arbitrage on pairs? options?

i've read some people doing arbitrage with currency pairs? Wouldn't hte broker find you out eventually?

What about with arbitrage on currency options, futures? Would there be more opportunities here?

Hello,

I'd like to answer your question fully, but I would need to know a little more about what you're asking. Sure, some are able to pull off arbitrage plays with all manner of assets - currencies, futures, options, etc. However, "arbitrage" is a loose term, it simply means "riskless profit". Most people further specify that it is a "riskless profit" that earns more than the risk-free rate interest rate i.e. US Treasury securities. If US debt obligations are paying 4.5% annually, and you can play an arbitrage that will net you 2.3% (annualized), you'd be silly to execute. You may as well buy some T-Bonds, why waste your time? However, if you can figure out a way to make more than 4.5% after transaction costs and taxes, now you're on to something! You're earning a riskless profit that pays better than another riskless asset.

Unfortunately for small players, transaction costs will surely beat you. Options traders on the CBOE (Chicago Board of Options Exchange) can trade for pennies a turn and can push hundreds of options at a time. You or I might be looking at hundreds of dollars for a large trade (per side) and probably do not command the capital necessary to deal in comparable size as a major player (smaller relative returns).

In addition, lots of arbitrage plays involve a hedge of some sort to secure the "riskless" part of the manuever. So while you're noticing the parity between the cash rate for GBP has deviated significantly enough from the GBP futures price that you can out-earn the current short-term US Treasury rate (all of this you're doing on-the-fly), you need to immediately buy the futures contract and short an exact but opposite amount in the cash market. This is tough to do.

I would say that it would be hard to arbitrage through a retail broker. Essentially, they control the prices they're feeding you. After all, they're really the counterparty to your trades. In addition, the cost for you to implement any type of quick arb play would bleed you out because of the spread. Again, floor traders and market makers face nearly insignificant costs to execute their own orders. We get to deal with a bid/ask & commission.

Imagine noticing that you could start with dollars, buy Euros, buy Yen with those Euros, and then buy dollars with those Yen, and wind up with more dollars. As a hypothetical play, dollars to Euros is 2-3 pips, Euros to Yen is 3-4 pips, and Yen to dollars is 3 pips. That's 8 to 10 pips just to make your trade. Since arb opportunities disappear in seconds you'd better notice, before everyone else in the world staring at the screen, that these three currency exchange rates have gone far enough out-of-balance to the tune of at least 11 pips. Then figure that you need to out-earn the annualized risk-free rate in order to make your arbitrage trade worthwhile - maybe another 4-5 pips so we're talking 15 pips or more. That's a lot.

Also remember that arbitraging is a highly advanced and specialized form of trading. This is far from a "buy on the break of a trendline" method. There are a lot of things that go into a proper arb trade and they can all bite you fierce if you're wrong about any of them.

I would intuitively think that there are more arb opportunities available on futures and options than electronic FX trading. But, you have to be on the floor to exploit those opportunities.

Let me know if I can clarify anything for you. Thanks!

-=DAVE=-

Personally, I would much rather wait for good trends.