Riskless profits isn’t something that comes up frequently when talking about investing and trading. But there is a rare market event that gives you the opportunity to create profit with very little risk exposure.
Triangular arbitrage happens when three currencies have price discrepancies among them. By trading one currency for another, and then a third currency, these differences can be amplified and multiplied into significant returns.
But what is the triangular arbitrage strategy, how does it work, and how do traders like you use it to increase their wealth with very little risk?
This article will help you understand this beneficial market phenomenon and how to use them to create a great return.
An introduction to triangular arbitrage
If you are wondering about the efficacy of the triangular arbitrage trading strategy (even when trading Cryptos), international banks often seek and use triangular arbitrage opportunities. If we know anything about banks it’s that they are extremely risk averse, only choosing a trading strategy which can create the biggest return with the lowest amount of market exposure.
Which is the point for triangular arbitrage, but how does it work?
When three currency exchange rates have a price difference – you trade the first currency for the second currency, and the second for the third and finally, the third currency pair for the first.
Although the concept seems simple, the execution speed needed to capture triangular arbitrage opportunities is break-neck.
But where there’s a will there’s a way. Keep reading to find out how big banks recognise and take advantage of this trading strategy.
Understanding the basics of arbitrage
As stated above, the mechanics of seizing the triangular arbitrage opportunity are simple in concept.
But it requires the trader to be aware of three currencies or more at the same time, and being able to recognise the slight rate disparity between different markets.
How do you do that?
Fundamentals of arbitrage
Although it seems like a very technical word, arbitrage simply means the buying and selling of assets, to take advantage of the price differences between two or three currency pairs.
The nuts and bolts of arbitrage can be a bit more technical though – and most obvious when talking about company Shares.
As you might already be aware, some companies offer their Stocks on multiple exchanges and these exchanges have different communication protocols that may cause a delay in the updating of a price.
So let’s take Sony as an example of simple arbitrage, and for two reasons – one it is traded both on the NYSE and NIKKEI, and is denominated in USD on the New York Stock Exchange, and JPY on the Tokyo Stock Exchange.
Say when the market opens the NIKKEI price on Sony is slightly lower than the NYSE, you would place a large long trade (buy) on Sony (listed on the NIKKEI) and place a short trade (sell) the same amount on the NYSE.
When the price is finally updated, you’ll be able to exit your trades and profit.
In Forex trading or Cryptocurrency trading (since this is also a type of currency market), assets are currency pairs, like BTC/USD for example.
If you notice that the rate of USD is different in BTC/USD, XRP/USD and let’s say ADA/USD, you can take advantage of that difference, by buying or selling the three pairs depending on the disparity.
Special features of triangular arbitrage
There are multiple types of arbitrage.
Simple arbitrage, which is simply done by taking advantage of the price discrepancies between two currencies or assets on two markets. You buy one currency pair and sell the other.
Cross-border arbitrage, which as the name implies, involves buying and selling across international borders – like the example above with Sony Shares.
Peer-to-Peer Arbitrage, is especially applicable to Cryptos since they are a peer-to-peer type of currency. This happens when a seller is selling their Crypto at a lower price, which the trader buys and sells immediately.
Finally, the type of arbitrage opportunity we have been speaking about since the beginning of this article – triangular arbitrage.
How triangular arbitrage works in the Crypto world
In the Crypto world, triangular arbitrage opportunities may present themselves more frequently, but are much more challenging to capture due to the volatility of the market.
Of course there is a benefit offered to Crypto triangular arbitrage traders that isn’t offered to “traditional market” traders, i.e. the lack of high fees.
The biggest disadvantages of the seizing triangular arbitrage opportunities, are the transaction costs involved. Placing three large trades in quick succession could accrue high fees, cutting into your profits no matter how low risk the trades are.
Let’s use EUR/USD, USD/GBP and EUR/GBP to calculate and see the market inefficiencies.
In this case, you would use this formula to see if an arbitrage opportunity exists: EUR/USD x USD/GBP = USD/USD x EUR/GBP = EUR/GBP.
Under ideal conditions, multiple of the pairs should be equal, and should be equal to the value of the base currency pairs.
Steps to identify arbitrage opportunities
If the values of the formula above do not agree, then you have market inefficiencies.
How to execute a triangular arbitrage strategy
When you see the inefficiency, you would sell the pair if the price is above the relative value or implied value, if the price is below, you buy.
The way FX trading works, you buy one currency while selling the other – so in EUR/USD you buy EUR while selling USD. When you sell USD/GBP you are selling USD while buying GBP.
So, you buy EUR/USD, sell USD/GBP, and then sell back to USD/EUR.
Advantages of using triangular arbitrage
The biggest advantage, especially when on the Crypto market, is the low risk this strategy carries if transaction fees are low or non-existent.
Financial gains and opportunities
This can be a very profitable strategy, but the conditions which allow it to be executed are rare and require the trader to place multiple large trades.
Risk mitigation through triangular arbitrage
The Crypto market is very volatile, by the time you find and see the discrepancy, it might be too late. The worse case scenario is if you actually start to commit the trades as the market turns.
Risks and limitations
As with any strategy, triangular arbitrage included, there are always risks involved no matter how safe and efficient they are.
Slippage risks in triangular arbitrage
Slippage is a significant risk when talking about triangular arbitrage. If the trades aren’t placed at the rate at which the discrepancy happens, then the efficacy of the strategy is completely negated.
Timing as a crucial factor
Timing is another factor that is extremely important when using this strategy.
Understanding liquidity concerns
A lack of liquidity can cause slippage, which in turn can cause the strategy to fail.
Automation in triangular arbitrage
This is the perfect strategy for trading bots, as they can not only help you identify the market inconsistency, but it can also immediately read market conditions – i.e. liquidity – and perform the trades.
This can further minimise the risk involved when using triangular arbitrage to trade. Furthermore, software can identify more opportunities than even the most astute and shrewd trader can.
In fact, most institutional traders prefer to find and take advantage of triangular arbitrage opportunities using automated software.
Final takeaways
Triangular arbitrage can be a very effective strategy when used correctly, but happens infrequently and is contingent on multiple factors.
Automating the process can help make the process much more efficient and effective.
