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There is a trading strategy that makes money if the price stays the same for a long time. do you know?
This is one of the most popular ways to make money and is employed by many of the biggest and baddest money managers in finance!
It is the "arbitrage trade".
What is arbitrage trading?
Carry trading refers to borrowing or selling financial instruments with lower interest rates and using them to buy financial instruments with higher interest rates.
Earn higher interest on bought financial instruments while paying lower interest rates on borrowed/sold financial instruments.
So the profit in the carry trade is the spread. Examples of arbitrage trades:
Suppose you go to the bank and borrow $10,000.
Their loan is $10,000 at 1% APR.
With borrowed money, you buy a $10,000 bond paying 5% annual interest.
what is your profit
Does anyone know?
bingo! 4% per year! It's the spread!
Now you might be thinking, "That doesn't sound as exciting or profitable as riding the market swings."
However, when you apply this to the spot forex market, it's also pretty nice to sit back and watch your account grow every day, thanks to the leverage and daily interest payments factored in.
Let me tell you, a 3% interest rate difference is 60% per annum on an account with 20 times leverage!
Examples of leveraged arbitrage trades:
Say you borrow $1 million at 1% interest.
Banks don't lend $1 million to just anyone. It requires your cash collateral: $10,000.
As long as you pay back the money, you get your deposit back.
The loan is approved, so you fill your backpack with cash.
Then you turn around, go across the street to another bank, and deposit $1 million into a 5% APR savings account.
A year has passed. what is your profit
Earned $50,000 in interest (1 million * 0.05) from the bond.
Paid $10,000 in interest (1 million * $0.01).
Net profit is $40,000.
From just $10,000, you made $40,000!
That's a 400% return!
Next, we'll discuss how arbitrage trading works, when it works, and when it doesn't.
We will also address the issue of risk aversion. (Don't worry, like we said, we'll talk more about that later)
What is Forex Arbitrage Trading?
In the foreign exchange market, currencies are traded in pairs (for example, if you buy USD/CHF, you are actually buying USD and simultaneously selling CHF).
Currency positions that are sold need to pay interest, and currency positions that are bought can earn interest.
In the spot foreign exchange market, the special feature of the carry trade is that the interest payment occurs every trading day on the position. Technically, all positions are closed when the spot forex market closes. If you make it to the next day, you won't see it happen.
The broker closes and re-creates your position, then they debit/credit you with the overnight spread between the two currencies. This is the cost of "holding" (also known as "rolling") to the next day.
The leverage offered by forex brokers has made arbitrage trading very popular in the spot forex market.
Most forex trading is on margin, which means you only pay a small amount of money and the broker covers the rest. Many brokers only require 1% or 2% margin. What a deal, right?
Examples of Forex Arbitrage Trading
Let's use a common example to show how good it is.
In this example, we'll take a look at Joe, a novice forex trader.
Today is Joe's birthday, and his grandparents are very generous, giving him $10,000 as a birthday present. Very good !
He decided to save it for a rainy day.
Joe goes to his local bank to open a savings account, and the bank manager tells him, "Joe, you have a savings account with 1% annual interest. Isn't it great?"
Joe paused, and said to himself: "At 1% interest rate, I can only make $100 a year for $10,000." "This is too boring!"
Joe is a smart guy and knows a better way to invest. Joe please reply to the bank manager, "Thank you, sir, but I think I'll invest my money elsewhere."
Joe has been doing paper trading (including arbitrage) for a few years so he has a solid understanding of how forex trading works.
He opened a real account, deposited $10,000, and put the plan into action.
Joe finds a currency pair with a spread of +5% p.a. and he buys $100,000 worth of currency pair.
Since the broker only requires a 1% margin, he deposits $1,000 (100:1 leverage).
Therefore, Joe now controls $100,000 worth of currency pairs, earning 5% annual interest.
What happens to Joe's account if he does nothing for a year? There are 3 possibilities here. let's see:
The position depreciates. The currency pair that Joe bought dropped like a rock. If the loss brings the account balance below the margin, the position is closed and all that remains in the account is the -$1000 margin.
The pair ended the year at the same quotes. In this case, Joe broke even, but he earned 5% interest on the $100,000 position. That means Joe has made $5,000 out of the $10,000 account, and that's only interest. That's a 50% profit! Awesome!
The position appreciates. Joe's currency pair took off like a rocket! So not only did Joe earn at least $5,000 in interest, but he also made a profit! That's a present for his next birthday!
Thanks to the 100:1 leverage, Joe has the potential to earn about 50% annually on his initial $10,000.
The chart below is an example of a currency pair with a spread of 4.40% as of September 2010:
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If you buy AUD/JPY and hold it for a year, you get a "positive spread" of 4.40%. Of course, if you sell AUD/JPY, the opposite happens:
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If you sell AUD/JPY and hold it for a year, you will get a "negative spread" of 4.40%.
This is a common example of how the carry trade works. Any questions about this concept? No? We know you'll figure it out soon! Tomorrow will cover the most important part of the course: the risks of arbitrage trading.
Know when to take a carry trade and when not to.
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