Experienced Forex traders have probably noticed that there is occasionally a slight discrepancy between the quotes for a given financial instrument as displayed by different brokers. Aside from possible manipulation by brokers, this happens as a result of temporary delays in the quotes feed, the smoothening of quotes, etc. The point of an arbitrage trade is to take advantage of these discrepancies. The trader places a buy order with a broker that has a lower price and simultaneously places a sell order for the same security with a broker that shows a higher price. The trade is executed when the profit that can be made from the existing difference in quotes is greater than the expenses incurred in the trade (i.e. the spread and commission that are paid to both brokers). This operation is known as classic (two-leg) arbitrage. The main advantage of classic arbitrage is the absence of risk and drawdowns. If the quotes of one dealer always lag the quotes of another dealer, it makes more sense to apply one-leg arbitrage, where trades are placed only with the lagging broker. The advantage that one-leg arbitrage has over classic arbitrage consists of a greater profit potential; the downside is that this strategy entails drawdowns.
If we study the reasons behind trading situations that make Forex arbitrage possible, we will see that in the majority of cases they are caused by a lag in market quotes of one broker relative to a more timely quotes feed of another broker. The delays happen for a number of reasons: the amount of time it takes for a quote to be transmitted from a liquidity provider through a broker’s server to your trading terminal can be greater for some brokers; as quotes pass through brokers, they may undergo such changes as filtering, smoothening, etc. As a result, when a security goes through significant price movements, the security quote that you see on your trading terminal lags behind the actual market quote as provided by liquidity providers. If the gap between the two quotes is wide enough to cover trading costs, you can place an order through the lagging broker, aiming to capture the difference between the lagging quote and the real quote of the broker with a faster quotation. In that case, you will have a statistical advantage over other traders. If the advantage is properly used, it is possible to achieve a stable growth of profitability.
It should be noted that, with one-leg arbitrage, it is completely unnecessary to hedge your open position with the second (faster) broker as you would when using the classic arbitrage strategy. There are two reasons for this: the profit will accrue to your lagging broker anyway, and hedging will result in higher trading fees in the form of spread and commission that you will have to pay to the second broker. This type of hedge-free arbitrage is referred to as one-leg arbitrage.
It should be apparent that successful application of Forex arbitrage requires access to a source that will provide quotes that do not lag. You can use a broker with a speedier quotes feed. A more reliable alternative involves the use of market quotes provided by a large bank or broker, e.g. LMAX or Saxobank.
The number of opportunities for arbitrage trading may vary widely from broker to broker, from dozens a day to only a couple per month. It depends on the degree to which a given broker’s quotes lag behind real market quotations.
We can conclude by busting a popular myth that one often sees expressed on the Internet. According to a firmly entrenched opinion of some, there is no point in engaging in arbitrage trading, because brokers will not pass on your arbitrage profits to you. They are able to do so because arbitrage advisors available on the market execute ultra-fast trades that are bound to alert brokers to arbitrage activity. Moreover, almost all brokers today require a minimum wait time between the buy and the sale of a position, usually not less than 1-3 minutes. The stipulation falls under brokers’ terms, and brokers have the right to cancel all trades that do not satisfy their terms of trading. However, arbitrage trades do not have to be executed instantly. If you increase the holding time of your position, you should not experience any hassles with your broker. Based on our own experience, if you wait at least 10 minutes before exiting your position, you will have no problems closing it.
Let me explain why arbitrage trading can still be profitable even when there is a wait time between the buy and sale of a position. You always have a small advantage when the quote is delayed and you place an arbitrage order. It is impossible to say where the price will head next after the quotes differential disappears, but if the volume of your trades is large enough, then half of your trades, irrespective of the subsequent price movement, will be profitable, while you will lose money on the other half. That way, when your trading volume is sizeable, the gains and losses incurred during subsequent price movements following the disappearance of the differential will offset each other, leaving you with a small advantage. When this advantage is cumulative, you will secure a stable growth in profitability. Essentially, the increase in the holding period between the entry and exit of your position will lead to an increase in the dispersion on your profitability chart (which will be reflected in the increase of the account drawdown, something that should be taken into consideration when choosing the size of the lot), while the average profitability of your trades will remain unchanged. Keep in mind, however, that this only holds true when you place a large number of trades, as you have the law of large numbers working for you.
The upshot is that Forex arbitrage strategies remain a useful and highly profitable way of investing your money.