Forex Trading system- Arbitrage

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OVERVIEW

The somewhat esoteric trading strategy known as arbitrage is sometimes employed bycurrency day traders with a home computer. However, this arena of trading is normallyleft to the experts and financial managers with highly specialized software and privatestreaming data sources. Nonetheless, this discussion is included because arbitrage trad-ing almost always guarantees a profit if the market entry and exiting trades are exe-cuted with utmost precision, and knowledge of the arbitrage mechanisms can benefitthe small-cap day trader.

In general, arbitrage is the purchase or sale of any financial instrument and simultane-ous taking of an equal and opposite position in a related market, in order to take advantageof small price differentials between markets. Essentially, arbitrage opportunities arisewhen currency prices go out of sync with each other. There are numerous forms of arbi-trage involving multiple markets, future deliveries, options, and other complex derivatives.A less sophisticated example of a two-currency, two-location arbitrage transaction follows.

Bank ABC offers 170 Japanese yen for one U.S. dollar, and Bank XYZ offers only 150yen for one dollar. Go to Bank ABC and purchase 170 yen. Next go to Bank XYZ and sellthe 170 yen for $1.13. In a little more than the time it took to cross the street that separatesthe two banks, you earned a 13 percent return on your original investment. If the anomalybetween the two banks’ exchange rates persists, repeat the transactions. After exchang-ing currencies at both banks six times, you will have more than doubled your investment

TRANSITIVITY

Within the forex market, triangular arbitrageis a specific trading strategy that in-volves three currencies, their correlation, and any discrepancy in their parity rates.

Thus, there are no arbitrage opportunities when dealing with just two currencies in asingle market. Their fluctuations are simply the trading range of their mutual ex-change rate. This fluctuating property of any three corresponding currency pairs is referred to as transitivityand is the necessary ingredient in all profitable arbitrage trades.

The actual trading mechanism requires executing three market entry trades simul-
taneously the exact moment that the exchange rate anomaly appears, then liquidating
all three trades simultaneously as soon as the previous exchange rate parity has been
reestablished.

EQUILIBRIUM

The upper three charts in Figure 5.1 are simply line charts of the three underlying cur-rency pairs, while the bottom chart illustrates any arbitrage opportunities present. Theformula to calculate the data in the bottom chart is based on the theoretical identityknown as the equilibrium formula, shown in Figure 5.2, which means the value of across rate should equal the ratio of the two corresponding USD pairs. In turn, that canbe used to plot the corresponding arbitrage oscillator. (See Figure 5.3.)

To determine if an arbitrage opportunity does exist and is in fact profitable, we mustfirst consider the transaction cost. We will assume that most reputable currency dealerswill charge three pips for the transaction cost of the major currency pairs and four pipsfor the transaction cost of a major cross rate. Therefore, the cost to execute one round-turn arbitrage trade in the EUR-GBP-USD triangle is 10 pips.

If we had executed such a trade at 1:45 A.M. when the arbitrage oscillator hit 18 pips
and liquidated as soon as the arbitrage oscillator returned to zero or less, we would
have earned an 8-pip profit with minimal risk.

The chart in Figure 5.1 illustrates an instance of where only one major anomaly oc-
curred within a 24-hour time frame. Figure 5.4, whose time range is one week later
(Tuesday, January 21, 2003, 12:00 A.M.to 11:59 P.M.), illustrates numerous arbitrage op-
portunities.

There are more than a dozen instances within a 24-hour time frame where the arbi-
trage oscillator exceeds the transaction cost requirement. Notice that the cross rate
chart (EURGBP, third from top) begins relatively smoothly but after 2:30 P.M., it becomes
very spiky (i.e., less smooth). It is during these periods that numerous arbitrage opportu-
nities may present themselves in a single triangle. Also interesting to note is the fact that
all of the anomalies after 2:30 P.M. occurred on the same side of the zero mean line.
Figure 5.5 is an example of the CHF-JPY-USD triangle for Thursday January 9, 2003,12:00 A.M.to 11:59 P.M., where there are at least six arbitrage opportunities with the 24-
hour time frame using one-minute closing quotes.

We selected this specific triangle because the equilibrium formula differs slightlyfrom the previous triangle: EURGBP = EURUSD/GBPUSD. This formula is applicableonly when the USD is the quote currency in both the USD currency pairs. However, inthe CHF-JPY-USD triangle, the USD is the base currency in the two USD currency pairs.This difference determines which pair is in the numerator and which is in the denomi-nator. The equilibrium formula for the CHF-JPY-USD triangle is shown in Figure 5.6.

In the preceding examples, we noticed that when anomalies do occur, the arbitrageoscillator normally returns to or near the zero mean shortly thereafter. In the next chart(Figure 5.7), we see a not-too-common phenomenon where a 14-pip anomaly occursonly to be immediately followed by a 19-pip anomaly in the opposite direction. Techni-cally, both anomalies could have been trapped with a single arbitrage trade, whichwould have netted the trader a 33-pip profit before transaction costs.

MAJOR CURRENCIES

In any currency pair, the currency listed on the left is called the base currency and thecurrency on the right is the quote currency. Central banks and currency dealers havemore or less arbitrarily established a relationship condition that determines thebase/quote positions for each pair. It is this relationship that dictates what the mathe-matical formula will be on the right side of the equation. (See Table 5.1.) Note the im-portance of the arithmetic operators / and x.

OBSERVATION

As mentioned earlier, we included this chapter in the belief that, in currency trading,any information on the inner working of the market can be illuminating or at least help-ful. However, the small-cap day trader should be aware that even though arbitrage op-portunities are always present, they are unfortunately very short-lived and correctthemselves in less than a minute or so. Automated trading software is the only realisticmethod of trapping risk-free arbitrage profits.