We have recently developed a new method for using our multileg hedge arbitrage software. In general, this version allows you to be very precise with your settings and parameters, and the new method is a further improvement on that.

Video about new Hedge Arbitrage Trading method

The method involves moving funds from one account to another in order to make one of the accounts unprofitable. Before we look into why you’d want to do that in the first place, let’s briefly examine the method itself.

We’ve observed that when using two brokers – a fast one (e.g., LMAX) and a slow one (e.g., an MT4 broker or one of the slower FIX API brokers) – most of the profits tend to accumulate on the side of the slow broker. This is due to the fact that when an arbitrage position is opened – whether it’s a buy or a sell – the market usually continues to move in that direction for some time after the arbitrage position is opened. As a result, the bulk of the profit accumulates with the slow broker.

All MT4 brokers as well as some FIX API brokers monitor the profitability of their clients. The typical broker first determines whether the clients are, as a whole, making or losing money; essentially, the broker looks at the entire server. If the server is in negative territory, it means that most of the traders are losing money, which is what the broker wants to see. As most of the accounts are placed in the B-book instead of being sent to a liquidity provider, the broker makes money not only from the commission fees it charges on trades, but also from those accounts that are unprofitable. A client’s loss is the broker’s gain. In other words, the broker effectively trades against the accounts placed in the B-book.

Next, the broker reviews the individual accounts to determine which accounts happen to be profitable ones. Once the profitable accounts are identified, the broker examines them more closely. If a profitable account has been profitable for several consecutive days or if there are rapid increases in profit, the broker can be expected to pay a lot more attention to that account. The broker will analyze all the trades in the account in order to figure out why the account is profitable. Eventually, the broker might take certain measures to reduce the profitability of the account by applying special dealing. For example, the broker might increase execution time, and the resulting slippage will obliterate all future profits.

However, if the trader is more of a long-term operator who keeps positions open for longer periods of time, the broker is likely to take a more hands-off approach. If the trader uses a strategy such as a martingale or a grid strategy – a strategy that usually leads to losses – the broker will simply keep the account in the B-book and wait until the trader inevitably starts to lose money, at which point the broker will pocket all the money lost by the account.

This is where our hedge arbitrage method comes in. The method uses a parameter called Max Equity Loss. This represents the maximum equity loss that needs to be reached before a position is closed. While a value within the range of 30-50% should work well, we recommend a gentler application of this parameter. You can set the value to 10%. This will then result in continuous, gradual losses of 10%. Keep in mind that you need to use the same maximum equity loss value for both accounts to ensure that everything works smoothly.

hedge arbitrage equity loss

Once you connect the two accounts, you can start trading. We use two currency pairs for demo purposes (AUD/USD and EUR/USD), but you can have more as long as they have a positive correlation. Currency pairs are said to have a positive correlation when they tend to react to the market the same way. For example, when EUR/USD goes up, GBP/USD goes up as well; the two currency pairs, therefore, enjoy a positive correlation. Consequently, if you decide to trade EUR/USD and GBP/USD, you can expect them to behave similarly, with the result that one of the accounts will show a profit and the other will end up with a loss.

To add a third pair, right-click with your mouse, select “Hedging pair”, and then click on “Add”. Choose the currency you want to add and specify the lot size you’d like to use, and you’re all set.

Note that you can also trade based on a certain market direction. If, perhaps as a result of some technical analysis performed on your end, you have determined that the market is likely to head in a given direction and that the direction will be sustained for some time, you can bet on that direction if you intend to lose funds in one of the accounts and make money in the other account, by checking off “Allow buy” or “Allow sell” as required (you do that in the same Hedging pair properties used to add currency pairs).

hedge arbitrage allow buy or sell

If you do use this setting, keep in mind that the second account should be the opposite of the first account; that is, if you check off “Allow buy” on one side, you’ll need to check off “Allow sell” on the other. You will also need to do that for all the currency pairs you’re trading. Of course, if you don’t want to trade based on a certain direction, you need not worry about this.

For your next step, click “open deal manually” for the pairs you want to trade. You now need only keep these positions open until you have a profit in one of the accounts and a loss in the other account (the magnitude of the loss and profit will equal the value of the maximum equity loss that you’ve chosen). Once you run up some losses (e.g., 20-40%) in the account designated for losses, you can connect it to your fast broker (e.g., LMAX). Trading in that account will then take place with LMAX. At that point, until the losses are recouped and the account gets back to its initial pre-loss level, the dealer will probably ignore this account and leave it alone to linger in the B-book. The dealer will believe that no arbitrage strategy is used, since there appear to be open loss-making positions. Consequently, subsequent hedging positions will probably not be flagged, unless the dealer uses some special plugins that aim to identify arbitrage trading.

To recapitulate, the idea behind this method is to run up losses in one of the accounts and then pair that account with the fast broker (e.g., LMAX). The other, profitable account will be used for your profits. You can use that profitable account to run up losses in the future if you want, or you can just take your profits off the table and close the profitable account altogether.

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