Why Arbitrage is a Sustainable Trading Strategy in the Forex Market

When it comes to Forex trading, most people think that it revolves around the attempt to profit through anticipation of the future direction of a market. But have you ever wondered if there is a way to profit from the forex market without predicting the future direction of a currency pair? You might be interested in finding out that there are numerous market strategies available, and perhaps the least risky out of all is forex arbitrage.

When something unknown and unpredictable surfaces, the world's financial markets are the first to react. The worse the news, the worse the markets' reaction. This is true, especially in the current situation we are in right now. The pandemic has brought about economic uncertainty and has pushed some markets to one of their lowest turns.

The current situation has affected the economies of countries around the globe. The initial impact hit China and Australia. China understandably took the very first hit on the forex market as news of the virus outbreak went worldwide. As a result, the Australian dollar has begun to be impacted too, as China is their largest trading partner.

The same goes for the European and American markets. The pandemic's impact has dramatically affected the forex markets, making it hard for traders and investors to find it sustainable due to its volatility. Luckily, traders can employ a strategy that can help weather the volatility of the current economic climate.

Sustainable forex trading through arbitrage

Forex arbitrage can be defined as the simultaneous buying and selling of the same currency in different exchanges taking advantage of price discrepancies. In theory, the practice of forex arbitrage usually involves both.

"With the constantly changing supply and demand, the spot and forward currency markets are not always in a state of equilibrium. When the markets are imbalanced, the potential for risk-free" or arbitrage profit exists," according to a study by Ching Hseu Liu. The more volatile the market, the higher the possibility of finding arbitrage opportunities across the forex market.

Taking advantage of market inefficiencies

When it comes to economic theory, trading on financial markets is bound by the Efficient Markets Hypothesis.

It suggests that markets will process all available information about asset values and prices efficiently and quickly in such a way that there will be little if any room for price discrepancies across markets, and that prices will move soon toward equilibrium levels.

While this theory indeed works, traders have found that markets have not shown themselves to be 100% efficient at all times due to asymmetric information between buyers and sellers.

One such occasion of market inefficiency is when one exchange's ask price is lower than another exchange's bid price, also known as a "negative spread." For instance, this may happen when one exchange quotes a particular amount for a currency, while another exchange is referencing a different price.

“When a situation like this arises, forex traders can make a quick profit by simultaneously executing a purchase from the first exchange and a sale to the other exchange. In essence, the trader begins the trade in a situation of profit, rather than having to wait for a favorable evolution of market trends,” says Tony Jackson, Chief Executive Officer of Jubilee Ace, an arbitrage trading platform.

These situations tend to occur more often in periods of market volatility. They can also arise because of price quote errors, failure to update old quotes (stale quotes) in the trading system or situations where institutional market participants are seeking to cover their clients' outstanding positions.

"Arbitrage benefits the most when there is high volatility. The volatility enables more opportunities for gaps in asset pricing and thus creating more arbitrage contingencies for traders," says Jackson. "Arbitrage can help traders increase their profitability even during unstable markets," he added.

The takeaway

The current situation has increased the volatility of the forex markets. Some traders may shy away from trading forex during times like this primarily when they focus on predicting the future direction of a currency. Thankfully, arbitrage is a sustainable trading strategy you can use to take advantage of volatile markets. Volatility often leads to market inefficiencies creating more arbitrage opportunities.