There are many pricing differences and mispricings when trading currencies. These can be exploited to make profits. These minor price differences usually occur in the exchange rates between currencies. To capture these mispricings, most forex traders and investors use arbitrage strategy. Locational arbitrage is one of the most well-known arbitrary trading strategies.Continue reading for more information.
First, you need to understand what arbitrage is before you can comprehend the concept of location arbitration.
Arbitrage technically refers to a strategy for trading that allows you to simultaneously purchase and sell assets such as stocks, commodities or currencies in order capture small price differences. Either you can buy or sell an asset in one market, or in multiple markets. Arbitrage trading strategies offer very low returns but are widely accepted as low-risk. Arbitrages can be risk-free.
Now that you understand what arbitrage is, let us get back to understanding locational arbitrage strategy.
Local arbitrage is when an investor attempts to profit from minor differences in exchange rates between different banks. These exchange rate differences are often very small and usually only last for a short time. Investors must act quickly to capture this price difference accurately. He might miss the opportunity, or his position could end in a loss.
The fact that the currency market is not centralized is one of the main reasons for mispriced exchange rates. The currency markets, unlike the stock market which are highly regulated and centralized via exchanges, are completely unregulated over the counter markets. The exchange rates may differ from one bank to another because all transactions are conducted electronically over-the-counter without any central market or regulatory entity.
Here's a great example to help you understand the concept better.
Let's say you are a trader and wish to trade the USD GBP currency pair. The USD is your base currency. The GBP is your quote currency. If the USD GBP currency exchange rate is 1.45, you will need to pay 1.45 USD in order to buy 1 GBP.
You approach ABC Bank, who offers a bid spread of 1.43/1.45 to purchase the USD GBP currency pair. The bank will pay 1 GBP to buy the bid value. The ask value is the amount you have to pay in order to buy 1 GBP from the bank.
You also approach another bank, XYZ, who offers a bid spread of 1.47/1.49 to purchase the USD GBP currency pair. You can see that there is a slight difference between the bid ask spreads of two banks for the same currency pair. This is where you can use location arbitrage.
The locational arbitrage strategy is simple. You simply need to buy GBP at bank ABC for 1.45 USD, and then immediately sell it to bank XYZ to get 1.47 USD. You can make 0.02 USD profit on this trade. This trade has the advantage of being virtually risk-free.
You can see that locational arbitrage, as you can see from the above example is one of the most straightforward trading strategies. Finding the price difference in exchange rates between banks is the hard part.It requires a lot dedication and determination. Here's a tip: The strategy is not profitable due to the low profit margins associated with location arbitrage. It requires significant investment capital in order to achieve high returns.