Arbitrage trading: a complete guide

Arbitrage involves profiting from the price difference between identical or related financial instruments​​, though this usually doesn’t involve large percentage profits. The bigger the mispricing of market inefficiency, the bigger the profit, and the quicker traders will jump in to exploit it. This will reduce the profit potential and bring the asset back into alignment with other market prices or information.

An arbitrage opportunity often becomes apparent through comparing assets. If two currency pairs​​ often move in the same fashion, but then start to diverge, this may present arbitrage in forex trading, under the assumption the two pairs will eventually start moving together again. If two very similar assets are priced differently without justification, this may also present an arbitrage opportunity.

This means that large inefficiencies or mispricing won’t last long, but small inefficiencies may last a long time, since there is less incentive to capitalise on them.

Arbitrage pricing theory assumes that asset returns can be predicted based on its expected return, as well as accounting for macroeconomic factors that affect the price of the asset. In trading, if this is true, an inefficiency can be identified and a trader could potentially profit from the difference between the “incorrect” price and the theoretical fair price.

Often, arbitrage is referred to as a “risk-free profit”, although, in reality, very few trades carry no risk. Therefore, an arbitrage method may provide a trading edge​ for winning, but if the arbitrage is based on assumptions and those assumptions are wrong, the trade could result in a loss. Arbitrage pricing theory is built on assumptions, which include the expected return of the asset, that interest rates won’t change, and that we can identify all variables that affect the price of the asset. This isn’t feasible with a high degree of accuracy, but it may still alert a trader of a potential opportunity.

Arbitrage pricing theory attempts to isolate where there is a potential profit, also assuming that the price will revert to its historical tendencies. Things that are mispriced tend to revert to more realistic pricing over time. Therefore, whether the theory is used or not, the concept is important for capitalising on these types of trading opportunities.

Arbitrage works by taking advantage of the financial markets​​ and the fundamental factors that drive a security’s price, such as supply and demand. This is done in multiple ways. There is statistical arbitrage, which equates to mean reversion​​, as well as triangular arbitrage for currency markets. Some more narrow strategies for arbitrage trading include risk arbitrage, fixed-income arbitrage and covered interest arbitrage, all of which will be discussed below. Arbitrage strategies are similar to high-frequency trading strategies​​, which are often used by institutional investors.

In all cases, a trader uses evidence and research to uncover a profit potential due to the mispricing of one or multiple assets.

Statistical arbitrage is the process of analysing statistics of how assets typically perform and then noting deviations. A high positive correlation between assets is a statistic that is commonly used, which is often found in another short-term trading strategy, pairs trading​​.

Using the share market​ as an example, if Ford and General Motors prices typically move together, but then suddenly move away from each other, this may be a temporarily exploitable opportunity. If they typically move together, there is reason to believe they will again in the future. This is based on a mean reversion model.

Using statistical arbitrage, a trader could short the stock​​ moving up and buy the one moving down. They should be moving in opposite directions, otherwise they are still correlated. In this way, the trader is not betting on the overall direction of both stocks, but rather the profits if the prices do converge again.

Popular commodity products West Texas Crude and Brent Crude typically move together also. They are priced differently, so if the typical spread between them narrows or expands, this may present a statistical arbitrage opportunity. This is demonstrated in the chart below.

Triangular arbitrage is often used for the forex market​​, when there is a pricing discrepancy between three related currency exchange rates. Triangular arbitrage involves three transactions: exchanging the initial for the first currency, exchange the first currency for a second, then converting the second back to the initial. If these transactions create a profit opportunity, there is arbitrage.

The profit potential is usually small, although, in moments of high volatility or currencies that are not traded as often, the potential for profit may be greater.

For example, if the bid in the EUR/USD is 1.0847 and the GBP/USD bid is 1.4808, this would imply a EUR/GBP bid rate of 0.7325. If the price is different, especially by more than a couple of pips, then there is opportunity for profit.

Retail arbitrage happens more outside of the financial markets. Being able to buy a widget at Walmart for $5, then sell it on Amazon or eBay for $6 is retail arbitrage, exploiting a mismatch in different markets.

Let’s put arbitrage into a real world context. Imagine that all houses on one street offer the same features and are priced roughly the same, but one house is being sold for far less. The house won’t last long, as maybe a homeowner will buy it, removing the mispriced asset. However, someone may buy the property at the lower price in order to re-sell at the same price of the other houses on the market in an attempt to net a profit. This is known as retail arbitrage, and it can be done in many ways and in various markets.

An arbitrage calculator, or arb calculator for short, calculates what the theoretical price of an asset should be based on other inputs and how much you should stake on a trade to guarantee profit.

For example, a triangular arbitrage calculator requires the prices from two currency pairs to calculate the fair price of the third. If the real market price is different, the trader can decide if this is a tradable arbitrage opportunity.

While an arbitrage calculator likely has some sophisticated programming behind it, traders are cautioned to understand the math behind the calculation. For example, if the calculator is rounding, this could eliminate or increase the amount of arbitrage. Therefore, consider double-checking the math before relying on third-party calculations.

Using our online trading platform​​, Next Generation, you can make use of simple arbitrage strategies, such as pairs trading, asset correlations for hedging and forward contracts, which are available across multiple markets and instruments. A particularly popular form of arbitrage trading is scalping​​, which is commonly practised on our platforms by both retail and institutional traders. Learn more about the best tips and strategies for forex scalping​​.

Arbitrage trading is often said to be a risk-free profit, yet that is rarely true. Most types of arbitrage create some sort of risk, even if that risk is self-inflicted. For example, a trader will typically want to simultaneously lock in all arbitrage trades. If orders are staggered, prices can change and the arbitrage may be lost.

For example, in a triangular arbitrage trade, prices are constantly moving 24-hours per day, in line with forex market hours​​. If an opportunity for arbitrage is found, all orders should be executed at the same time. Failure to do so means that each price is changing before the next order goes out, and any calculations in regards to the arbitrage may no longer apply.

Other risks include using poor, illogical, or insufficient data. This could apply to a statistical arbitrage trade. Two currency pairs may recently appear correlated, but then diverge. Therefore, the tradability depends on how long the correlation lasted and how likely those assets are to be correlated again in the future.

In general, transaction costs, spreads, and commissions are always a risk when spread betting or trading CFDs. Read more about our trading costs​​ that should be taken into consideration before opening or placing a trade.