Arbitrage Trading Strategies (Example And Backtest)

Last Updated on January 26, 2023

Arbitrage trading seeks opportunities for low-risk profits. However, to make the most of this trading approach, you need to know some important things about arbitrage trading strategies. But what exactly are arbitrage trading strategies?

A statistical arbitrage trading strategy involves buying and selling the same or similar asset in different markets to take advantage of price differences. Thus, arbitrage trading strategies are methods you can use to exploit arbitrage opportunities in any market. This may involve simultaneously buying and selling related assets on the same exchange or buying and selling the same asset on different exchanges.

In this post, we answer some questions about arbitrage trading strategies. To provide a better understanding of the strategy we provide you with an example that contains a backtest.

What are statistical arbitrage trading strategies?

Arbitrage is a type of trading in which a trader attempts to benefit from price discrepancies between similar or related financial assets by simultaneously buying and selling the asset in different markets. Thus, arbitrage trading strategies are methods you can use to exploit arbitrage opportunities in any market. This may involve simultaneously buying and selling related assets on the same exchange or buying and selling the same asset on different exchanges.

In the forex or cryptocurrency market, common arbitrage strategies include direct arbitrage (two-currency arbitrage) where a trader simultaneously the same currency pair in different exchanges, and triangular arbitrage which involves three related currency pairs and aims to benefit from the inefficiencies in the conversion of one currency to another. Another arbitrage strategy in forex is covered interest arbitrage where the trader tries to exploit the interest rate differential between two currencies by going long the currency that has a higher interest rate over the one with a lower interest rate.

Other arbitrage trading strategies used in the equity markets and others include:

  • Pure arbitrage
  • Retail arbitrage
  • Risk arbitrage
  • Convertible arbitrage
  • Merger arbitrage
  • Dividend arbitrage
  • Futures arbitrage

What is arbitrage (definition)?

Arbitrage is a type of trading in which a trader attempts to benefit from price discrepancies between similar or related financial assets by simultaneously buying and selling the asset in different markets. These disparities emerge when several financial organizations price an asset differently. This implies that arbitrage includes purchasing the asset at one price from a financial institution and then selling it practically immediately to a different institution in order to benefit from the difference in prices.

By simultaneously buying and selling the same or comparable asset in different marketplaces at different prices, you lock in the difference. Arbitrage opportunities last a short time, so to take advantage of them, one has to act fast before other arbitrageurs do. While arbitrage opportunities emerge as a result of market inefficiencies, arbitrage trading both exploits and addresses such inefficiencies.

Is arbitrage trading still possible?

Yes, but the window of opportunity is very small in today’s tech-controlled marketplaces. The majority of arbitrage possibilities emerge during news events when price quotations are most volatile. Exploiting pricing inefficiencies can swiftly narrow a price differential, thus traders who use arbitrage tactics must be ready to respond fast. As a result, arbitrage opportunities are usually available for just a limited period.

As a matter of fact, because of advancements in artificial intelligence (AI)-driven trading algorithms used by major institutional trading firms, arbitrage opportunities frequently last only a fraction of a second, which makes it nearly impossible for individuals trading on their own to act quickly enough to participate. To stand a chance at profiting from arbitrage trading in today’s market, you must use an automated system that can spot the opportunities and trade them in that microsecond.

Is arbitrage trading legal?

Yes, arbitrage trading is legal. In fact, in the US, arbitrage trading is encouraged as it helps to maintain liquidity in the market and also ensures pricing efficiency. While trying to make profits, arbitrage traders improve the efficiency of financial markets by buying lower-priced assets and selling higher-priced ones. As a result, the price discrepancies between identical or comparable assets shrink when they buy and sell.

Arbitrage fixes inefficiencies in market pricing and increases liquidity in the market in this way. Arbitrageurs function as financial middlemen by buying and selling the same asset in multiple markets, hence giving liquidity to the markets. As a result, arbitrage trading is not only allowed, but also encouraged in the United States since it improves market efficiency. Arbitrageurs also serve a vital service by serving as intermediates, supplying liquidity in various markets.

Can you lose money with arbitrage?

Yes, there is always a risk of losing money when using an arbitrage strategy, even though it is not that common if you have a system that exploits the arbitrage opportunity fast enough. Nonetheless, in extreme cases, the investor may even incur a loss at the time of the arbitrage’s convergence. In this case, the investor is worse off than if he had solely invested in the riskless asset.

The loss can arise from the market quickly correcting the price discrepancy due to the actions of other traders who were fast enough to exploit the price difference before your order hit the market. In that case, you may lose from the trading cost if the market achieved a neutral situation or you may even lose more if the difference has already reversed (meaning you are selling lower and buying higher) before your buy and sell orders hit the markets.

Which broker is best for arbitrage trading?

The best broker for statistical arbitrage trading is one that has low trading costs and very fast execution speed. Arbitrage trading is mostly dependent on speed. Traders with the best speed have a higher chance of taking advantage of the price discrepancies, which is why most arbitrageurs make use of automated systems and try to locate their servers close to the exchanges to get in ahead of every other person.

But it is not enough to use trading algos for arbitrage trading. Your algo and your broker’s platform must be based on a fast language like C++, rather than a slow one like Python. You can’t gain any arbitrage advantage with a Python-based system.

Furthermore, the broker’s trading fees must be low enough to allow you to make some profits after deducting the trading costs. In fact, you will have more tradable arbitrage opportunities if you are using a broker with low trading costs, and here’s why: when the trading fees are low, you can profit from small discrepancies in price, but if the trading fees are high, the price discrepancies must be high enough to offset your trading fees and make you profit before you can consider it a tradable arbitrage opportunity.

What is the best arbitrage platform?

Depending on your market and the arbitrage strategy you are using, the best arbitrage platform is one that offers you the best speed of execution. You may have to test many platforms to find out the one that works best for you. Different markets require different platforms. The platform you can use for exploiting arbitrage in stocks cannot be the same to use for forex or cryptos.

For cryptos, most of the platforms are bots that are programmed to buy and sell from different exchanges. But you must have enough balance in the various exchanges to start with and will periodically have to rebalance your assets in those exchanges.

Arbitrage trading (examples)

There are different types of statistical arbitrage trading, but we will give two simple examples of direct and triangular arbitrage:

  1. Direct arbitrage in stocks: This involves buying and selling a stock on two different exchanges. Let’s say Company X’s stock is listed on both Canada’s TSX and NYSE and that the stock is trading at an equivalent of 10.00 USD on TSX while trading at 9.00 USD on NYSE at the same time. If you buy 1000 shares of that stock from NYSE and at the same time sell 1000 shares of the stock on TSX, you would gain $1.00 in profit (trading fees not included) per share. For your 1,000 shares, you would make $1,000 in profit.
  2. Triangular arbitrage example in forex: Let’s say that you have $1 million and the currency rates are EUR/USD = 1.1586, EUR/GBP = 1.4600, and USD/GBP = 1.6939. There is an arbitrage opportunity with these currency rates: Sell dollars for euros — $1 million divided by 1.1586 equals €863,110, and then sell euro to pound (€863,100/ 1.4600 = £591,171). Finally, you exchange pounds for dollars to get $1,001384 (£591,171 x 1.6939). When you subtract the original investment from the total, you would have made $1,384.

Statistical Arbitrage trading — What are the risks?

There are risks in arbitrage trading, and they can come in different forms. There are the common ones:

  • Fast price fluctuations: Arbitrage opportunities are often short-lived (in microseconds), as price movements are usually very fast. As a result, it is possible to place a trade and the opportunity disappears before your orders could even get to the market.
  • Trading fees: There can be a price discrepancy in an asset between two exchanges, but if the discrepancy is not large enough to cover the trading fees and still turn a profit, the arbitrage opportunity is not tradable. Making such a trade would result in a loss.
  • Technical issues: There can be technical issues on the part of the broker or the exchange and your trade doesn’t get executed. In some cases, especially cryptos, some technical issues or mistakes can lead to a permanent loss of funds. Given that you trade with a huge amount ($100,000) just to make a little profit ($100), the risk may be too much for the profit potential.

Do you pay taxes on arbitrage?

It depends on how long the trade lasts. For most statistical arbitrage trades, which usually last for a few seconds or minutes, the profits are taxed at the short-term capital gain rates, which are usually between 15-30%. In the case of futures arbitrage and any other arbitrage that can be held for more than a year, the gains will be taxed on a long-term capital gain rate, which can range from 0 to 10%.

So, the answer is yes. But how you are taxed depends on the duration of the trades. However, tax should not determine your statistical arbitrage trading strategies.

What are the disadvantages of statistical arbitrage?

Some of the disadvantages of arbitrage trading include:

  • The revenue potential is usually very small: The little prospect of earnings is the most significant disadvantage of arbitrage for many investors. This is natural, as lower risks mean lower returns as well. However, whether or not to carry out an arbitrage transaction ultimately requires weighing the various advantages and limited potential rewards of arbitrage.
  • Excellent arbitrage possibilities are hard to come by: The number of arbitrage opportunities is directly tied to market efficacy. The more arbitrage possibilities there are, the lower the market efficiency; the better the market efficiency, the fewer arbitrage opportunities there are.
  • Arbitrage platforms may not be reliable: This is especially true in the crypto market where the capital can be lost forever because of a little mistake, such as using the wrong network.

What is triangular arbitrage?

Triangular arbitrage involves a trader converting one currency into another and then converting that second currency to a third one, and finally converting the third currency back to the original currency. It can happen on the same exchange (extremely rare), but it is more likely to involve three different exchange banks.

We have given the example above, and below is a graphical representation of how the exchanges are done with three different banks. This is why it is called triangular arbitrage.

Arbitrage trading strategies
Source: IG.

What is latency arbitrage?

Latency arbitrage is a situation where high-frequency traders have the edge above any other participants in the market. They get into the market to exploit any mispricing before any other trader.

Latency arbitrage is used by institutional investors who can afford the systems and co-location necessary for high-frequency trading. They exploit tiny price changes in a stock caused by the time difference between their systems and other players.

What is statistical arbitrage?

Statistical arbitrage is a type of short-term financial trading strategy that employs mean reversion models with widely diverse portfolios of assets held for short periods of time. These tactics rely on sophisticated mathematical, computational, and trading platforms.

In its simplest form, it is just like pair trading where a trader identifies a divergence in two historically correlated assets and trades for its convergence by going long on the lower-priced asset and going short on the higher-priced asset.

What is hedge arbitrage?

No. Hedging is making more than one trade in opposite directions to reduce the chance of significant financial loss, while arbitrage is trading a price differential across multiple markets for the same commodity in order to benefit from the imbalance.

Is crypto arbitrage possible?

In the past, it was. But that is no longer the case now. Whenever there is a price discrepancy, the crypto exchanges lock their wallets for deposit or withdrawal. The ones that do not lock their wallets may not have enough liquidity to make you any profit.

Is it risk free?

No, there are always some risks. Even with a smart bot, you can still lose money due to fast market fluctuations.

Arbitrage trading strategy backtest

A strategy backtest with trading rules and settings is coming shortly.

Similar Posts