Traders use software programs to detect arbitrage trading opportunities they can take advantage of for potential profits. Three kinds of software programs commonly used for arbitrage trading are automatic trading software programs, alert programs, and remote alert programs.
What Is Arbitrage Trading?
Arbitrage trading seeks to profit from temporary market inefficiencies that result in the mispricing of the same asset in different markets or at different brokers or similar assets in the market. Arbitrage trading helps to quickly correct such temporary pricing inefficiencies, bringing prices correctly back in line across various markets, brokers or different forms of the same financial asset or instrument. The temporary imbalances that form the opportunities for arbitrage trading ideally present a trader with the opportunity to make simultaneous buy-and-sell trades that lock in a small profit resulting from variations in pricing.
For example, in the forex market, there may be a slight temporary discrepancy between the exchange rate for EUR/GBP and the two currency pairs, EUR/USD and GBP/USD, that can enable a trader to profit from simultaneously selling EUR/USD and buying EUR/GBP and GBP/USD. Another example of an arbitrage trading opportunity occurs when different brokers offer slightly different bid-ask spreads that give a similar opportunity to obtain a small profit by simultaneously purchasing an asset at one broker's lower quoted price while selling it at the other broker's higher quoted price.
Using Automatic Trading Software
Since arbitrage trading opportunities generally only exist for a very brief period of time—often just a few seconds—it is too time-consuming for traders to do arbitrage calculations on their own. Therefore, traders use a variety of software programs that can instantly detect and calculate arbitrage opportunities.
One type of software program employed by arbitrage traders is automated trading software. This kind of software is loaded onto a trader's brokerage trading platform, and whenever the software program detects an arbitrage opportunity, it instantly initiates the designated trades on the trader's behalf. This type of program is designed to overcome one of the primary challenges of arbitrage trading: the timely and accurate trade execution necessary to take advantage of trading opportunities that may only exist for a few brief seconds.
Using Trade Alert Programs
Traders who are not comfortable with having trades automatically executed, preferring instead to make all final trading decisions themselves, use what is known as trade alert software. Like automatic trading software, trade alert software constantly scans different markets, instruments, and brokers for arbitrage trade opportunities. When it detects an arbitrage opportunity—rather than executing the trade automatically—it only signals an alert of the opportunity to the trader, who then makes the decision whether or not to execute trades on the opportunity.
Using Remote Alert Programs
Some traders, rather than running their own software programs, subscribe to a remote alert service. Subscription to the service enables them to receive arbitrage trading opportunity alert signals in the same manner as they would using their own software programs. The difference is that the alert signals are provided by software running at another location outside of the trader's own computer or network.
The Bottom Line
Institutional traders or market makers have several advantages over retail traders in relation to arbitrage trading, including faster news sources, high-performance computers, and more sophisticated arbitrage trading software programs. Regardless, arbitrage trading remains popular with many traders.