Arbitrage Trading in the Forex Market
Introduction
In this article, I will describe the historical stages and challenges that forex market arbitrage trading has gone through. I’ll explain why this type of trading serves as a source of income for some traders and is unsuitable for others. Additionally, I will provide practical recommendations for novice traders.
A Bit of History
In 1971, the Bretton Woods system was abolished by US President Richard Nixon, replaced by the Jamaican currency system, based on free currency trade — free currency conversion. This marked the beginning of the forex market. In its early years, the Forex market had a distinctly two-tiered structure:
On one level, market-maker banks conducted currency exchange transactions among themselves, and on the second level, the bank dealt with a large client. Over time, the structure expanded, and new participants emerged due to a lowered entry threshold. Entry into the global currency market became cheaper due to technological development. The share of small private or so-called retail traders makes up about 6%.
How a Brokerage Firm is Structured for Traders with Small Initial Capitals
The development of technologies for the forex market, which led to cheaper access to the global currency market, on the one hand, opened the door for retail traders to speculative currency trading. On the other hand, it allowed brokerage firms to intervene in the trading process. The first brokerage companies for retail trading did not have the technical ability to bring traders’ transactions to the real forex market. The broker acted as a counterparty, meaning when a trader bought currency, they bought it from the broker, and when they sold it, they sold it to the broker. Due to limited capital and a low level of knowledge, most traders lost their money, and the broker earned not only from trading commissions but also from traders’ losses. Also, technology developers provided the broker with additional tools, such as manual dealing, allowing them to manipulate or intervene in trading. For instance, brokers could “throw in off-market quotes” or widen the spread, thus triggering traders’ stop losses.
Later, with the increase in the number of clients in brokerage firms and the emergence of forex robots, the same technology developers “invented” a virtual dealer — which increased order execution time and, thereby, slippage.
The emergence of successful forex robots, such as latency arbitrage, scalping robots, and news trading programs, led to the appearance of liquidity bridges. The bridge allowed forex brokers to create hybrid A + B book working schemes and divide traders into successful and unsuccessful groups. The unsuccessful ones remained in the B book, while the successful ones were moved to the A book. Thus, the broker shifted its risk to the liquidity provider, who can also have A and B books.
Is Arbitrage Trading Legal in the Forex Market?
Arbitrage trading is legal as it helps level prices in the market and prompts brokers to switch to the A-book scheme. However, on each broker’s website, you can read their Terms, indicating whether the broker allows arbitrage trading. And if not, the broker may not pay your profits in case of significant gains. If a broker does not allow arbitrage trading, a B-book broker probably doesn’t want to bother dealing.
If allowed, it doesn’t mean much for you as a trader. I won’t go into details — think for yourself, and we can discuss.
What Types of Arbitrage Trading Can be Identified as Main?
Latency Arbitrage
This type of arbitrage is based on differences in data transmission speeds between different servers or liquidity sources. Traders using latency arbitrage look for slow servers (or servers that delay price updates) and use a fast connection or quick access to another broker or price source to take advantage of temporary price discrepancies. This type of arbitrage is the most popular as it allows for maximum profit with virtually zero risk. However, the trader faces the broker hindering such trading for reasons you can guess based on the above. However, there are ways to disguise latency arbitrage, allowing the trader to use this strategy for a long time without changing the broker, which I will discuss later. That is, the main task of a trader using latency arbitrage in the forex market is disguise.
Triangular Arbitrage
This method is based on the fact that there are moments when the rates of three currency pairs do not correspond to each other. For example, if there is a certain discrepancy between the synthetic quote obtained from the quotes of EUR/USD, EUR/GBP, and the real quote of USD/GBP, then by sequentially buying and selling these pairs, you can achieve risk-free profit. This process is usually automated due to the short duration of such discrepancies. In current trading realities, triangular arbitrage doesn’t work on a single account as forex brokers use filters preventing differences between the quote and its synthetic expression. For this reason, traders use two or three accounts, but the discrepancy in this case also arises due to speed differences, as in latency arbitrage. The main task of a forex trader using triangular arbitrage is to select brokers with different liquidity providers and low slippage.
Swap Arbitrage
A swap in Forex is the difference between the interest rates of two currencies that make up a currency pair. Swap arbitrage involves exploiting differences in swap rates among brokers or differences in swap rates for the same currency pairing with one broker. Traders can profit from these rates’ differences, especially if they use leverage. The main task of a forex trader using swap arbitrage is to analyze many brokerage firms for swap rates across various instruments.
Statistical Arbitrage
Statistical arbitrage in the context of forex is based on statistical models and quantitative analysis methods to identify and exploit temporary discrepancies between currencies or currency pairs. This might involve analyzing historical price data to determine likely corrections in the future.
The most common application of statistical arbitrage in forex is the “pair trading” strategy. This is when a trader looks for two interrelated currencies or currency pairs that temporarily “diverge” from their historical correlation. The trader will sell the overvalued currency (or currency pair) and buy the undervalued currency, expecting their prices to revert to historical correlation.
Such a form of arbitrage requires deep knowledge of statistics, quantitative analysis, and swift trade execution, as the discrepancies might be short-lived.
Latency Arbitrage Masking
Masking of latent arbitrage can be divided into several categories and methods. For instance, the SharpTreader Arbitrage program uses the following techniques:
· Use of Trailing Stop: This increases the duration of a trade and the subsequent profits.
· Use of a Locking Account: SharpTreader Arbitrage employs various locks in its embedded strategies. Here’s the most common method: the same instrument initiates a buy on one account and a sell on another. When an arbitrage situation arises on the buy side, the program closes the sell deal, and vice versa.
· Use of Virtual Order Trailing with Locking: This implies a trailing stop for a virtual order during the lock-in period.
· Use of Filters: This allows the order to be closed only after a certain period has passed or after the price has changed by a certain number of points.
· Setting Pauses between Arbitrage Trades: This means there’s a deliberate waiting period between successive trades.
Pic. 2 — Analyses of arbitrage order (SharpTrader Arbitrage Platform)- It’s crucial to analyze each order to understand the slippage during the opening and closing of the order — this will help determine if the broker is using plugins on your account. The maximum possible profit will assist you in setting trailing stop levels.
Additionally, supplementary methods may be used, specifically creating a non-toxic flow by employing manual trading or trading robots on the same accounts where latent arbitrage is applied.
The most well-known software providers for arbitrage trading in the forex market are BJF Trading Group Inc. and Westernpips
These companies and their respective software solutions allow traders to exploit price discrepancies between different markets or similar instruments in a single market while offering features to mask these arbitrage activities to avoid detection by brokers or regulatory authorities.
How to Choose Arbitrage Trading Software
Choosing software for arbitrage trading on Forex or other financial markets requires careful analysis and understanding of your requirements and risks. Here are a few tips to help you select the right software:
· Type of Arbitrage. Determine which type of arbitrage you plan to use (e.g., triangular arbitrage, statistical arbitrage, latency arbitrage, etc.). Different software may be optimized for different strategies.
· Platform Compatibility. Ensure the software is compatible with your trading platforms or brokers.
· Execution Speed. For some forms of arbitrage, especially latency arbitrage, execution speed is critical. Research how quickly the software can execute trades.
· Reliability. Read reviews from other users and check how reliable the software is under real trading conditions.
· Support. Look for software that offers strong customer support, quick responses to your queries, and assistance when issues arise.
· Updates. Financial markets constantly evolve, and software should be updated to remain relevant.
· Cost. Consider not just the initial cost of the software but also any ongoing fees for updates or support.
· Demo Version. Many software providers offer demo versions that allow you to test their features before purchasing. This ensures that the software fits your needs and functions smoothly.
Test a demo version of the software before purchasing. This allows you to evaluate its functionality and ensure it meets your requirements.
Choosing arbitrage trading software is a critical decision that can significantly impact your success. Research user reviews on sites that provide relatively honest software reviews, such as https://www.forexpeacearmy.com, https://myfxbook.com, and https://bestarbitragesoftware.com. Assess not only reviews about the software but also about the software developer.
Carefully explore all available options and choose a program that fits your needs and budget.
Mistakes early in the journey of a forex arbitrage trader
Many traders believe that arbitrage trading software is a money-making machine, not just any money but 100% profit daily. I’ve had clients convinced they could earn 1000% daily consistently.
The question of how much one can earn in a month by arbitrage trading depends on various factors, and there isn’t a specific amount that can be considered standard. Here are some of the factors that influence potential income:
· Starting Capital. The larger the capital you start with, the more potential income increases risks.
· Arbitrage Strategy. Some strategies may yield higher returns compared to others but might be riskier.
· Market Conditions. At different times, arbitrage opportunities may arise more or less frequently.
It’s essential for traders to have realistic expectations and understand the market’s complexities to succeed in arbitrage trading. Not understanding these complexities and diving head-first can lead to substantial losses.
· Technical Infrastructure. The quality and speed of your trading platform and internet connection can influence your ability to respond rapidly to arbitrage opportunities. For this reason, you should always heed the recommendations of the arbitrage software developer and not try to cut costs on the server where your program will run. The most popular VPS for arbitrage trading are ultrafxvps.com and beeksfx.com.
· Experience and Skills. As with any other form of trading, a trader’s experience and skill play a key role. Experienced traders can identify and capitalize on arbitrage opportunities more quickly and efficiently.
But the most crucial factor is broker restrictions: many brokers may limit or prohibit certain types of arbitrage trading and employ virtual dealers or other plugins to disrupt your strategy.
For this reason, you should adhere to the following rules to become a successful arbitrage trader:
-Listen to and follow the recommendations of software developers.
-Thoroughly explore all the features of the software and use them.
-Look for new brokers for arbitrage trading.
If you think forex arbitrage is a steady income without a significant investment of time and effort, then this method is not for you. I wouldn’t advise trading on the forex market at all. I would also not recommend trading on the forex market for entertainment.
Forex trading involves significant risks, and it’s vital to approach it with a professional mindset and adequate preparation.
Terms in this article
Spread — The difference between the best asks (selling) prices and bid (buying) prices at a given moment.
Stop-loss — This type of order on the forex market is used to limit losses.
Leverage — Often called “leverage”, in the context of forex and other financial markets, it denotes the ability to control a position significantly larger than a trader’s invested funds. Leverage is typically expressed as a ratio. For example, 1:100 leverage means a trader can control a position 100 times larger than the funds in their account. If a trader has $1,000, they can control a position worth up to $100,000. Leverage allows traders to amplify potential profits from small price movements in the market. However, it’s crucial to understand that leverage also magnifies risks: potential losses can be increased similarly. If the market moves against a trader’s position, losses can quickly exceed their initial investment, leading to a margin call or the closure of positions.
Forex Bridge — The bridge or liquidity bridge is crucial for brokers, allowing their clients to trade directly via a Prime Broker at interbank rates.
Examples of forex bridges:
· PrimeXM
· OneZero
· FXCubic
These terms and concepts are foundational in forex trading and crucial for traders to understand and utilize effectively.
Liquidity Provider (LP) — Liquidity providers connect brokers to leading banks, hedge funds, and other significant market participants. As a result, a broker’s order book gets multiple buy and sell orders for various trading pairs.
Examples of liquidity providers:
· Finalto
· Swissquote Bank
· Saxo Bank
· Invast Global
· CMC Markets Connect
A-Book — This is a broker’s operating scheme where all client trades are directly passed on to the interbank market. This scheme is often referred to as straight-through processing (STP). In this model, the broker earns commissions for each trade or a markup on the spread. The A-book model eliminates the conflict of interest since the broker earns regardless of whether traders profit or lose.
B-Book — This is a scheme where the broker acts as the liquidity provider for your trade, meaning your trade doesn’t reach the interbank market. It’s colloquially called a “kitchen” model in some languages. In this case, the broker’s profit is the client’s loss and vice versa. If the client earns, the broker incurs losses.
Locking in a Trade (or just “locking”) — This means simultaneously opening opposing positions on the same instrument in the Forex market. For example, simultaneously buying and selling the same currency pair.
Toxic Flow & Non-toxic Flow — These terms pertain to the types of trading flows or orders from traders and their potential impact on liquidators or liquidity providers.
Toxic Flow: It’s when orders from traders are considered harmful to liquidity providers because they might anticipate the market’s direction. For instance, if a trader is consistently making profits, it might be at the expense of the liquidity provider.
Non-toxic Flow: Conversely, it represents order flows from traders that don’t necessarily harm or take advantage of the liquidity providers. These trades are more random and don’t consistently exploit market trends.
Understanding these concepts is essential for anyone involved in Forex trading, as they influence trading strategies, broker relationships, and the overall market dynamics.
Conclusion:
I hope this article will help you take the first steps in arbitrage trading, understand the structure of the forex market from a trader’s perspective, and get closer to your financial goals. I will gladly answer all your questions and look forward to any comments.
Boris Fesenko
CEO, BJF Trading Group Inc., ON, Canada
