What is arbitrage trading?

Before answering the question of what is arbitrage trading on the forex or cryptocurrency market it is necessary to understand that arbitrage trading can be implemented by different arbitrage strategies (methods) that can differ from each other globally and can also differ only by improvements (enhancements) of the same arbitrage trading algorithm.

I will discuss four types of arbitrage trading that give rise to all other types.

Latency Arbitrage for Forex and Crypto Markets

The first and most popular not only on Forex, CFDs, and precious metals, but on Cryptocurrencies market, is latency arbitrage, or as it is also called one leg arbitrage. Latency arbitrage always involves a source of fast quotes (fast feed), which are always compared by the latency arbitrage program with the quotes received from a slow broker. If the price of the instrument at a fast broker increases by a certain number of pips relative to the price of the same instrument at a slow broker, this instrument is bought, if vice versa – sold. If you look at the history of latency arbitrage programs, you can understand that this development was predetermined by one factor – Forex brokers hate traders who use latency arbitrage and try to find them and throw sand in their wheels, using all kinds of plug-ins, although this type of trading is legal and it improves the market by leveling prices on it. Developers of latency arbitrage programs tried to oppose forex brokers and invented sophisticated algorithms for forex latency arbitrage software. As the first latency arbitrage robots opened an order for a very short time (a few milliseconds) and fixed a profit of one or two pips, the main criteria for determining the latency arbitrage trader were the order time and profit. Such a problem was solved by the latency arbitrage product developers through the use of trailing stops and imitation manual trading, but this solution did not help for a long time, as brokers improved the search algorithms.  At the next stage, the latency arbitrage software developers invented hedging orders on the same account on the other account – it allowed to increase globally the lifetime of the order and also to increase profit on one of the hedged accounts and loss on the other one. Now latency arbitrage can not be called one-leg arbitrage, as it has the second leg 😊 Although the essence has not changed, the real profit = profit on one account – loss on the other account = a few pips. This is how to lock latency arbitrage was born, which also underwent some changes and improvements and continues to successfully exist nowadays. On the other hand, since most crypto exchanges did not go the way of forex brokers and created a fair market, latency arbitrage crypto exchanges do not need additional improvements.  

Hedge Arbitrage for Forex and Crypto Markets

In hedge arbitrage, there is also a comparison between two or more brokers. For example, we have broker A and broker B. If the price on broker A for a certain trading instrument exceeds the price of the same instrument on broker B by the given number of pips, then the hedge arbitrage program sells this instrument on broker A and buys it on broker B, thereby fixing profit. Then the hedge arbitrage program waits for a reverse signal when the price on broker A will be lower than the price on broker B by a certain number of pips to close the previously opened position. This trading method seemingly does not harm a forex broker, but the problem is that among two brokers in a hedge pair, one will always be faster than the other and the profit of the hedge arbitrage trader will accumulate on the slow broker. As a matter of fact, in this situation, all orders initiated by hedge arbitrage software can be divided into two types: orders initiated due to quoting differences between liquidity providers and orders due to latency. The first ones can be classified as non-toxic for the brokerage companies and a real STP broker will not pay attention to them and the second ones are toxic and do not differ at all from the Latency arbitrage trading.  In this situation, a fast broker would be happy and a slow one would not as the main profit of brokerage companies is not from commissions but traders’ losses. As in the case with Latency arbitrage software, hedge arbitrage programs have undergone numerous changes and improvements. The main objective of the developers was to make hedge arbitrage software trade less frequently on signals caused by delays and to process only signals caused by differences in the quotes of different liquidity providers.

Hedge arbitrage software for cryptocurrency exchanges also as in the case of latency arbitrage software do not need such improvements. 

Statistical arbitrage for Forex

Statistical arbitrage is based on the fact that some instruments have a historical correlation. For example, DE30 is a stock index that represents 30 of the largest and most liquid German companies and FR40 is a benchmark French stock market index. If these instruments diverge, the program of statistical arbitrage buys one and sells the other and waits until the moment when the total position will be profitable due to the correlation. Some traders try to use statistical arbitrage to trade currencies or cryptocurrencies, but in our opinion it is risky. Because historically correlated currencies or cryptocurrencies at some point can lose correlation for a long time. 

Triangular Arbitrage for forex and crypto markets

The strategy is based on the idea of comparing quotes of cross-currencies like EURGBP, AUDNZD, EURJPY… with an artificial synthetic quote obtained from two currencies of each pair: EURUSD and GBPUSD, AUDUSD and NZDUSD, EURUSD and USDJPY…

Triangular Arbitrage is a long-known arbitrage strategy, which gained popularity at the time when Forex brokers did not make alignment of quotes. I.e. it was possible to find the difference in the cross-currency and its synthetic pair. At the moment there are almost no such brokers and the use of triangular arbitrage between two or three different brokers leads us to the same problem as the use of hedge arbitrage, all the orders opened by the program can be divided into two types orders opened due to the difference in the quotations of different liquidity providers and orders arising due to latency. Although the triangular arbitrage will still be less toxic for the broker than the hedge arbitrage. 

In essence, the challenge for the developer of arbitrage strategy algorithms for arbitrage platforms is to create an algorithm that will disguise latency arbitrage as much as possible.