Developed by our company, BJF Trading Group, the Lock Arbitrage algorithm is an excellent tool for arbitrage traders. This article will explain how it works and how it makes it difficult for brokers to determine that an arbitrage system is being used.
A little bit of history is in order. We developed our first arbitrage robot in 2005, and the robot quickly became very popular with the trading community. Already at the time, there were a lot of people who believed that arbitrage trading had stopped working. They were wrong. Any viable strategy is always evolving, so if you have a viable strategy, it will work even when market conditions change. Market conditions can change in all sorts of ways. In the case of arbitrage trading, they have changed because brokers have taken to obliterating arbitrage trading strategies – not just arbitrage strategies, in fact, but all profitable strategies in general.
Why are brokers hostile to some strategies? Brokers come up with all sorts of explanations to justify their action against trading strategies they don’t like. They tend to claim that these strategies are illegal, or that these strategies somehow damage their servers. That’s patently false. Arbitrage strategies are perfectly legal. Moreover, they’re good for the market, as they make the market more efficient. If you’re unconvinced, there’s plenty of information online that will confirm that arbitrage strategies are legal and that they serve to improve the way the market works.
Here’s an analogy. Suppose you go to an ice cream parlour and buy ice cream for $1. Suppose that the price of that ice cream increases to $1.20 half an hour later. Will the vendor accuse you of having bought the ice cream illegally? Of course not. It works exactly the same way with the forex market. If I want to sell a given currency at a certain price and there’s someone willing to buy that currency from me at that price, then all parties gain – including the broker, whose job in this situation is to make sure that, as a seller, I am able to find a buyer. The problem is that many brokers use the B-book model, in which case orders are never sent to the market, but are actually filled on an in-house basis. Or they might use some hybrid models. Those brokers end up harming the market, because orders are not reaching the market, which means that the market is not as liquid as it should be; additionally, because these orders never reach the market, they have no effect on market prices, which in turn distorts the market. A distorted market is an inefficient one. The only benefit here is that these brokers are able to offer lower commission fees, putting pressure on other brokers to lower their commission fees as well in order to stay competitive, resulting in the cost of trading going down.
To reiterate, arbitrage trading is perfectly legal, and if a broker’s website informs you that arbitrage trading is prohibited, you’ll do well to steer clear of that broker. It is highly likely that this broker will try to kill any profitable strategy that you use, because the broker is a B-book broker using a profit model that requires you to lose in order for the broker to gain. This conflict of interest is very important to understand, and I encourage you to share this article with as many market participants as possible.
The more traders realize that they need to stay away from brokers that do not allow arbitrage trading, the more efficient the market will be.
Now that you know that the locking arbitrage software that we offer is perfectly legal to use, it’s time to learn why it works better than ordinary arbitrage trading applications. Think of how a broker tries to identify arbitrage traders. The broker looks for two things: very small profits (on the order of 1-2 pips) and very short order duration (several milliseconds). Using an algorithm developed by us, the locking arbitrage software takes two slow brokers and compares their quotes with quotes coming from a fast feed. We offer the fast feed at no cost to you, and the software constantly compares quotes coming from that fast feed with quotes coming from the two slow brokers. During this step – step one – the software opens two opposite orders with the slow brokers: a buy order with one and a sell order with the other. It doesn’t matter which broker gets which order. This is your lock. When the market moves and the price changes, you’ll have a profitable position with one broker and a loss-making position with the other one.
Step one normally takes place when the market is quiet in order to avoid exposure to losses that can happen in a more active market. You have, at this stage, two open orders, and you’re hedged.
Let’s assume that – step two – the price as shown by the fast feed goes up, while the prices displayed by the slow brokers are still the same. We know that the market is heading higher. At this point, we close the sell order. As we have our sell order with Broker 2, we close it with Broker 2. We now need to create a virtual order. What is a virtual order? That is a frequently asked question. With latency arbitrage, the sell price – the price at which we closed the sell order with Broker 2 – would be the price at which we’d open the buy order. With locking arbitrage, we also watch the buy price as it moves up, applying a trailing stop to that virtual order; but, unlike with latency arbitrage, where we’d just close the buy order, with locking arbitrage we reopen the sell order. By closing the sell order and then reopening it, we make a profit on the buy order.
Bear in mind that the sell order is reopened with Broker 1. There are no open orders with Broker 2. All the second broker sees is that there was a sell order and that the sell order was closed, probably because a stop loss was triggered as a result of the price having gone up. The reopening of the sell order with Broker 1 took place after the arbitrage situation; in other words, there’s no reason for Broker 1 to think that there was any kind of arbitrage activity. At this time, our lock has already given us a profit of 15 pips less the commission fees paid on the trades.
Let’s assume that the price displayed by the fast feed starts to fall. At this point – step three – we close the buy position. We’re now left with only the sell position. We then apply a virtual trailing stop to the sell position. As we know where the buy order was closed, we create a virtual order, and we trail the sell position until the trailing stop is triggered and a profit is made. Once that happens, we reopen the buy order with Broker 2, having made a profit of 10 pips less the commission fees.
What is accomplished with all this activity? First, you obtain good order duration. You keep orders open for no less than a specified minimum time, e.g., five or ten minutes. That is, orders have to be open for no less than five or ten minutes. The algorithm allows you to choose the order duration that you need. If an arbitrage situation takes place before the five-minute period is over, the software simply skips that arbitrage opportunity. That way, if the broker requires orders to be open for a minimum amount of time, that requirement will have been met.
You also achieve minimum profitability. You can specify a minimum amount of pips by which the price has to move before a profit is booked. If a price move does not meet or exceed the stipulated minimum profit amount, the system does not trade based on that price move.
Finally, you can also set minimum intervals between orders. For example, assume you’d like to trade a given currency and you open a first order. If you set the interval to ten minutes, ten minutes will need to pass before a second order is opened.
In short, you completely control your trading environment. Because your profitability is based on the closing of orders, on the creation of virtual orders, and on moving from one broker to another in order to reopen your orders, you need to control your minimum order duration and minimum profitability. The software allows you to do just that. This makes it very difficult for the broker to identify the algorithm as one that is associated with arbitrage trading, and consequently the broker will not attempt to hinder your trading strategy.
I’d like to again suggest that you share this article with other fellow traders. We want as many traders as possible to know that arbitrage trading is legal, that it does not damage brokers’ servers, and that it actually contributes to making the market more efficient. If a broker makes claims that are contrary to these facts, you should probably look for another broker. We recommend that you look for a broker that allows all sorts of trading strategies and, more importantly, does not attempt to kill your strategy by introducing slippage or delaying fills. You want to make sure that the broker lets you trade if your trading strategy is a profitable one. Ultimately, you want to have confidence and trust in your broker.