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.