Arbitrage is the practice of purchasing a financial instrument and then immediately turning around and selling it, hopefully for a profit. This is most effective when there are two separate but related markets involved so the trader can take advantage of price differences. Additionally, arbitrage works best when large amounts of the currency (or another financial product) are used because exchanges generally are in sync with each other. If a price difference does exist, it is usually only a tiny amount and for the trade to be worthwhile a larger amount is needed in order to see any gains.
Arbitrage can be risky because markets often change quickly, and if you are trading the amounts needed to make profits, there is more of your money put at risk. For arbitrage to be most successful, an understanding of the differences between bid and ask prices is a must. The bid price is the amount that the trader is willing to purchase a currency for and the ask is the amount that a trader is willing to part with a currency for. These differences are important because arbitrage usually involves exploiting the tiny differences between the bid and the ask. For example, if the Japanese yen has a bid / ask spread exchange rate of 104.45 / 104.50, one trader is willing to purchase the yen for 104.45 yen for each U.S. dollar, and another is willing to sell it for 104.50 yen per dollar. By taking advantage of this slight discrepancy, the astute trader can make a profit off of this seemingly minute difference.
