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I am not a finance expert at all, but I recently got this idea from a conversation with a friend on whether it is possible to make money by starting with a fixed amount of dollars and then try and keep exchanging it for other currencies and finally exchange back to dollars while turning profit.

An example should be something like this: $10 ⟶ ¥10000 ⟶ €5 ⟶ $12 (profit)

Is this possible? Is there a word for it? As a physical person, is it wise to do this as a way of investment?

Rodrigo de Azevedo
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Kaki Master Of Time
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    If it were even remotely feasible we'd all be billionaires. – Alan B Jul 08 '21 at 10:46
  • It's the same flawed concept (arbitrage) that explains how the protagonist of the Mission Earth series (by L. R. Hubbard) makes all his money. It is satire. – evildemonic Jul 08 '21 at 14:12
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    "As a physical person, is it wise to do this" — I'm not sure that being an incorporeal person particularly helps with currency trading. – Paul D. Waite Jul 08 '21 at 15:05
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    "Can someone make money by cycling through currencies and exchanges?" Yes, the currency exchange - at your expense. – Transistor Jul 08 '21 at 21:21
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    @RodrigodeAzevedo We’ve cracked it! Now we can get rich selling our $7 e-book How to Achieve Financial Independence Through Currency Trading If You First Transform Your Body into a Gas – Paul D. Waite Jul 08 '21 at 21:51
  • I am currently being shown advertisements on YouTube which claim to do this with cryptocurrencies. Needless to say, these ads are nothing but scams, full of vague claims about "sophisticated algorithms and artificial intelligence" and ridiculous talk about how I'm only one of a limited number of people chosen to be shown the ad, and how I have to move fast before the big banks figure things out. They have obviously chosen the arbitrage angle because it sounds somewhat feasible to the layman. – n00b13 b00b13 Jul 09 '21 at 04:17

7 Answers7

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I recently got this idea from ...

You're not the first. (Or the 8000th.)

Is there a word for it?

Arbitrage (pronounced in French) is "the simultaneous purchase and sale of the same asset in different markets in order to profit from tiny differences in the asset's listed price. It exploits short-lived variations in the price of identical or similar financial instruments in different markets or in different forms.

Arbitrage exists as a result of market inefficiencies and it both exploits those inefficiencies and resolves them."

Sadly, no, you can't make any money off of it, because other people already have.

EDIT: "cryptocurrency" is not a Magic Word which makes trading negate the laws of economics and sociology. The answer to whether one can arbitrage cryptocurrency is the same as whether you can answer all other currencies: how inefficient (slowness in price changes reflected from market to market) the cryptocurrency markets are. I guarantee that you're not the 8000th person to try and arbitrage cryptocurrency. If there's still a difference in prices between markets, the whole cryptocurrency market is seriously broken.

RonJohn
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  • There are arbitrages available in the option markets. Very little of this dribbles down to retail traders since others have faster access (HFT), bigger computers, more complex and efficient programs to search and find them, etc. I'd assume this is similar in true arbitrage (different markets) and the big boys own the edge. – Bob Baerker Jul 06 '21 at 12:37
  • @RonJohn but would the equation become easier if we introduce cryptocurrencies into the cycle? – Kaki Master Of Time Jul 06 '21 at 12:44
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    @KakiMasterOfTime see my edit regarding cryptocurrency. – RonJohn Jul 06 '21 at 12:55
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    @KakiMasterOfTime Just to 100% guarantee you aren't the first person to think of this, I did have a friend who wrote an arbitrage program for trading crypto. If I recall correctly he was making a few cents a week... – Davis Yoshida Jul 06 '21 at 21:33
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    Considering how much processing power is behind the entire crypto system, it would be a joke if there are significant market inefficiencies with regards to exchange rate updates. Whatever exchange that lags so much to create a market deserves to go bankrupt for it. – Nelson Jul 07 '21 at 02:51
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    There are plenty of "broken" markets due to capital controls. – Rodrigo de Azevedo Jul 07 '21 at 06:28
  • @RodrigodeAzevedo but are they broken in the speed at which exchange rates are transmitted around the world? – RonJohn Jul 07 '21 at 10:45
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    @KakiMasterOfTime if you see arbitrage opportunities in crypto, it's usually a good indicator one side of your trade is about to blow up very violently. Failing exchanges and currencies often offer what looks like an arbitrage opportunity, but in reality the market reflects the reduced trust in one exchange/currency over another. (See eg. the MtGox fiasco - Bitcoin was trading at a significantly higher price compared to other exchanges, because what MtGox called "dollars" was quickly turning worthless). – Maciej Stachowski Jul 07 '21 at 14:41
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    Typically the prices of crypto is synchronized between the various exchanges within a fraction of a percent. This is specifically because of high volume traders with low exchange fees engaging arbitrage via API. But, during periods of high traffic the exchange prices can differ. For example on May-12-2021 there was a massive selloff and the prices on Coinbase were no longer tracking the prices on Binance and the other exchanges (the spread for BTC also went to from the usual $0.01 to $600). Similar events have been happening once a month this year and Coinbase breaks every time. – user4574 Jul 07 '21 at 14:53
  • Are you misunderstanding the question? I read it as the OP want to buy a currency. Hold on to it for a while (days to months) until the exchange rate is favourable and then buy a third currency. Rinse and repeat. – d-b Jul 07 '21 at 22:42
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    @d-b if I did misunderstand it, then so did the other four answers. (One seems more of an anecdote.) – RonJohn Jul 07 '21 at 22:44
  • 8,000 is an oddly specific number. Is there any reason you can guarantee specifically 8,000? Or is that just a random number? – Evorlor Jul 07 '21 at 23:46
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    @Evorlor note what I did not say: "only 8000 have already had that idea". Thus, more can have had the idea, but not less. – RonJohn Jul 08 '21 at 00:00
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    Actually cryptocurrencies are often inferior for arbitrage because transaction rates are very slow (e.g. for bitcoin less than 10 transactions per second) making it difficult to impossible to execute your trade and/or requiring higher fees. There was an "Odd Lots" episode recently where there was discussion about why apparent arbitrage opportunities persist in crypto markets. – JimmyJames Jul 08 '21 at 13:58
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    Here's the Odd Lots episode about real-world arbitrage in the crypto markets that I think @JimmyJames is thinking of. – Josh Kupershmidt Jul 09 '21 at 19:32
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An example should be something like this: $10 ⟶ ¥10000 ⟶ €5 ⟶ $12 (profit)

This is called triangular arbitrage. The concept is simple and well-known. The process is not risk-free. There are many potential execution pitfalls. Even if you manage to identify a profitable cycle, the prices could change before you manage to complete the cycle. Your example involves three trades (USD → JPY; JPY → EUR; EUR → USD). During the execution of the first trade, the prices of currency pairs in the second and third trades may move in such a way that makes the entire cycle unprofitable. For these reasons (and many others), retail investors may not be able to make any money from triangular arbitrage.

Since you appear to be a programmer, you may be interested to know that the Bellman-Ford algorithm can be used to quickly check whether or not a profitable arbitrage cycle exists, and if so, find one of the cycles. The detection of arbitrage cycles is one of the applications of shortest path algorithms, and this use is mentioned in popular algorithms textbooks such as Algorithms by Sedgewick and Wayne (see § 4.4 Shortest Paths), and Introduction to Algorithms by CLRS (see Problem 24-3 "Arbitrage").

The Bellman-Ford algorithm only finds one cycle. To get the list of all profitable cycles, a simple depth-first search (DFS) should suffice (the inefficiency of DFS may not matter if you are only involving a small number of currency pairs). This is an interesting exercise in implementing graph algorithms, but don't expect to make any money from your implementation!

Flux
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    (This means the big guys with beefy servers directly connected to the stock exchanges with fiber are running already Bellman-Ford non-stop just in case) – user253751 Jul 06 '21 at 16:20
  • Are you misunderstanding the question? I read it as the OP want to buy a currency. Hold on to it for a while (days to months) until the exchange rate is favourable and then buy a third currency. Rinse and repeat. – d-b Jul 07 '21 at 22:42
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    @user253751 except that currencies are not traded on stock exchanges - it's decentralised https://en.wikipedia.org/wiki/Foreign_exchange_market – Erwin Bolwidt Jul 08 '21 at 07:42
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One of my teachers (established engineer doing his Ph.D. in older age teaching us) at the university made a solid amount of money designing special hardware, one of the uses of which was to trade on exchanges and make money precisely the way you describe.

The problem for small players?

There are big players with:

  • specialized hardware (made to specification for them)
  • running specialized software (made to specification for their use)
  • connected by dedicated lines directly to the exchange database (which they pay a lot of money for)
  • sitting in the building next door to exchange or in the server rack of the exchange itself

That allows them to make these trades before your computer running your trading app even gets to authenticate to the standard API...

mishan
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There are two ways to do this:

  • One is to find "instant" cycles of currency pairs which are not completely equivalent and result in a higher amount after conversion, as explained in the other answers.

    As they state, the issue is that you're far from the first one to think about it, and the market tends to self-correct, so the window to do it is very very very short, and the gains tiny.

    Also, once you factor in transaction costs, the likelihood you will actually make any money is vanishingly small unless you deal with very large volumes.

  • The other way is really just plain speculation: you exchange your USD for another currency which you think will appreciate against the USD, and when it does, exchange it back to USD (you don't even need a third currency in this case, though nothing prevents you from cycling through more currencies). Exactly like you would buy shares of a company the price of which you think will go up and then re-sell them once it has gone up. One of the main drivers for currency exchange variations are changes in interest rates, and lots of people play oracle trying to guess what the central bank will do.

    Like stocks, this is of course quite risky, as currency exchange rates do not always go in the direction you think they will. On the other hand, there are sometimes other forces at play which make some operations possible on currencies which are not possible on stocks, as central banks can have policies that will force them to buy or sell at specific prices.

    As a consumer, you will however often be hit by the large "spread" between buy and sell rates, which means that even if the exchange rate does not move at all, you'll lose money.

jcaron
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About the time when the Euro was introduced, one major store in the UK accepted Euro for payment (they don't do that anymore), and returned your change in pound.

Unfortunately for them, they had confused the exchange rate. Instead of say £1.00 = €1.20, they applied a rate of €1.00 = £1.20. So you took 100 euros, bought five pound worth of items, they returned £120 - £5 = £115. You kept £30, went to the bank, and changed the remaining £85 to €100. With your fresh €100 note you went back to the store and repeat.

They figured it out rather soon.

gnasher729
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    This is an interesting and amusing anecdote, but that's what it is: an anecdote which does not answer the question. – RonJohn Jul 07 '21 at 22:45
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    @RonJohn, the last sentence is the answer. If it were possible, people would figure it out and do it, and other people would notice and not offer freebies. – o.m. Jul 08 '21 at 19:34
  • @RonJohn even if it were pure fiction, it still illustrates the problem. – Christopher King Jul 09 '21 at 00:27
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A while back there was a situation where one crypto exchange had a price per bitcoin that was quite a bit higher than all the other crypto exchanges. One could in theory sell bitcoin on that exchange, withdraw the dollars, move them to another crypto exchange, buy bitcoin, transfer the bitcoin to the original exchange and repeat. There were a couple of problems with this.

  1. There was a long queue to withdraw dollars as the exchange had a limited capacity to transfer dollars so the process could take a while.
  2. The exchange in question had a bug in its code that allowed people to steal bitcoin from it. A much more profitable line of work than Arbitrage.

This lead to the collapse of Mt.Gox with people having significant nominal bitcoin and dollar balances left on it. If exchanges show a difference significant enough that you could make a profit there is probably a reason for it. It is not so much investment as speculation.

William Hay
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The name is arbitrage.

Yes, if an opportunity exists, you can do it. However, the very act of doing it will destroy the opportunity for anyone else to do it. Arbitrage has this nasty habit of causing equilibrium between markets. So you are essentially in a race with anyone else who is trying to do this as well to be the first.

It is a very hard way to make money.

Ryan
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  • Sure you can break the laws of man, but the laws of economics will still crush you. – Ryan Jul 10 '21 at 18:36
  • That is easily explained by significant trading frictions which allowed a disequilibrium as given by nominal prices, however, it would disappear if transaction costs are taken into account. Happens with natural gas all the time because you need pipes to link markets together. However price differences dissipate by accounting for costs to transport between those markets. – Ryan Jul 11 '21 at 23:03