Understanding the concept of arbitraging is a great way to solve many problems if you're new to trading.
Arbitraging is a trading strategy that allows traders to profit from differences in prices for the same underlying in different markets. Arbitrage can take many forms and is more common in the forex or foreign currency markets than in the security market. Triangular arbitrage involves trading in three currencies at once. To make a profit, traders try to exploit price differences between three currencies.
Arbitraging is a form of currency trading that involves one currency being sold/bought for another. This happens when the seller requests a lower selling price than the buyer expects, creating a negative spread. This is more a hypothetical situation than it is a real one, as it occurs in a volatile market with low volumes and high volatility.
Triangular arbitraging is when a trader places three simultaneous trades. He/she will buy one currency and sell another. The third currency acts as the base currency. How does this happen? Arbitrage opportunities arise when the exchange rate quoted crosses-exchange rate is different. This can happen when one currency is undervalued and another currency is overvalued. The most popular triangular arbitraging combinations are EUR/USD, USD/GBP and EUR/GBP. However, there may be an opportunity for any combination.
An example can help you understand the situation.
Let's assume that EUR/USD trades at 0.8667 on a given date.
The exchange rate USD/GBP is 1.5027
For 1.3020, EUR/GBP
The Euro is undervalued compared to the Pound in the above scenario. This creates an opportunity for arbitraging.
The cross-currency rate can be calculated as 0.8667x 1.5027, or 1.3024
The trader must take the following steps to initiate a triangular arbitraging spread.
You can sell dollars for euros and euros for ponds. To complete the transaction, you can also sell dollars for pounds. This is how it happens.
Selling dollars for euros $1000,000 x 0.8667= EUR 8,66,700
Selling euros for pounds EUR 8,66,700 x 1.3020 = PS11,28,443
Selling pounds for dollars PS11:28,443 x 1.5027= $16,95 7,711
There are several steps involved in the creation of a triangular arbitrate.
- Recognizing a triangular arbitraging possibility - It occurs when the quoted currency exchange rate is not the cross-currency one.
Calculating the difference in cross-rate and implied crosses-rate
If there is a difference between the prices in the previous step, trade the base currency for another currency
- Next, trade the second currency for a new currency
- The trader converts the third currency into the original currency and, after accounting for trading costs, makes a net profit.
Triangular arbitrage is a risk-free trading opportunity that allows traders to profit from small differences in asset prices. However, there are inherent risks.
Triangular arbitrage requires significant initial investment because of the small price differences between currencies. You will need to trade large volumes in order to make a significant profit. Margin will increase your risk exponentially.
These opportunities then disappear as soon they occur, lasting anywhere from a few seconds to a few minutes. Currency market discrepancies can adjust very quickly. Arbitrage trading is possible only if an algorithm-based trading platform is used.
Arbitrage is a window of opportunity created by market inefficiency. Arbitrage opportunities should not occur in an ideal scenario where prices can be found. Triangular arbitraging opportunities are more rare than you might think. Advanced automated trading software is required to identify triangular arbitraging opportunities. When certain criteria are met, this software will initiate trades.
Triangular arbitrage is a cost-effective way to make a profit in a market where there is little risk.