Forex Triangular Arbitrage: It Doesn’t Exist…

…at least not on the online trading platforms. If you’ve had some immersion in the finance world, you’ve probably heard of arbitrage (read here if you are not familiar), an opportunity for risk free profit. Triangular arbitrage with forex is just the same, but involves three currencies. All it takes is for one of the currencies to be out of whack, and you have a shot to make a quick trade and free money. There’s a problem though, actually several of them and together, they make it very difficult for us, the independent trader, to make any profit.

First of all, you’ll be using an online trading platform with forex. As you might already guess, online trading means computers and they communicate trade information very fast. So fast in fact, that the size and duration of a currency imbalance is very brief. Even if you do notice an imbalance, it is gone before you can do anything about it. It would take computer software to find this and execute the trade. But this leads to another problem.

The bid-ask spread will eliminate your chance to make a risk free profit. Even if you find a currency imbalance with computer software and act on it, the amount of profit you make will be lost because of the bid-ask spread. The online trading platforms, and any dealer for that matter, use bid-ask spreads in the forex world so they can make a profit.

Thirdly, the amount of profit you can make on a percentage basis is quite small. This forces a trader to use a large amount of capital to make a small profit. Of course, this is risk free and if repeated multiple times can lead to bigger returns. But most independent traders don’t have $10,000, or more to trade around.

Finally, and this is perhaps the biggest obstacle to conducting triangular arbitrage with forex, is the very nature of the online trading system. When you deposit your money and start trading on Forex.com or Oanda, you aren’t actually trading foreign currency. I know, I was quite shocked and surprised to hear this. What actually is happening is that you are speculating on the movement of the spot forex market.

So instead of trading actual currencies, you are just placing bets on where you think they will wind up. I found out by chatting to an online advisor at Refco, back when they were in business. Don’t worry, you can still make plenty of money trading forex. It’s just good to know what you are actually doing.

To sum it up, the only way triangular arbitrage is possible with forex, is to have physical currency, a computer software spotting imbalances, and a means of trading that physical currency with those rates at near instantaneous levels. In essence, only large institutions with these resources can attempt this. It’s unfortunate that triangular arbitrage won’t work for us on online trading platforms but this won’t stop us from making smart investments.

Forex Trading: Why to Avoid Opening Mini Accounts

You’ve probably seen it advertised everywhere, open a forex trading account for as low as $300 and begin trading right away. It seems tempting because the amount is small, what could possibly go wrong? Forex trading sites will claim that the leverage and volatility of the foreign currency market are reasons enough to trade there instead of with stocks. Make a $400 dollar profit in one day with forex trading, or in 2 weeks with stock trading? Most people would be lured towards the $400 in one day. But then, if they make it sound so easy, there must be a catch. There is: forex trading in mini accounts is not practical for investment purposes.

So you ask, why do forex trading sites offer mini accounts if they are inherently difficult to succeed with? Because it’s easy money for them. They figure a novice forex trader spent a couple days on their forex trading game and maybe pulled a profit. Of course, it’s all fake money and in large amounts, so the novice forex trader thinks they did decent. Yet, they’re not confident enough to put $2500 on the table so they decide to start smaller, $250 sounds better. It’s very logical. If you went to the casino and had only played poker a few times in your life, you definitely wouldn’t sit down at the $2500 table, you would pick the one with the lowest entry cost.

Let’s say you go to Forex.com and sign up for their mini forex trading account, it only has a minimum of $250 and let’s say you have $300 to invest with. You’re probably very excited and anxious to place your first real forex trade ever. I don’t blame you, it is exciting. But here’s why forex trading in a mini account is bound to fail:

You only have a limited amount of bets you can make, you have limited experience and there is this little thing called a Margin.

Because you’re trading in such small amounts in the mini account, you need to leverage your money big time to purchase the required $10,000 lot. Forex.com stipulates that your margin is .5%. On first glance this looks wonderful, stock accounts have a 50% margin which is astronomical compared to .5%. However, .5% pertains to your $10,000 lot, not your account balance. Therefore, you need to have $50 dollars in your account to maintain the required margin.

Well that doesn’t sound too bad, $50 is only 16.6% of my account, that’s manageable. Wrong; this is where your limited amount of bets comes in to play. You have to put up $50 dollars of your money for each $10,000 lot you want to purchase. Below is a chart on what happens to your account if you place 1 trade and lose your entire amount repeatedly:



Now obviously this is worst case scenario. Most people will manage to make a few dollars here and there, and they will of course exercise good judgment in ending their trade if it’s losing. The point of this illustration is to show you how fast you can deplete your account—it only took 5 trades. Forex trading companies know that most people are not very experienced and it’s only a matter of time before they lose their money.

I should point out that forex trading sites make their money on the spread, not on trading commission. As your positions worsen, they gain more on you. When you decide to cut your losses this ends up being a nice bit of profit for the forex trading companies.

Finally, I would like to give you an analogy as to why forex trading in a mini account is a bad investment. Go back to the chart and look under the “Trade as % of Balance” column. Notice how each trade becomes an incrementally bigger part of your total holdings. No where on Wall St. will you find money managers and sensible traders putting down 20% or more of their position in one holding. It would be dangerous to do so. For most conservative portfolios, putting 5% of their holdings into one trade is the norm. That way, if it goes bust you only risked 5%.

The forex trading world is far more volatile. You could argue that you’re justified in taking on that kind of risk because the return is big. You are, only if you can limit your exposure. Putting 20% or more of your holdings into one position is dangerous.

Forex trading seems glamorous on the outside and the companies offering such services do a good job in showing the upsides to it, but naturally they don’t discuss the downsides. I hope this has helped put a new perspective on the way you look at forex trading; especially in mini accounts. Many people don’t get a chance to see this down side to forex trading until it’s too late and they have lost money. If you have $1000 or more, you could try the mini account if you feel you are ready. If you have any less, don’t bother, you are better off saving your money. Take care and make smart investments.