ADVERTISEMENT



Forex Triangular Arbitrage Strategy

triangular arbitrageTriangular arbitrage also referred to as cross currency arbitrage or a three point arbitrage is one of the Forex strategies that elude the understanding of most Forex traders.

To have an understanding of the triangular arbitrage strategy as applied in Forex trading; it is important to first look at the meaning of arbitrage. An arbitrage opportunity arises when one can buy and sell related assets simultaneously usually selling expensive assets and buying cheap assets at the same time to realize a profit.

Arbitrage in Forex trading is mainly practiced in an attempt to take advantage of different price discrepancies that may arise in the market. Such discrepancies are very short term as the imbalance is corrected by the actions of the arbitrageurs themselves.

An example of arbitrage opportunity utilized widely in Forex trading and other financial markets are arbitrage between the same or related instrument traded in different brokers or exchanges. A discrepancy in the quotes provided by the brokers or exchanges present an arbitrage opportunity where the trader may buy from the cheaper exchange feed and sell the same instrument in the expensive exchange feed.


Triangular arbitrage

Triangular arbitrage in the Forex market involves three or more currencies. The trader has to look for an opportunity where one currency is overvalued compared to a second currency but undervalued when compared to a third currency.

Most commonly, traders will identify triangular arbitrage opportunity based on three currency pairs. Such an opportunity involves a base currency and two other counter currencies. The following equation is used;

A/B x B/C x CA = 1; where A represents the base currency, while B and C represent the counter currencies.

A triangular arbitrage opportunity occurs when the above equation is not equal to 1 implying that one market is undervalued while the other is overvalued. Before looking at an arbitrage example; let’s first understand what it means to buy or sell a particular currency pair;

  1. Buy EURUSD; this means you are buying euros and selling dollars (selling dollars for euros/Buy currency B using currency A).
  2. Sell EURGBP; this means you are buying the pound and selling euros (selling euros for pounds/ Buy currency C using currency B).
  3. Sell GBPUSD; this means you are buying the dollar and selling pounds (selling pounds for dollars/Buy currency C using currency A).

In the above transactions;

  • The sale of dollars in transaction one is balanced buy the purchase of dollars in transaction three. The purchase of euros in transaction one is balanced by the sale of euros in transaction two.
  • The purchase of pounds in transaction two is balanced by the sale of pounds in transaction three.

triangular arbitrage2

Hence, to implement a triangular arbitrage trade given there are exchange rate discrepancies found using the previously discussed equation (A/B x B/C x CA = 1); we first exchange the base currency for the second currency. After this; the second currency is traded for the third.

Based on the imbalance in the rates between three pairs; a riskless profit (excluding transaction costs) is locked in. The profit is realized by trading the third currency back to the initial base currency.

Below is an example of a triangular arbitrage transaction;

Assuming $1 million in trading capital; and the exchange rates; EURUSD = 0.8621, EURGBP = 1.4610 and USDGBP = 1.6942;

Leg1; Buy EURUSD (sell dollars, buy euros); $1 million x 0.8621 = 862, 100 euros

Leg 2; Sell EURGBP (sell euros, buy pounds); 862, 100 euros / 1.4600 = 590, 474.45 pounds

Leg 3; Sell GBPUSD (sell pounds, buy back dollars); 590, 474.45 pounds x 1.6942 =
$1, 000, 381.81

Realizing the profit; subtracting the invested $1 million from the final figure gives a profit of $381.81. This is the arbitrage profit having not subtracted transaction costs.


Disadvantages of Triangular Arbitrage in Forex Trading;

  • Triangular arbitrage opportunities in the Forex market are very rare and may require constant monitoring using an automated program or software.
  • The triangular arbitrage trading strategy is not entirely riskless and faces various risks including execution risks where the broker may delay or not fill one or more legs of the arbitrage. In the Forex market; such delays would lead to failure of the strategy since market movements are relatively rapid compared to other instruments.
  • Executing the triangular arbitrage strategy will often require sophisticated and advanced equipment or programs to automate. Such infrastructure is not available or may be too expensive for the ordinary retail Forex trader.
  • Transaction costs will often reduce profits generated from the triangular arbitrage strategy or even make it a negative expectancy strategy overall. Triangular arbitrage opportunities in the Forex market may often occur during high impact market events when trading costs such as spreads and slippage are high.
  • Discrepancies in exchange rates that lead to triangular arbitrage opportunities often happen in fractions of cents. For this reason; traders executing this strategy will be forced to use huge lot sizes so as to realize a reasonable profit. This also means that the strategy is only reasonably profitable to traders with deep pockets.
  • Most Forex brokers will not allow triangular arbitrage strategies (and arbitrage strategies in general). In the case of triangular arbitrage; the trader’s profit comes directly from the broker’s pockets (or liquidity provider in case of non-dealing brokers) and hence most will not allow such a strategy. Most traders will attempt to hide triangular arbitrage strategies from their brokers by using different brokers for the different transaction legs in the arbitrage.
  • A triangular arbitrage strategy requires high connection speeds on the trader’s end as well high execution speeds from the broker. In most cases; these two are not available to most retail Forex traders.

Advantages of Triangular Arbitrage Strategy;

  • Triangular arbitrage allows traders to earn during price discrepancies or unstable markets.
  • When well implemented, the triangular arbitrage strategy carries relatively low risk compared to other trading strategies.

Conclusion;

Given the very few triangular arbitrage opportunities that occur in the Forex market, traders willing to use this strategy should combine it with other strategies that present more profit opportunities. They should also understand the inherent risks and barriers associated with the triangular arbitrage strategy.

Read 919 times

Comments (0)

Rated 0 out of 5 based on 0 voters
There are no comments posted here yet

ADVERTISEMENT

ADVERTISEMENT

ADVERTISEMENT

ADVERTISEMENT

ADVERTISEMENT

Newsletter Subscription Form

You are more than welcome to subscribe to our Newsletter and be among the first who get to hear about regular updates on forex and other related news, brokers' updates, websites' changes and more!
I agree with the Terms and conditions and the Privacy policy
Thank you!