Forex Arbitrage Definition & Trading Example

What is Forex Arbitrage?

Forex arbitrage is a trading strategy where a speculator attempts to make a profit by exploiting the inefficiency in currency pairs.  This inefficiency is always self correcting, so the window of opportunity for profiting from the spread is very limited.

How to Calculate the Arbitrage

In order to calculate the arbitrage traders use forex arbitrage calculators.  There are a number of free forex calculators available for download on the internet.  Prior to initiating trades, speculators should use free demo accounts to see if trading the arbitrage can be a profitable venture.  A trader would need accounts with forex brokers in multiple locations around the world.  Most arbitrage techniques require trading in two to three currency pairs. 

Below is an excerpt from http://www.nobletrading.com.

The basic formula for the relationship of three related currency pairs, having 3 different currencies, is as follows.

AAA/BBB x CCC/AAA = CCC/BBB

Chance of triangular arbitrage occurs whenever this equation goes wrong. A triangle arbitrator buys BBB spending AAA, then buys CCC spending BBB and lastly returns to AAA selling CCC, capturing a small profit. The chance of profit is maximized by utilizing margin from brokers and trading with higher amounts.

For example take exchange rates EUR/USD = 0.6522, EUR/GBP = 1.3127 and USD/GBP = 2.0129. With $500,000 one can buy 326100 Euros, using that he can buy 248419.29 Pounds. He can now sell the pounds for $500043.19. Thus he can earn a profit of $43.19.

Can You Make A Living Trading Forex Arbitrage

As you can see from reading this article making profits from arbitrage is a complicated and sophisticated trading approach.  Making money from forex arbitrage requires a lot of patience and complex computer programs.  Also, these windows of opportunities are very limited as other traders are looking at the same information.  So, in order to make a decent cash flow from forex arbitrage would require the use of an enormous amount of margin.  The best option for traders is to use forex arbitrage as a small part of their trading strategy, and not the main source of income.

Tim Ord
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