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Forex broker arbitrage

There’s been a new “automatic profits” systems launched recently (and I think you know how I feel about these sorts of appeals – see Getting sucked in by easy, automated trading), and a question came in from one of my newsletter readers about it.

Hi John,

Is it true that retail Forex trader can exploit the price between Broker A and Broker B as claimed by XXXXX?

Assuming Broker A has an offer of 1.3400 EUR/USD, and Broker B has a bid of 1.3450 EUR/USD.

If a Forex trader T do a single trade with both of them using hard cash, T can pay Broker A with USD134000 to get EUR100000, and sell the EUR100000 to Broker B to get back USD134500.

He will make a profit of USD(134500 – 134000) = USD500.

But for leveraged Forex trade, if trader T buy EUR from Broker A, he still have to close out his position with Broker A.

So, how could trader T makes the so called “arbitrage profit”?

Please enlighten me! Thanks!

Best regards!

Paul

To answer Paul’s primary question as to whether it’s possible to do arbitrage trades between two or more different retail forex brokers, the simple answer is Yes.

There are, at times, variations between the prices quoted by brokers. The vast amount of the time they are very small, and untradable when the spread is taken into account. On rare occasions, though, there’s the potential to arb the differential if you have multiple accounts and can execute both sides instantly with no slippage, requotes, or execution lags.

Now, let me address Paul’s example.

Cash-Only
The first part is absolutely right. If you could go to Bank A and swap USD134,000 for EUR100,000, then turn around and take those euros to Bank B and exchange them for USD134,500, you would indeed make $500 in profits. Of course competition among the banks isn’t likely to see the spread be 50 pips wide in EUR/USD. You’d be lucky to get 1 pip, which would be a whole $10 gain. It becomes a question of the value of the gain given the resources and effort required to make it.

Leveraged (real-world brokers)
Things aren’t quite so each when working with retail forex brokers because you aren’t actually exchanging currency at any point. What you have to do instead is enter a long position with one broker at the same time you enter a short with the other. Using Paul’s numbers, you’d have to get long EUR/USD with Broker A at 1.3400 and go short with Broker B at 1.3450 to take advantage of the spread.

Here’s the rub, though. Now you’ve got two open positions – one long, one short. You can’t lock in your profit until the two brokers get their prices back in line – or at least until the spread between the two shrinks. When that happens you close both the short and the long with the respective Brokers. Depending on what the market does in between, you may make money on either the long or short, but they would offset and you’d book a profit of however much the spread narrowed.

For example, EUR/USD rallies and both brokers are quoting 1.3500/01. The spread has collapsed, so now you can exit the positions. The long at Broker A will make 100 pips (1.3500-1.3400) while the short at Broker B will lose 51 pips (1.3501-1.3450), so you’ll net 49 pips.

Sounds like a good deal, right? Don’t get too excited yet.

The Risks
This strategy isn’t as simple and easy as it sounds. Here are the considerations.

  1. As I noted, the opportunities are few and far between. Brokers have common liquidity providers coming from the inter-bank market. They aren’t making their own prices beyond adjusting the spread.
  2. The spreads between brokers will be small, even smaller when factoring in the bid/ask spread.
  3. The spreads will generally close quickly, so you need to be able to move fast.
  4. You have to execute the trades through both brokers at the same instant with no slippage because even just a little bit (perhaps caused by an execution delay on one side in moving markets) could turn a sure winner into a sure loser in a blink.
  5. It would almost certainly be a massive waste of time constantly watching the markets to find arb opportunities manually, so you’d need an automated system.
  6. On the off chance a spread between brokers does persist and the market moves quickly in one direction while you’re holding the open long and shorts, you could end up margin called out of one leg, leaving you exposed in the other.
  7. If the spread persists through daily roll-over, you’d be subject to carry. Yes, you’d receive on one side of the position, but not as much as you’d pay on the other. This will impact the profitability of the arb position.
  8. Are the brokers involved ones you’d want to have your money with (which can speak to execution in #4) or are allowed to have your money with (if you live in certain places)?
  9. If the brokers catch on they will adjust and arb opportunities will vanish.

Those are the ones that come to me off the top of my head. There could be others.

Credibility Issues
I’ve looked at the promotional copy for the arb system in question. There are some red flags that jump out at me right away. First, the fact that the guy who is promoting the system refers to the market it as “the forex” drops his credibility to me by several notches. Second, there’s one instance where he talks about having actually done a trade, but beyond that it’s all “could have” types of wording.

Then there’s the sample charts. I have SERIOUS questions about the opening gap examples shown seeing as you can even make out the dates or times on them. How do I know if they match up and thus if those spreads are actually even tradable? Two brokers could be 1000 pips apart in their quotes, but if one of them is close then you can’t take advantage.

Oh, and this system is only semi-automatic. You actually have to pull the trigger to both enter and exit yourself. That means you have to be camped out in front of the screen both looking for opportunities and waiting to close out the trades once you’re in them. That reduces your number of possible arbs considerably. It also brings up the very valid question of whether the system’s gains are worth the time invested, not to mention the two thousand dollar price tag.

A Limited Lifespan
While arbing is a valid way to make money, keep in mind it’s not going to do anything to help your long-term development as a trader. That’s an important consideration because these sorts of systems tend to have a limited life.

I have my issues with Efficient Market Theory, but it gets certain things right. Competition in the forex brokerage business is stiff, and getting more so, and regulatory oversight is increasing. High frequency trading (algos, etc.) is on the rise. Folks with a lot more computing power than you are working to take advantage of just these types of mispricings. That all works to bring everyone toward a common point. It will tend to mean tighter spreads, both bid/ask and between brokers.

We are rapidly moving toward homogeneity of pricing, and if you don’t develop your trading to adapt to the constantly changing trading environment you’ll find yourself with nothing very rapidly.

By John

Author of The Essentials of Trading

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