Arbitrage

P

Purple Brain

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This doesn't seem a particularly appropriate forum to create this thread, but given the general nature of the topic, I couldn't find one more suitable.
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There is much discussion around the arbitrage that would occur if brokers offered prices wildly out of line with each other, but I have to confess, I don’t get how it would work in practise.

If someone (Broker-A) was willing to sell at a price lower than someone else (Broker-B) was willing to buy, I can see how you’d buy all you could get your hands on from Broker-A and sell it on at the higher price to Broker-B. Technically, you’re flat. But it’s not like a physical product where you’ve passed it on from A to B, you still have two open positions: A long with Broker-A and a short with Broker-B. You’ve locked in a profit on the deal but you’ve still got two positions open. How do you wind them down?

Also, the bid/offer presumably has to be ‘outside’ on either the offer/bid or bid/offer for this to be workable. If Broker-A is at 130.20/25 and Broker-B is at 130.10/40 no arbitrage is possible as neither is selling at a lower price than the other is willing to buy – Broker-A is ‘inside’ Broker-B. Have I got that right?

It would only work in a situation where for instance: Broker-A at 130.20/25 Broker-B at 130.30/35. Is that correct?

I'm sure I'll look back on this post in the fullness of time and cringe, but I really can't figure it out.
 
Hi PB,
I thought I'd try and answer this and then thought better of it as I'll only muck it up! But this gives you the gist of how it works: Investopedia Arbitrage Video

The way to look at it is that broker A might have their prices out of whack, or broker B or both brokers - you may not necessarily know. So, you might win on one trade and lose the spread on the other but come out in front across the pair - or make a little on both trades. barjon does the risk version of this (as described in the video) between the FTSE and the DOW: Barjon's Money Machine
Tim.

PS. Thread moved to the 'Trading Systems forum. Not ideal, I know, but more appropriate than The Foyer!
 
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How the hell is that second example in the video considered to be an arbitrage trade? Looks like you're long a takeover to me and if the takeover hit's the sh1tter you're gonna be out of pocket... There's no hedge in place to ensure that you don't lose on the outright and so you have a theoretical unlimited risk. I'd have that is in start contrast to the concept of arbitrage.

Barjon's method is based on the mean reverting historic correlation relationship between FTSE and DOW isn't it? While I agree that there being an inherent risk accepting element is obvious, I fail to see how it draws any parallels whatsoever with the method explained in the video. It's not information based for a start as he looks only at the statistical likelihood of normalisation of the 'relationship' based on nothing more than the 'gap' when that itself is inferred by a number of variables i.e. FX, flows, index composition, etc.

Anyway this seems like a long ting... back to lulz lurking :clap:

steamroller.jpg
 
timsk said:
Hi PB,
I thought I'd try and answer this and then thought better of it as I'll only muck it up! But this gives you the gist of how it works: Investopedia Arbitrage Video

The way to look at it is that broker A might have their prices out of whack, or broker B or both brokers - you may not necessarily know. So, you might win on one trade and lose the spread on the other but come out in front across the pair - or make a little on both trades. barjon does the risk version of this (as described in the video) between the FTSE and the DOW: Barjon's Money Machine
Tim.

PS. Thread moved to the 'Trading Systems forum. Not ideal, I know, but more appropriate than The Foyer!
Click to expand...

Thanks timsk, but I'm none the the wiser. Lovely graphics, but no content that addresses my confusion.
 
scose-no-doubt said:
It's not information based for a start as he looks only at the statistical likelihood of normalisation of the 'relationship' based on nothing more than the 'gap' when that itself is inferred by a number of variables i.e. FX, flows, index composition, etc.
Click to expand...
Are you a mightypen multinic?
 
Purple Brain, there is no arbitrage if one spread contains the other. That situation occurs every day with a multitude of brokers. FXCM for example may have a spread of 2 pips+ on EURUSD. You can't arbitrage that because your current broker's spread is 1 pip. It's not an arbitrage. If that's your confusion, you needn't worry. It is as you think it is. The alternative would be that all market makers and brokers would have to shrink their spreads to 0, otherwise they'd be arbitraged! Only an idiot or a conman would tell you that is an arbitrage. Which is not to say that arbitrages don't exist.
 
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You'd profit if different brokers had prices that were out of line with each other, that then came back into line. You'd only close both of the trades when they come back into line with each other.
I used to actually do this (among other brilliant and profitable tricks) a good few years ago, before they all wised up and tightened their ships :(
Is that what you mean??
 
scholfield said:
You'd profit if different brokers had prices that were out of line with each other, that then came back into line. You'd only close both of the trades when they come back into line with each other.
I used to actually do this (among other brilliant and profitable tricks) a good few years ago, before they all wised up and tightened their ships :(
Is that what you mean??
Click to expand...

Can you give a specific example of an arbitrage trade? Prices being out of line and coming back in line and how you traded that. Thanks, just what I'm looking for.
 
Shakone said:
Purple Brain, there is no arbitrage if one spread contains the other. That situation occurs every day with a multitude of brokers. FXCM for example may have a spread of 2 pips+ on EURUSD. You can't arbitrage that because your current broker's spread is 1 pip. It's not an arbitrage. If that's your confusion, you needn't worry. It is as you think it is.
Click to expand...
I'm glad I got that bit right. It wouldn't have made any sense otherwise. So arbitrage is going to be a relatively short lived are rare phenomenon - especially for the muppets providing the opportunity.

In another respect though, every trade we take with our brokers, they're effectively arbing us - buying on the bid and selling on the ask?
 
Purple Brain said:
Can you give a specific example of an arbitrage trade? Prices being out of line and coming back in line and how you traded that. Thanks, just what I'm looking for.
Click to expand...

Sure. I'm not even sure if classes as an 'arbitrage' trade. Nothing quite so sophisticated!

Me and my dad used to do this quite alot about 10 years ago!
We had a few brokers. Deal4free (who are now called CMC) and a few other ones.
In the morning we'd keep check of all of each brokers prices of whatever instruments we were trading. They were typically within a tick of each other in the morning. On occasions, one broker would usually get out of line with the other 2. Sometimes by as much as 20 or so ticks. Often after a news event, but sometimes it didn't even need that catalyst.

At this point, we'd simply look for the biggest gap between the brokers on a particular instrument, and then buy it with the 'cheapest' broker, and short with the most expensive broker. Once everything had settled down, they always came back in line with each other, usually within an hour or so.

There was a similar trick that my dad used to do which I'm not entirely sure on the specifics. But from memory, Deal4free would close the Dax market about 8 pm whilst the Dow would carry on moving around. Sometimes, the Dow would crash, and my dad could see that CMC were not moving their 'indicative' price of the Dax down enough. (Say dow crashed 100 ticks, and they moved their DAX price down 20 ticks). So, as soon as the Dax market was tradeable again, my dad would short the DAX , and typically within seconds, the DAX would shoot down to reflect the move that the market had made whilst they were 'closed'.

Neither of these really seem to happen any more. They all seem to know what they're doing better now!
 
scholfield said:
Sure. I'm not even sure if classes as an 'arbitrage' trade. Nothing quite so sophisticated!

Me and my dad used to do this quite alot about 10 years ago!
We had a few brokers. Deal4free (who are now called CMC) and a few other ones.
In the morning we'd keep check of all of each brokers prices of whatever instruments we were trading. They were typically within a tick of each other in the morning. On occasions, one broker would usually get out of line with the other 2. Sometimes by as much as 20 or so ticks. Often after a news event, but sometimes it didn't even need that catalyst.

At this point, we'd simply look for the biggest gap between the brokers on a particular instrument, and then buy it with the 'cheapest' broker, and short with the most expensive broker. Once everything had settled down, they always came back in line with each other, usually within an hour or so.
Click to expand...
Excellent! So not an arbitrage trade as you point out, but smart trading all the same. You could have got away with just taking either the short or the long on expectation of it regressing to the norm, but of course taking both, you're effectively flat - and with double the profits. Nice work. A pity such opportunities are less common these days, but understandable the brokers got their act a little tighter.

This is quite similar to a pairs trade if I’ve got it right, where you trade the weak long and the strong short on the basis they'll both regress to the mean, except you're using the same instrument which by virtue of broker mis-pricing has acquired two separate identities.

scholfield said:
There was a similar trick that my dad used to do which I'm not entirely sure on the specifics. But from memory, Deal4free would close the Dax market about 8 pm whilst the Dow would carry on moving around. Sometimes, the Dow would crash, and my dad could see that CMC were not moving their 'indicative' price of the Dax down enough. (Say dow crashed 100 ticks, and they moved their DAX price down 20 ticks). So, as soon as the Dax market was tradeable again, my dad would short the DAX , and typically within seconds, the DAX would shoot down to reflect the move that the market had made whilst they were 'closed'.
Click to expand...
Rather sloppy management on the part of the broker – they deserved to be punished for it. Would be tough to spot opportunities like that these days I'm sure.

scholfield said:
Neither of these really seem to happen any more. They all seem to know what they're doing better now!
Click to expand...
They must have been the good old days. Money for nothing, and your pips for free.
 
scholfield said:
Sure. I'm not even sure if classes as an 'arbitrage' trade. Nothing quite so sophisticated!

Me and my dad used to do this quite alot about 10 years ago!
We had a few brokers. Deal4free (who are now called CMC) and a few other ones.
In the morning we'd keep check of all of each brokers prices of whatever instruments we were trading. They were typically within a tick of each other in the morning. On occasions, one broker would usually get out of line with the other 2. Sometimes by as much as 20 or so ticks. Often after a news event, but sometimes it didn't even need that catalyst.

At this point, we'd simply look for the biggest gap between the brokers on a particular instrument, and then buy it with the 'cheapest' broker, and short with the most expensive broker. Once everything had settled down, they always came back in line with each other, usually within an hour or so.

There was a similar trick that my dad used to do which I'm not entirely sure on the specifics. But from memory, Deal4free would close the Dax market about 8 pm whilst the Dow would carry on moving around. Sometimes, the Dow would crash, and my dad could see that CMC were not moving their 'indicative' price of the Dax down enough. (Say dow crashed 100 ticks, and they moved their DAX price down 20 ticks). So, as soon as the Dax market was tradeable again, my dad would short the DAX , and typically within seconds, the DAX would shoot down to reflect the move that the market had made whilst they were 'closed'.

Neither of these really seem to happen any more. They all seem to know what they're doing better now!
Click to expand...

You were arbing broker feeds and not the market is all but it's still technically an arb trade.

Doesn't happen as much any more cos they all use the same/similar feeds.
 
scose-no-doubt said:
You were arbing broker feeds and not the market is all but it's still technically an arb trade.
Click to expand...
Had they decided to just take either of the brokers' prices - both were out of line with the underlying, one higher, one lower - they would have made money purely on the mis-pricing. Are you saying because they decided to take two trades based on broker mis-pricing it becomes an arb trade? If so, I don't follow the logic.
 
Doesn't matter what the underlying was cos he didn't trade that, he traded the two broker feeds against each other.

You could trade the underlying against the SB quote if you wanted but now you're getting into different territory.

Anyway I'm out. Hope you find what you're looking for though I can guarantee you'll be far better off logging of and reading a book on the subject.
 
scose-no-doubt said:
Doesn't matter what the underlying was cos he didn't trade that, he traded the two broker feeds against each other.
Click to expand...
Not exactly. As I said, he didn't have to trade both. Either/both mis-pricing trade(s) was a winner when it realigned with the underlying. My point was that it wasn't an arb trade, but two separate mis-pricing trades, either/both of which could have been taken independently of the other. Your response didn't address the logic you used to claim it as an arb trade.

scose-no-doubt said:
You could trade the underlying against the SB quote if you wanted but now you're getting into different territory.
Click to expand...
That would probably be more comfortably classed as an arb trade I think.

scose-no-doubt said:
Anyway I'm out. Hope you find what you're looking for though I can guarantee you'll be far better off logging of and reading a book on the subject.
Click to expand...
I'm not so sure everyone who writes books on the subject has necessarily been in the trenches. Neither of course has everyone who claims to have been in the trenches actually been in the trenches, but enough who have, have provided me with insights to my queries that no book has ever touched upon.
 
Definition of 'Arbitrage'

The simultaneous purchase and sale of an asset in order to profit from a difference in the price. It is a trade that profits by exploiting price differences of identical or similar financial instruments, on different markets or in different forms. Arbitrage exists as a result of market inefficiencies; it provides a mechanism to ensure prices do not deviate substantially from fair value for long periods of time.

Courtesy: Investopedia
 
Joseph Trader said:
Try to find out more info about arbitrage between spot FX and FX futures contract.
Click to expand...
Hi Joseph, thanks for your suggestion. I'm up to speed on what could constitute an arbitrage trade - any number of instruments as per Barjon's post above. What I'm really asking for is an actual example of an arbitrage trade. Not live of course, just one that has been done or even a hypothetical arb trade.

Just like to get my head around the mechanics of it and being a bit on the dim side find a worked example fills in the gaps that technical definitions often leave in my comprehension any process.
 
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