An arbitrage trader buys assets at lower rates and sells them at higher rates to profit without any net cash flow. In theory, there is no cash and risk involved in arbitrage trading. But in practice, there is the involvement of capital and risk.
The most common and famous currency pairs in the arbitrage strategy are EUR/USD, EUR/GBP, and USD/GBP.
Arbitrage: Meaning
Arbitrage is the method of taking benefit out of price imbalance between two or more markets. The trader is often called an arbitrageur, and he uses the imbalance in his favor by making frequent deals in different markets.
Arbitrage Example
Suppose an iPhone is selling for $500 in the US and for Rs. 1,00,000 in India.
So, current exchange rate 1USD = Rs. 75By simple calculations you know that an iPhone is expensive in India since Rs 1,00,000 = $1334, which is more than $500. With t such mispricing, a person can take advantage of this situation by using the following strategy:
- Purchase an iPhone in the US for $500.
- Sell it in India for INR 100,000.
- Convert INR 100,000 into $1334.
This simple technique will help you get an arbitrage profit of $1334 - $500 = $834 per iPhone.
If we follow this strategy for 100 iPhones, the profit would be a whopping 100 x $834 = $83,400.
About Triangular Arbitrage Trading Strategy
Triangular arbitrage is the difference between the negative spread strategies, which offers better chances. Arbitrage is making a profit from the price difference between two or more than two markets. So, you buy at low rates and sell at high rates.
Fun Fact: Other names of triangular arbitrage are cross-currency arbitrage and three-point arbitrage.
How Triangular Arbitrage Strategy Works?
As the name shows, in a triangular arbitrage FOREX trading strategy, the trader trades on three or more than three different currencies. In this trading strategy, the investors hunt for a particular currency that is overvalued in comparison with another currency but undervalued in comparison with the third currency.
Triangular Arbitrage Strategy: Pros
- No Effect of Unstable Market Triangular arbitrage forex trading strategy allows investors to earn profit even in unstable markets or price discrepancies.
- Low Risk When a triangular arbitrage trading strategy is implemented well, it carries out comparatively low risk relative to other trading strategies.
- No Open Currency It allows traders to make profits with no exposure to any open currency.
Triangular Arbitrage Strategy: Cons
- Monitoring Required In the FOREX market, triangular arbitrage is very rare; that’s why there is a requirement for continuous monitoring.
- Extra Cost High transaction cost and commission often reduce the profit, and sometimes it causes loss. Most of the brokers do not offer triangular arbitrage strategies.
- Requires Advance Tools In the execution of triangular arbitrage, there is a requirement for some advanced and sophisticated programs or tools to automate. This type of infrastructure is too expensive and mostly not available to the ordinary retail Forex trader.
Step-by-Step Guide to Triangular Arbitrage Strategy
- Spot a triangular arbitrage indication, including three currency pairs.
- Spot the implied cross rate and cross rate.
- If there is a difference in the rates in step 2 is available, then trade the main currency for the second currency.
- After this, trade the second currency for the third currency. At this point, the investor is capable of locking in a no-risk profit.
- Change the third currency back to the base currency to make a profit.
Example: USD/EUR/YEN
- First Step Suppose the currency rate for
- USD/EUR is 6,
- USD/YEN is 3,
- EUR/YEN is 2.
The first thing is to find out the cross rate. The cross rate is the exchange rate between two currencies using USD as a reference. - Second Step Here, we can understand that 1¥ gives you 0.5€, and the actual rate is 1¥ is equal to 2€. So, that tells the yen is strong. Now you need to go to the second pair and convert your 600 dollars in yen. So you got 200¥.
Now, as you got yen, you went to the third pair to convert your 200¥ in Euros. So, you converted it in Euros and got €400. - Third Step Now your base currency was in dollars, so you need to convert it in dollars, so further you went to pair one and converted your Euros with dollars and what you got is $2400. Now minus your $600 as you invested it in the initial stage.
The remaining amount is $1800, which is your pure profit.
PS: Reread it to understand it better.
Should you use a Triangular Arbitrage Strategy?
The strategy requires a highly analytical mind and impromptu skills. You should have constant monitoring and the ability to process data with quick reactions & executions. Therefore, this becomes a little difficult with manual trading tools & brokers. Thus, ensure trading with a technically advanced broker.
Note that the strategy is helpful for a short period only, and one must be able to spot opportunities quickly or lose the deal.
SummaryThese opportunities are there for a concise time in the market. In order to get an effective profit, a trader needs to find these opportunities fast and react quickly according to the situation. In theories, it looks so easy and mouth-watering but in real life, to perform a triangular arbitrage is so tricky.
