can make the most of your trading strategy.
  • Get the right trading platform — One of the most important things for successful arbitrage trading is to use a trading platform or program that can help you move quickly. Sometimes, you need to take advantage of seconds and the right platform can make a difference.
  • Have a strategy in place — Be prepared with a strategy that you can use. While you won’t know everything, a good strategy can help you reduce poor decisions related to emotion and place trades based on data.
  • Take profits — Be ready to take profits when they come. Don’t run profits, especially if you have reached the level specified in your plan and strategy.
  • Avoid emotional decisions — It can be tempting to go with your gut or let the latest news of the day or other items rule your trading. However, if you can reduce emotion, you’re more likely to succeed in the long run.
  • Start with a practice account — Learn the basics with a demo account. Practice ahead of time so you know how to use the platform, understand how to execute trades, and can move quickly as needed.
  • Limit your risk — Make sure you aren’t putting too much of your account at risk. Try to keep each trade to between 1% and 2% of your account balance.
  • Check multiple sources — To be effective as an arbitrage trader, you need access to different markets. Pay attention to different sources so you can identify inefficiencies.

 

Is arbitrage trading profitable? 

Arbitrage trading can be profitable, but it is important to understand the odds. According to Larry Pesavento, only about 10% of traders are successful. If you want to be successful, you need to practice consistency and stick with a strategy. Often, a lack of patience and discipline negatively impacts traders.

With arbitrage trading, there can be a steep learning curve, so if you want to come out on top, you need to be careful to avoid giving up too early.

 

Arbitrage trading: general terminology

  • Arbitrage trading — The act of buying one asset in a market and then selling it immediately in another market, usually for a higher price.
  • Pricing inefficiencies — These are times when the price of an asset isn’t in line with the market. These inefficiencies lead to different prices in different markets and can be exploited by arbitrage traders.

Conclusion

While arbitrage trading can be profitable, it also takes a lot of work. The idea behind arbitrage is to be able to quickly exploit small differences in prices across markets. As a result, you need to trade frequently and be able to trade in large quantities, sometimes using leverage. So, while the sophisticated trader can be successful, it can take a lot of work and it can come with some risks.

 

FAQs about arbitrage trading

Can you teach yourself how to use arbitrage trading?

Yes, but it can be difficult to find reliable resources. You need to practice with demo accounts and look for information that does not make outrageous claims about returns.

Do you need a lot of trading screens for arbitrage trading?

It depends on how many charts you are tracking. While it is possible to trade using your phone or only one monitor, this might not be ideal and might not give you access to the information you need. A general rule of thumb is to use one monitor for four charts. So if you want to be able to look at 16 charts, you need four screens.

Is arbitrage trading illegal?

No. Arbitrage trading is completely legal. In fact, it is considered as one of the things that helps improve market efficiency since it forces prices to fall in line.

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