Triangular Arbitrage: How To Trade In Three Currencies
If you are new to trading, understanding the concept of arbitraging will help you solve many riddles.
Arbitraging is a method adopted by many traders to earn profit from price differences for the same underlying in different markets. Arbitraging can take many forms, and it is more commonplace in the forex market or foreign currency market than in the security market. Triangular arbitraging involves trading in three currencies simultaneously. Traders try to take advantage of price discrepancies between three foreign currencies, to bag a profit.
In the currency market, the most common is two-point or two-currency arbitraging, when one currency is sold/bought against the other. It occurs when the seller asks for a selling price that is lower than the buyer’s expectation, creating a negative spread. It is more like a hypothetical condition than happening in reality – occurring in a market with high volatility and low volume.
In triangular arbitraging, the trader will place three simultaneous trades, buying one currency and selling another, using a third currency as the base currency. How does it happen? The arbitrage opportunity arises when there are discrepancies between the exchange rate and the quoted cross-exchange rate. The situation can occur when a specific currency is overvalued against one currency but undervalued against the other. One of the most commonly traded triangular arbitraging combinations is EUR/USD, USD/GBP, and EUR/GBP, but the opportunity may arise for any combination.
Understanding the situation with the help of an example might help.
Let’s say, on a particular date, EUR/USD is trading at a rate of 0.8667.
The exchange rate between USD/GBP is 1.5027
And, EUR/GBP for 1.3020
In the above scenario, the Euro is undervalued against the Pound, creating an opportunity for arbitraging.
You can calculate the cross-currency rate = 0.8667x 1.5027 or 1.3024
To initiate a triangular arbitraging spread, the trader must undertake the following actions.
Sell dollars for euros, while simultaneously selling euros for ponds. And to complete the final leg, sell pounds for dollars. Here is how it takes place.
Selling dollars for euros $1000,000 x 0.8667= € 8,66,700
Selling euros for pounds € 8,66,700 x 1.3020 = £11,28,443
Selling pounds for dollars £11,28,443 x 1.5027= $16,95,711
The process of orchestrating a triangular arbitrate involves several steps.
– Identifying a triangular arbitraging opportunity – it occurs when the quoted exchange rate doesn’t match the cross-currency exchange rate
– Calculating the difference between the cross-rate and implied cross-rate
– If a difference is present at the prices calculated in the step above, then trade the base currency for the other currency
– The next step involves trading the second currency for a third
– In the final step, the trader converts the third currency back into the initial currency, and after calculating the costs involved in trading, earns a net profit
Considering The Risks Factors
Triangular arbitraging is a risk-less trading opportunity, where the trader gains from marginal differences in asset price. But there are certain inherent risks involved.
Triangular arbitraging involves significant initial investment, mainly because the price difference between the currencies is usually narrow. To earn a substantial profit, you would need to trade in large volumes. Using margin will increasing your risk manifold.
Next, these opportunities disappear as soon as they occur- lasting from a few milliseconds to a few seconds. The currency market discrepancies tend to adjust quite fast. Because of this, anyone who wants to adopt arbitrage trading would need an algorithm-based automated trading platform.
Arbitraging is a small window of opportunity that arises due to market inefficiency. Under an ideal situation, where prices are discoverable, arbitraging opportunities shouldn’t occur. Even then, triangular arbitraging prospects are rarer. To identify a triangular arbitraging opportunity, you will need advanced automated trading software. This software will initiate a trade when specific criteria are met.
Due to relatively low risk, triangular arbitraging is an efficient way to earn a profit when the market conditions allow.