Triangular Arbitrage: The Ultimate Guide

Arbitrage is a method of trading that takes advantage of discrepancies in the price or the information of an asset. Inefficiencies in the market cause these discrepancies.

Triangular Arbitrage strategies include buying and selling investments on two different exchanges and taking advantage of price differences - just one form of neutral market strategy.

Buying and selling similar assets at different prices simultaneously at arbitrage is a potential opportunity in the financial markets.

An arbitrageur will buy more affordable assets at a discounted price at the same time and sell more expensive assets for a profit. The practice of arbitrage is theoretically riskless and does not require any capital. However, the reality is that arbitrage strategy generally involves both capital and risk.

Triangular arbitrage: what is it?

This strategy, also called three-point and cross-currency arbitrage, offers improved chances than negative spreads.

It involves trading three or more various currencies, which increases the possibility of profiting from the market inefficiencies.

A trader using this trading strategy can look for different situations in which a particular currency is overvalued compared to one currency. But it is undervalued in comparison to other currencies.

During the trading hours, triangular arbitrage opportunities are witnessed 6% of the time.

Euro/USD, dollar/GBP, and euro/GBP are arbitrage currencies commonly traded. The combination of any of the three actively traded pairs can be used.

To fully implement a triangular arbitrage strategy with the three currencies, the following mentioned steps must be followed:

1. By identifying three currency pairs for triangular arbitrage,

2. Determine the implied cross rate 

3. The second currency should be traded if the rates from step 2 differ

4. A second currency is then exchanged for a third. Due to the imbalance in the rates between the three pairs at this stage, the trader can lock in a no-risk profit,

5. A third currency is converted back into the first currency to profit.

Basics of triangular arbitrage

Triangular arbitrage offers risk-free benefits whenever the quoted exchange rates are different from the market cross rates. Or, to put it another way, foreign exchange markets are inefficient. In this way, one market may have an overvalued exchange rate and another undervalued.

International banks, for instance, profit from these inefficiencies by participating in the foreign exchange market.

Exchange rates differ by a very small amount. Therefore, for this arbitrage to be feasible, large transactions are needed.

Margins are often used to increase returns on transactions. However, traders should also understand transaction fees. Traders should be completely aware of the endless possibility of higher transaction costs.

A wide range of players in the forex market competes intensely. Market competition is constantly improving market efficiency. This makes arbitrage opportunities short-lived.

Also, cryptocurrency trading makes use of triangular arbitrage. Even though cryptocurrency exchanges and markets are still in the early development stages, they offer a greater arbitrage opportunity than traditional currency markets.

A triangular arbitrage strategy can generate good profit in a fraction of a second. So let's take a closer look.

How does triangular arbitrage work?

Arbitrage trading works because financial markets are inherently inefficient. Markets are driven primarily by supply and demand, and a change in either can affect the price of an asset.

Traders engaging in arbitrage seek to take advantage of the momentary market hiccups. In this way, they attempt to spot price changes when different supply and demand levels are present on different exchanges.

An investor could profit quickly and with little risk as a result. Moreover, as part of the arbitrage trading strategy, traders can even use automated trading systems to their benefit.

In automated trading systems, algorithms are used to spot price discrepancies, allowing traders to take advantage of market exploits before they become widely known and the market adjusts.

Triangular arbitrage example

Take the following Triangular Arbitrage Examples: Suppose you have $1 million, and the following exchange rates are provided to you: EUR/USD is 1.1586, EUR/GBP is 1.4600, and USD/GBP is 1.6939.

An arbitrage opportunity exists at the below-mentioned exchange rates:

To buy euros with dollars, multiply $1 million by 1.1586 = €863,110

In pounds, we sell 863,100 euros for 591,171 pounds

Convert pounds to dollars: £591,171 x 1.6939 = $1,001,384

Calculate the final amount by subtracting the initial investment: $1,001,384 - $1,000,000 = $1,384

The arbitrage profit on these transactions is around $1,384 (assuming no transaction costs or taxes).

Quick overview on different types of arbitrage

1. Statistical arbitrage

The process of statistical arbitrage involves analyzing statistics about asset performance and taking note of deviations from those expectations. It is common practice to find a high correlation between assets, which is often seen in pairs trading.

A briefly exploitable opportunity may exist when Ford and General Motors' share prices move together but suddenly diverge. As long as they typically move together, they will likely come again in the future. The model assumes mean reversion.

Shorting the up-moving stock and buying the one that moves down is called statistical arbitrage. To be independent, the stocks should be moving in opposite directions. This way, the trader does not position himself to profit from a convergence of the prices but rather profit if they converge.

Also, West Texas Crude and Brent Crude are popular commodity products that tend to move together. As they are priced differently, an opportunity for statistical arbitrage may arise if the typical spread narrows or expands between them. 

2. Triangular arbitrage

A triangle arbitrage is often used in the forex market when a price discrepancy between three related currency exchange rates.

Arbitrage in the form of triangles involves the exchange of an initial for a first currency, exchanging the first currency for a second currency, and converting the second currency back to the initial currency. Arbitrage occurs when these transactions create profit opportunities.

In general, the profit potential is modest, although if the currency is traded less often or there is high volatility, the profit potential can be greater.

For example, if the EUR/USD bid value is 1.0847 and the GBP/USD bid value is 1.4808, the EUR/GBP bid rate would be 0.7325. Profits are possible if the prices are different, especially if they are different by more than a few pips.

3. Retail arbitrage

Arbitrage in the retail market occurs more outside of the financial markets. For example, to exploit a mismatch in different markets, a widget can be bought at Walmart for $5 and sold on Amazon or eBay for $6; retail arbitrage.

Here are some real-world examples of arbitrage. Consider a street where all houses have similar features and are priced similarly. However, one house is substantially cheaper than the others.

Homeowners may purchase the house before long, and the mispriced asset will be removed. Then, someone can buy the property at a low price to resell it higher to profit.

Arbitrage in retail can be fully done in different ways and in many markets.

4. Simple Arbitrage

In simple arbitrage, one asset is bought and sold simultaneously on two different exchanges. Because the transactions are executed simultaneously, traders may assume very little risk compared to retail arbitrage.

Imagine, for instance, a company that trades on multiple stock exchanges. Arbitrage involves buying the stock at the lower price on one exchange and selling it at the higher price on the other exchange if the stock is trading at different prices on the different exchanges.

5. Merger Arbitrage

Mergers and acquisitions of publicly-traded companies constitute a riskier arbitrage strategy. Merger arbitrage involves buying a company's stock targeted for a takeover and selling it after the deal closes.

Unlike other forms of arbitrage, merger arbitrage does not immediately reveal price discrepancies. As a result, a risk-free profit isn't guaranteed, but traders are betting that one might occur.

Arbitrage in mergers involves locking up your money for a longer period as well as taking on the risk that the merger won't materialize or your shares won't be resold for the price you hoped for.

Triangular arbitrage in forex markets

A mismatch in the exchange rates among three foreign currencies leads to an imbalance between them. Triangular arbitrage occurs as a result of that imbalance. These opportunities are rare.

The most common traders who take advantage of these opportunities are those with advanced computer equipment or software. Trading involves converting an amount at one rate (EUR/GBP) and then converting it at another rate (EUR/USD).

Assume low transaction costs as a net profit and then transfigure the result back to its original (USD/GBP).

To finish a triangular arbitrage system involving three currencies, the following steps are necessary:

1. Understanding the triangular arbitrage opportunity that involves three currency pairs.

2. Differentiate between the cross rate and the inferred cross rate.

3. In case a difference between stage 2 and stage 3 is available. At that point, a subsequent currency is traded.

4. Then you have to trade the second currency for the third. Traders can take advantage of this stage to achieve a no-chance benefit. A discrepancy exists between the three currency pairs.

5. For a benefit, change the third currency back into the underlying currency.

Triangular arbitrage in cryptocurrency trading

Crypto arbitrage is a method for making money by exploiting different asset prices between different markets. Hence, it is achieved by simply purchasing digital currencies at a lower price on one exchange. Then, later on, the trader will be selling them quickly on yet another exchange at a high price.

If Bitcoin (BTC) is quite a lot more expensive on X than By bit, you can choose to buy Bitcoin on By bit and sell it on the X exchange and can profit from the difference in its price.

Typically, these crypto arbitrage traders (arbitrageurs) will take advantage of price differences between two or more exchanges for the same asset.

To earn the difference as soon as possible, it is crucial to trade them! Most of the time, price differences are caused by trading volumes which cause a shift in the demand and supply levels.

Additionally, it is generally less risky to invest in crypto arbitrage but lower returns. Cryptocurrencies are tricky to trade because it is difficult to comprehend how they work fully and maximize returns by applying them strategically.

How can you profit from crypto arbitrage?

To profit from crypto arbitrage, traders carefully prepare their trading strategy and consider various factors, such as trading fees, the volume of transactions, and the time needed to execute the trades. In addition, arbitrageurs always employ a hedging strategy.

It is possible to make money through cryptocurrency arbitrage when the markets differ and present anomalies. Then, through making small profits over time, a trader can make significant profits.

Before investing in cryptocurrencies, it is crucial to develop an investment strategy. Trading crypto arbitrage can be profitable if traders have the right tools, strategies, and knowledge.

Arbitrage calculators: their importance

Now let's talk about how to calculate triangular arbitrage! Arb calculators calculate the theoretical price based on a range of other inputs and the amount you need to bet to guarantee profit from a trade.

In a triangular arbitrage calculator, for example, the fair price of the third currency pair is calculated by comparing the prices of two currency pairs. Traders can decide whether this is a tradable arbitrage opportunity when the real market price differs from the quote.

Traders are cautioned to understand the math behind the calculation, even if an arbitrage calculator is likely to be complicated.

For example, if the calculator rounds, this could result in fewer arbitrages or more. You should, therefore, double-check the math before relying on the calculations of third parties.

Pros

1. The risk of investing long-term is not involved in this transaction because we purchase and sell an asset simultaneously.

2. Thrives in volatile markets - Arbitrage trading offers a means of trading volatile markets without taking a big risk.

3. Independent of the market direction - You can even make money regardless of the certain market direction. On the other hand, you will find more arbitrage opportunities during robust bull markets. Due to this, traders are more inclined to ride the Bull Run than arbitrage.

Cons

1. Exchanges make money from transaction fees imposed on traders. A swing trader may not notice the transaction fees, but they can hurt an arbitrageur and reduce his profits.

2. It's hard to predict how exchanges and cryptocurrencies will behave at high volumes. Transaction times and costs are also a concern. Your money might also disappear if an exchange closes.

3. If we achieve excellence in crypto arbitrage, we must use the latest technology to execute trades quickly enough for us to profit.

4. A crypto mispricing should be high enough for you to still be profitable after costs, considering the market's transaction fees, costs, and stability.

Is Triangular Arbitrage always risk-free?

Triangular arbitrage opportunities do not guarantee success for currency mispricing strategies. However, triangular arbitrage transactions can be carried out extremely quickly using the electronic trading platform.

Additionally, it takes time for the trader to be notified of the mispricing after finding a suitable option, entering transactions, and paying. Therefore, a fraction of a second delay is considered important, even if only a few seconds.

The triangular transaction cannot be completed if each trading order is a limit order to be filled at the arbitrage price. And thus, the price shifts due to certain market conditions or because any third party offers a completely different price.

Traders will be charged the same amount for closing a trade when the price moves destroy the arbitrage condition.

The foreign exchange market is a competitive market, where a trader needs to uncover arbitrage opportunities quicker and more efficiently than competitors to be profitable.

In this electronic trading arms race, arbitrageurs are expected to keep improving their execution speeds to outperform other arbitrageurs. However, the expenses of staying ahead in this competition make it difficult to outperform the rest of the arbitrageurs continually over time.

FAQs

1. What is the profitability of triangular arbitrage?

A "riskless" profit could be made through this type of arbitrage if quoted currency exchange rates are not equal to market cross-trade rates. As a result, if two currencies are also trading against a third currency, the exchange rates should be synchronized; otherwise, a profit possibility exists.

2. Can triangular arbitrage be achieved in crypto?

Many markets and currency options are available on most exchanges, so there are many opportunities for triangular arbitrage. For example, ETH can be exchanged for BTC, LTC for ETH, and back to BTC again. A substantial difference would have resulted in a profit.

3. How can triangular arbitrage be identified?

Determine the cross rate and implied cross rate of three currency pairs to identify a triangular arbitrage opportunity.

4. Can arbitrage be illegal?

The United States allows arbitration trading and encourages it to contribute to market efficiency. Arbitrageurs are also useful as intermediaries in different markets, providing liquidity.

5. How legal is bitcoin arbitrage?

Crypto arbitrage is the only legal way to exploit price differences between markets.

Conclusion

Arbitrage is the practice of taking advantage of differences in pricing or inefficiencies within financial markets, such as forex, commodities, and shares, to profit from that.

Arbitrage is valuable for traders because it allows them to profit from mispricings that drive markets back to equilibrium.

The strategy can provide a low-risk investment option, but it does have some risks, as do all strategies.