Triangular arbitrage in forex trading guidelines

Triangular forex arbitrage is a technique adopted by a lot of traders to profit from price differences for three different currencies in different markets. In general, arbitrage occurs when you buy or sell security such as bonds, stocks, currencies, shares, commodities, etc, in different markets to earn from the mismatch in the price of the underlying instrument. The investors who do that are called arbitrageurs. They always look for price differences and buy a security at a lower price and sell it at a higher price. This allows them to gain money with no risk. In this course, we will shed the light on the triangular arbitrage, and give you all you need to know about this forex strategy. 

Triangular Arbitrage guide

What is triangular arbitrage ?

Triangular arbitrage is a trading strategy that represents taking opportunities from the discrepancy between three foreign currencies in the foreign exchange market ( forex ) . The triangular arbitrage happens when the market is inefficient and differential in supply or demand which leads to a mismatch between prices. This process executes through the successive exchange of one currency to another when there is a difference in the quoted prices for the underlying currencies. This means that the forex investor has to convert one currency to another, then convert it again to another currency, and after that convert it back to the original currency. This process takes only seconds. Moreover, you take advantage of this opportunity when the exchange rate of a currency is different from the cross-exchange rate. This arises when one market is overvalued and the other is undervalued.

How does the triangular arbitrage work ?

The triangular arbitrage occurs when one market is overvalued and the other is undervalued. This inefficiency leads to discrepancies in prices. In this case, participants in the foreign exchange market ( forex ) , such as international banks, will exploit this opportunity to generate profits. However, the price difference between the exchange rates is very small (fractions of cent). So you have to trade a considerable volume of transactions to get a feasible arbitrage. In fact, triangular arbitrage is a risk-free benefit. This means that you can generate money from the arbitrage without exposure to any risk. The investor makes 3 simultaneous trades, he/she buys one currency and sells another, and the base currency is the third one.

Example

let’s take an example to understand how this process works. Say that a trader has 2 million and he finds the following exchange rates in the market: EUR/ USD = 0.8820, EUR / GBP = 1.3360, USD / GBP = 1.5162

cross-rate = 0.8812 × 1.5162 = 1.3361

You have to Sell $ for € and at the same time sell € for £, then sell £ for $. Here are the steps you must follow for the triangular arbitrage: 

  1. Sell $ for €: $ 2 million × 0.8820 = 1 764 000
  2. Sell € for £: 1 764 000 / 1.3360 = 1 320 359.28
  3. Sell £ for $: 1 320 359.28 × 1.5162 = 2 001 928.74

The profit gained from this triangular arbitrage will be 2 064 631.9 – 2 000 000 = 1 928.74. we can conclude from this calculation that even with the use of a large capital you gain a small profit. this is due to the small price discrepancy. in the real life, the profit would be smaller, since in this example we did not consider the transaction costs.

Triangular arbitrage

How to use triangular arbitrage ?

Triangular arbitrage is a riskless trading strategy. In which traders gain from the mismatch between the quoted exchange rate and the market cross rates. This trading strategy involves a large initial amount, this is because the price discrepancy is very small. So to earn significant profit you would invest a large amount of money. Moreover, the arbitrage crypto opportunity disappears quickly. Because the market discrepancy tends to adjust fast.

A lot of traders compete for this opportunity in the foreign exchange market. So to make advantage of the triangular arbitrage you have to discover it earlier and more efficiently than competitors. Therefore, to do that you can use automated trading platforms based on algorithms.

How to use arbitrage trading with automated trading platforms?

The automated trading platforms have simplified the execution of the trades. These platforms involve an algorithm in which trades execute automatically when particular criteria are met. Moreover, they enable traders to put rules for entering and exiting a trade. Then the computer will automatically execute the trade based on the rules put in the algorithm. But trades happen rapidly that the arbitrage opportunities vanish seconds after appearing. This is because the market is a self-correcting entity, it moves fast and automatically. That is why traders will employ automated trading platforms to identify opportunities and exploit them before they disappear.

Triangular arbitrage in forex trading

Triangular arbitrage rarely appears in the forex trading. Because of the nature of the foreign exchange market. However, the market is quite competitive as there is a large number of participants (individual and institutional traders). Therefore, the competition between participants always corrects the discrepancy in the market which is why the arbitrage opportunity does not last long. Nowadays, these opportunities are generally caught by high-frequency forex traders. Therefore, employing high-speed algorithms help forex traders quickly identify the mispricing and instantly do the necessary trades. The strong existence of high-frequency traders pushes the market more efficiently. Which reduces the number of potential arbitrage opportunities.

Conclusion

Triangular arbitrage is an opportunity that appears in the foreign exchange market due to the discrepancy between three foreign currencies. It is a useful strategy that allows traders to generate profits from the mismatch between the quoted exchange rate and the market cross rates. However, triangular arbitrage is a risk free forex trading strategy. In the real world, the triangular arbitrage chances are rare and do not last long, as there is strong competition between players in the market. So to identify this opportunity you have to use automated trading platforms which work with a high-speed algorithm. These automated platforms help traders exploit the triangular arbitrage at a convenient time before they disappear.