The second part of this article talks about playing one currency pair against another. This is very different from the type of arbitrage discussed in the previous part and in many ways can be more profitable. It takes some time to set it up but it’s based on time-honored concepts of market movement.

Mean Reversion Arbitrage
This method is based on finding two currency pairs that are well-correlated. That means that they have a strong tendency to move up and down in sync. There is usually a good fundamental reason why two pairs would be well correlated, so that correlation will tend to remain in place over long periods of time. But there will be times when they seem to move independently of one another, and those are the times when money can be made by trading them against each other.

Here’s the theory: Because the two currency pairs maintain their correlation over time, one can assume that when they start to move independently, it will be a temporary event, and that at some point they will return to their old ways of moving in sync with one another. After they have moved apart by a certain amount, we simply ‘bet’ that they will move back together again in the future.

For instance, if the EURUSD and the GBPUSD are seen to be closely correlated, they will generally both move up and down more or less together. This can often be seen by studying the charts. Should a time come when the EURUSD moves up but the GBPUSD moves down, they will separate, and we will trade based on the assumption that in time they will come back together. In this case we would short the EURUSD and buy the GBPUSD, so that we can gain overall if the EURUSD falls or the GBPUSD rises, or both. It’s not a perfect strategy (what is?) but statistics have borne out its valued over the years.

Caveats to heed: First, be aware that it’s never certain how far two currency pairs will pull apart before they revert to their correlation, so you might ride a fairly decent loss (particularly on one side) before you see the gains developing. Also it’s typical to end up losing money on one side of the hedge even if you make a greater amount on the other side. It’s not too common to make money on both sides, but it does happen. Finally, there are times when currency pairs will pull apart a significant amount, then instead of coming back together they simply begin tracking their up and down movements without ever really reverting to their original mean. This is when you must simply take a loss and move on to the next trade.

I haven’t gone into the math required for this technique at all, but it’s important that you understand how to do the necessary calculations before you attempt this strategy. Perhaps I’ll tackle that in another post.