What is Arbitrage Option in the Forex Market?

What's arbitrage? Arbitrage is the simultaneous selling and buying of identical financial instruments benefiting from price discrepancies between different brokers, exchanges, clearing firms, etc. therefore looking in a profit. On paper, arbitrage is a risk-less dealing strategy. In the real earth however, risks abound.

So exactly why trade arbitrage? Well, if the risks could be managed, arbitrage can be extremely profitable whenever you can find the opportunities and make opportunities before they disappear. In the end, the arbitrage opportunity is present because one side is slow to respond to market news, momentum, etc. When it corrects the ability is gone.

Why arbitrage fx options? Well, because the opportunity exists when you look far it. The fx is a cash inter-bank or inter-dealer market. In simplest words, this means the foreign currencies traded in forex are traded directly between banking institutions, foreign currency dealers and fx investors wishing either to diversify, speculate or hedge foreign currency risk. The forex market is not only a "market" in the traditional sense simply because that there is no centralized location for forex currency trading activity and, therefore, trades placed in forex are considered over-the-counter (OTC). Forex trading between parties occurs through personal computer terminals, exchanges and over telephones at 1000s of locations worldwide. Therefore the fx is not as efficient for the reason that NYSE for example. Price inacucuracy exist between trading platforms, clarifying firms, banks, etc if only for a small timeframe. Options pricing is also affected for that same reasons but since you'll find other components involved in prices an option than just the price tag on underlying currency, they tend to exist for longer durations.

One of the most common factors that cause option pricing differences is this calculation of volatility. Volatility is generally the standard deviation measured over a short time. Sounds simple enough right? Nicely, if compare the volatility determine across different forex option suppliers, you'll likely find differences as large as 2%. When you discover this you have also likely found an arbitrage opportunity.

Now that you've found an arbitrage prospect, how do you trade this? Well, that's a bit trickier and this also article cannot possibly cover all the risks associated with pulling off the trade but I will list some issues you should look at.

First of all, are your options really the same? Are this contract sizes, expiration dates and times exactly the same? American or European style?

You should consider execution risk. Will at this time there be slippage. Will there be considered a time delay in getting crammed. Is the market moving also fast?

Exit strategy, how will you exit the trade and however capture the profit? What happens if your options expire in-the money? Out-of-the-money? Imagine you get assigned a position on a single option but not the additional?

These are just a some of the issues one must consider when attempting to profit from option arbitrage. The important thing to option arbitrage is not unlike any trade -- planning and chance management. Plan the trade, deal with the risks, and execute the plan and will also be successful.