Arbitrage is basically a way of working one aspect of a market against another, typically to exploit small discrepancies and make small profits. There are several different ways to apply the concept of arbitrage in the Forex market. I’ll talk about two of them here.

Interest Rate Arbitrage
When trading Forex, you are borrowing from (or lending to) your broker by way of trading on margin. If you buy a certain pair, you may need to pay some interest, but if you sold that pair you would be paid interest in turn. Because different brokers charge different amounts of interest it’s sometimes possible to find a discrepancy between two brokers such that if you buy a pair from one and sell the same pair to another, you’ll earn more from the paying broker than you pay to the collecting broker. This is a rare instance, but it can occasionally happen.
More prevalent is trading an interest free account against a typical interest bearing account. In this scenario, you trade with the interest bearing broker in one direction – say long the EURUSD – so that you can earn interest for holding the position for a while. Then you hedge that position buy selling the EURUSD with the interest free broker. Since you won’t pay interest on your short position, you will profit from the interest paid by the long position – and the two positions themselves will cancel each other out.
This strategy allows you to earn money consistently from interest regardless of what direction the prices move. The downside is that interest free accounts are typically only available to Islamic traders, and they exist because of a tenet of Sharia law which forbids charging or collecting interest. The other considerations are that you must make pretty large trades in order to gain any decent amount from the interest and of course you need to have two accounts instead of one.

Next installment – Mean Reversion Trading.