Arbitrage not tradable?

Trading Discussion
1

Hi forum,

I am currentley trying to get my head around arbitrage trading, triangular arbitrage in particular.
For everyone who hasn’t heared of it here is a good explanation:

How do I use an arbitrage strategy in forex trading?

So I do understand the overall mechanics of this technique. You trade one curruncy for a second and the second for the third. The sum of the second exchange should then result in a profit, given proper rates.

The thing I don’t understand at this point is the following:
So if we had a EURUSD-course of 1.3239 you don’t actually have 100000 Euro that you exchange for 132390 dollars. Of course you exchange the units but you don’t have the money physically. What I actually get is the difference (profit or loss) into my account.

So regarding the arbitrage-technique: If I go and trade the three correlating pairs as shown in the example above I would have a zero-balance in my account (ignoring the spread for the time being). I would have three trades running, but not really exchange one currency for another?

Am I getting this right? I hope I explaned it halfway decent and didn’T confuse even more ^^
Am I missing something or did I confuse something?

Hoping for someone to to unravel this mystery.
Thank you

2

Hi Yodel,

I may not be understanding you clearly so correct me if I am not.

Take EUR/USD, You buy 100,000 EUR and sell 130,000 USD at rate 1.3000 (0 spread). Your account has 10,000 margin in USD. This is a long position.

What’s happening here is the Broker has arranged a loan of 130,000 USD from party A who wished to sell it. Now you have 130,000 USD Which you now sell and buy 100,000 EUR from party B who has loaned you through the broker now party B is on the short side.

Fast forward… Rate moves to 1.3500 you then now reverse the transaction. You ask party B to return your now 135,000 USD to you while you return his 100,000 EUR bearing in mind you gave 130,000 USD he must now pay you an extra 5,000 USD he will not do this via the 100,000 EUR instead it will be deducted from his margin assuming he had a 10,000 USD margin, he will now have to take 5,000 USD from his margin. You on the other hand would receive that deducted $5000 from party B into your account giving you 15,000 USD.

Not forgetting Party A who now needs his initially 130,000 USD back as well, this will now be returned to him and everyone is now content.

So what has happened? Party A (liquidity provider) granted initial loan based on your margin 130,000 USD.

You traded it with Party B who also received a loan from Party A (two faced bastard) on the other side of the market for 100,000 EUR based on his margin. Now the rate/price controlled by Party A and his buddies in the interbank market have moved the price against one of you and has charged both of you a cost/spread to make money.

You were right and Party B was wrong and party A does not care as he has not spent money in fact has gained from the spread and any position he himself has held. In the end all he had to do was wait. Let us for one second entertain the possibility that in fact no cash existed at all and this whole transaction was based on nothing and didn’t even take place, in fact all party A did was open 2 positions and close them, then change the digits in each persons account to match the trade. That’s it… And you just paid him for it too.

Okay! That’s out the way…

So now do you really think that by trading correlating pairs you are arbitrage trading? The most common arbitrage possible is from taken advantage of a swap rate. I have never tried this so not sure but one could perhaps buy AUD/USD for example with a large margined account and leave it with out stops or TP’s and then hedge the trade with a pair that is known to move in the opposite direction with a higher yielding swap rate, the hedge should take out the margin risk all the time the swap rate will be accumulating after a month or two you close out all trades and work away with the swap.

Brokers close you account instantly if this is discovered. Arbitrage is the business of major institutions not retail traders.

3

Wow…

Just wow.

That is one convoluted and, seriously misguided explanation.

4

YodelYum, to pursue arbitrage at a retail level is almost impossible, and trading it manually IS impossible.

You would need accounts at different brokers, and a very savvy piece of software. But the problem is, most retail brokers get their price feeds from the same sources, so the price differentials you need to make arbitrage work is nullified.

5

@emeraldorc
Thanks for the extensive explanation. Maybe I didn’t explane my question properly.
As I said, im still trying to fully get my head around all this arbitrage-thingy. But I wasn’t planning to get in to a hedge trade and hold it as long as eg 500 Points as you wrote.

As far as I understand this topic one would have to get in and out as fast as possible to actually avoid further movement of the market. The correlating trades sure have the pattern of a hedge, but they would (should) not be exposed to further market conditions.

The point where I tend to agree with you is that it this whole arbitrage-thing seems to be a kind of trading reserved for major institutions rather then single traders. Buy still I am curious because there seem to be traders out there that successfully use this strategy.
Anyways thanks for your information.

@Master Tang
Who are you reffering too?
Im sorry if I wrote some rubish in my post, as I said, I am still at it understanding the whole thing…

Edit
@Master Tang Thanks for your answer. I already thought it would go that way…

6

As Master Tang already answered to fully arbitrage something you need two banks…one that will sell you something cheap, and the other that will buy something from you more expensive than you paid for it at the first bank…

For example: Bank A: EUR/USD 1.2002/1.2004

Bank B: EUR/USD 1.1998/1.2000

So you would Buy 100 000 EUR from Bank B and then sell them to Bank A for 120 020 $ profiting in return 20$…of course if you would Buy 1 000 000 EUR from Bank B and sell it for 1 200 200 $ you would profit 200$…now this was possible before the Internet and where you would have some small discrepancies in prices for some short amount of time…

Today that is not possible as master Tang explained…everyone is linked…

By the way there is also a triangular arbitrage which involves buying/selling/buying into three currencies and making profit which is considered 0 risk…

7

Without getting into an argument as it appears some here prefer. I was just making sure he understood how the whole business of trading works.

The definition of arbitrage is simply exploiting a loop hole. Note I did also point out that it is the area of big banks and not retail traders and secondly I don’t actually trade in arbitrary way so I simply gave an example of what may be considered arbitrage.

So your remark is rather misguided itself and unecessary but never mind, it appears you have answered the OP’s question which is what we are here for. It’s amazing how people dwell on this egotistical idea of right or wrong…

It’s all relative…

8

Nope. Never wanted to start an argument.

But since you continue to think you have posted something describing arbitrage, I would like to point out that you did not explain “arbitrage”, you basically explained a “hedge”.

Swap rates, or carries are in no form part of a true arbitrage.

As for the first part of you post, I won’t even start with the issues it presents. Let alone why it was even posted as an explanation for arbitrage. No ego, and not dwelling on a thing. I have better things to do. The only problem I have is there are too many people reading this forum that really have no clue, and might get the wrong idea of how a broker actually works.

  1. A broker never “loans” you nor anyone else money to make a trade.
  2. Your order is almost never be matched perfectly by another trader. It is warehoused by your broker in the larger group with longs or shorts (whichever way you traded on the pair you traded). If the total of the longs against the total of the shorts gets out of balance, your broker opens a trade balancing it’s overall position (in the real market) holding that position until the in house order book comes back into balance again.
  3. “liquidity provider”? No.

It’s really pretty simple accounting. Just think of your broker as a bookie. They want bets on both sides to equal out and just pocket the vig. Your money comes from the losers, and your loss goes to the winners. Who it gets paid to doesn’t matter. It’s just part of the total of the difference.

9

I guess I have to agree or there will 10 pages before long. No worries mate your explanation is fine just incomplete. I can tell you read but since I spent sometime reading market microstructure. I understand the dealers inventory.

You are describing a dealer or market making broker that assumes risk… See Maureen O Hara on Market microstructure on the subject. Note she is the Pioneer of this subject in the US and her books are read by all economics students from Harvard to Cambridge.

There is another broker who does not assume risk which are referred to as ECN of NDD he passes the orders to a liquidity provider, UBS, Barclays, eye. Some even claim to pass orders into dark pool. This I don’t believe as this pool reserved for institutions.

Currency is zero sum there is no excess or the dealer looses, all orders must be matched exactly. So please expand on how this is not the case…

Also I used the term loan because we are in leveraged market. If you trade a 100k lot on margin, someone clearly loaned you temporarily to make the trade. No different from a mortgage or any other margin based trade. Again explain why you think loan is inappropriate…

Anyway as an economist and trader I am happy with my explanation and I did describe a hedge but one that aims to capitalize on a swap rate. Like I said it is an example that may not be 100% full proof but an example of what could be a FORM of arbitrage from a retail perspective.

The rest is not my concern. I won’t do it anyway.

In the words of LBC’ s James O Brian “What are your qualifications?”

10

Thanks for your answer!
Maybe I didn’t point it out clear enough. In my first post I was actually referring to triangular arbitrage. And my question was how to actually trade it.
I am aware that there is also the type of arbitrage between brokers (I know it as latency arbitrage) and I wasn’t planning to trade that. As everyone in this thread agrees, this type is almost impossible to trade by a retail trader.

My question was solely referring to triangular arbitrage and how to actually utilize it in real market conditions. Im sorry if I messed things up

11

Well for triangular arbitrage you could possibly do something along these lines:

SELL 1 lot EUR/USD

BUY 1 lot GBP/USD

BUY 1 lot EUR/GBP

What would you do here is sell euros for dollars, then buy pounds for those dollars, then buy back the euros selling pounds…I have never tried it because you need three brokers/banks and you need their rates to be misaligned by a small amount for that period of time…

Using this on your broker might work if it gets rates from different liquidity providers, and for that fraction of a second they are off…try it on live with micro/mini lots first

I gave you one example, you can mix whatever other currencies you want: NZD JPY, USD JPY, NZD USD (sell, buy, buy) …

EDIT: I would look for low spread currencies…

12

Because there is no loan, never has been, and never will be.

You never really buy anything, nor sell anything in RETAIL forex, it’s a pretend world ECN or NDD or not. Leverage is not a loan, it’s simply a fictional markup of your money’s worth. Of course it’s also why someone can blow a one thousand dollar account in a 10 pip move, but that’s another story.

13

My final analogy was exactly what you said. We keep repeating each other. Anyway, I prefer the term loan simply because it easier to describe the process but yes nothing ever leaves anything.

Anyway have a good weekend Master Tang. Simple confusion of terminology understanding of the OP’s question. All resolved… :slight_smile: Beer?