How to Use Arbitrage in Financial Trading

If you’re a financial trader, a key point to remember is that relationships are at the heart of the financial markets. Financial assets are usually interrelated in several ways. An example is the crude oil market. When the price of crude oil falls, it means that the profits of oil-producing companies will fall as well.

There are also other types of relationships between different asset classes. For example, when the dollar rises, the price of gold tends to fall because of the relationship that exists between the two. As a trader, you can benefit from these imbalances and relationships through a concept known as arbitrage. This article explains how you can use arbitrage to boost your profits.

Statistical Arbitrage

Statistical arbitrage has a foundation in the mathematical concept of correlations, which refers to the relationship between two assets. To implement this, you can use an online platform that will help you calculate the correlation, or use Microsoft Excel or Google Sheets to calculate the relationships. In the latter method, you should download the price data for the assets you want to analyze and use a correlation formula to generate the result. The answer will be between -1 and +1. A number close to minus one means little correlation exists, while a number close to +1 means there is a correlation. If there is a correlation between the two assets, you can place two simultaneous trades, where you buy one and sell the other. You will benefit from the difference between the profit and loss from the two trades.

Before you open any statistical arbitrage trade, there are a few things you need to know. First, the time period that you analyse is important. For example, if you are opening a trade that will last for less than a day, it is not ideal to analyse a period of more than three months or a year. Second, you should be careful to ensure the initial date and time of the price data is the same. Finally, even for assets that are known to have a strong relationship, you should always conduct your own analysis first.

Interest Rates Arbitrage

Different countries have different interest rates. For example, in the United States, the interest rates are at about 2.25% while in Japan, the lending rates are at minus 0.4%. This presents two ways of trading the situation. First, you can borrow the low-yielding Japanese yen and then invest it into the high-yielding US dollar. This type of interest rates arbitrage is called a carry trade.

Another method of interest rates arbitrage is to consider the forward statements from the central banks. For example, if the US Federal Reserve expects to increase rate hikes and the Bank of Japan expects to continue lowering rates, you can buy the high-yielding USD and at the same time short the Japanese Yen. To be proficient, you need to analyse recent statements from the central banks, which will give you an idea of what to expect.

Commodities-Currencies Arbitrage

This type arbitrage focuses currencies and commodities. Examples of currencies that move in tandem with the commodity prices are Russian Ruble, Saudi Arabia Riyal, Nigerian Naira, and Canadian dollar. Crude oil is a major part of the economy of these countries. If the price of crude oil declines, it could affect the underlying currencies. Therefore, you can short these currencies if the price of crude oil declines. However, in the future these economies are trying to diversify themselves from relying on crude oil, which could change how arbitrage can be implemented.

There are other types of arbitrage. For example, merger arbitrage is usually ideal for traders who focus on stocks. When company X announces that it will acquire company Y, the stock price of company X tends to move lower while that of company Y tends to move lower. However, there are other factors because a deal must be accepted by regulators and shareholders. Other types of arbitrage are convertible bond arbitrage, dual-listed companies arbitrage, and risk arbitrage.

Arbitrage is a big industry. A study by BarclayHedge found that hedge funds focusing on merger arbitrage totaled more than $66 billion. There are also funds that focus on other types of arbitrage. As a financial trader, to succeed in arbitrage, you need to take time, study, and practice this strategy using a demo trading account. Online broker easyMarkets provides a comprehensive learning resource to help you understand the basics before practicing arbitrage.