Traders are always looking for new methods to capitalize on the inefficiencies of the markets and Forex arbitrage, in theory, is one method that some traders attempt to take advantage of.
The Forex market is not centralized which means there is no central exchange, like the CBOT, where transactions take place. Because there is no central market, there is no set price for a specific currency pair. This allows brokers to set their own price for each currency.
This picture shows the difference between two brokers for the EURUSD at the exact same time.
As you can see, the sell and buy prices are different and it is these types of differences that allows you to profit on the pip difference between the two brokers. Depending on the difference, you would sell at one broker and at the same time, buy at the other broker.
The few pips of difference would be the profit potential before transaction fees.
Forex Arbitrage: Profiting from the inefficiencies that are available for a short time in currency prices between brokers.
Using that definition, we can see the major drawbacks of this type of trading strategy:
- You must have top of the line platforms to be able to enter the trades at the exact same time
- The differences are short lived so you may actually put yourself in the negative if the transaction is not done flawlessly.
- You must have multiple trading accounts
Trading Size Does Matter
With Forex arbitrage, you are looking to capitalize on the difference of a handful of pips. Having an account size of a few thousand dollars does not really afford you the chance to make any decent profits with this type of strategy.
Even using the leverage afforded by brokers in the U.S. (currently maxed at 50:1), a small trading account would not be suited for this type of trading method.
Is Forex Arbitrage dead?
Arbitrage depends on the inefficiency of price between brokers/currency pairs. What if there was a way to make pricing more efficient?
The Federal Reserve Bank of New York released a research paper citing that algorithmic and high frequency trading may cause efficiency in the spot Forex market. This would have devastating effects on a trader’s ability to use arbitrage as a Forex strategy.
In the early 2000’s, the difference in pricing was occurring roughly 1 in 20 seconds in the popular currency pairs EURUSD and USDJPY. During those times, it would appear that being able to take advantage of the difference in pricing would have been quite easy.
Since 2008 however, the discrepancy was almost zero. (http://libertystreeteconomics.newyorkfed.org).
Missed Opportunity?
While some traders may be saddened by the increase in efficiency in the Forex market, for the majority of retail traders, Forex arbitrage was never really a viable opportunity. Even with the availability of software that pinpoints the inefficiencies that still do occur you need a healthy account balance or need heavy leverage which no longer available in US/CAN brokerages to make decent profits.
There are still plenty of ways to profit from the Forex market. Methods such as support/resistance, pullbacks, and reversals have stood the test of time and don’t rely on mispricing like Forex arbitrage does.