Triangular Arbitrage Advantage
Triangular arbitrage is a profit that occurs when a quoted exchange rate does not equal the market's cross exchange rate. Triangular arbitrage exploits an inefficiency in the market where one market is overvalued and the another is undervalued. Price differences between exchange rates are only fractions of a cent, and in order for this form of arbitrage to be profitable, a trader must trade a large amount of capital. There may be some opportunities available on forex ECNs, however, this remains a game of the quickest so latency and colocation play a large part in determining who profits from triangular arbitrage opportunities. You will need a low spread broker with a fast execution.
Why Three Currencies?
We could not possibly arbitrage successfully with only two currencies and make an instant profit by simply converting dollars to yen, and then immediately converting yen back to dollars. In fact, you would lose some money due to the exchange making their dime on the bid-ask spread. Since two currencies would only get you back to where you were (minus the spread), there needs to be a third currency for arbitrage to work successfully.
When is Arbitrage Possible?
Arbitrage is possible when three currencies are mispriced in relation to each other. A mispricing that allows for a quick profit, by simply converting an amount of cash three times, is a rare opportunity that arbitrageurs are always looking for. A mispricing might only last for 1 or 2 seconds, so traders have to be extremely quick to execute the transaction. Research has also shown that opportunities exist more during the part of the business day when markets are more liquid. An example of a time like this is when both foreign exchange traders from Europe and Asia are very active.
Assume that the trader spots an arbitrage opportunity in EURUSD and finds that yen crosses offer the best opportunity. The mechanical implementation of the strategy would follow this approximate process:
- Buy 100,000 EURUSD at market
- Confirm execution of the EURUSD order at or near the requested price.
- If the order receives poor execution that is worse than the synthetic currency pair or will make the trade too expensive, then close the trade and look for a new opportunity. The cost is the spread and whatever commission was paid.
- If the order receives reasonable execution, continue.
- Choose half of the synthetic leg to fulfill. The order does not matter. If it the EURJPY is the first order to use, then the task is very easy. The EURUSD and EURJPY pairs both use the same base currency. The lot sizes on the trades should be identical. Because we bought the EURUSD in the named currency pair, we will need to sell the EURJPY to hedge out the euro component of the trade. The EURJPY sell for 100,000 should be executed at the market.
- The remaining leg of the trade is the USDJPY. Buying EURUSD put us short dollars. In order to hedge the dollars, we need to buy dollars. Thus, we must buy USDJPY. We cannot, however, blindly purchase $100,000. Although we bought €100,000, that trade put us short $128,200. The unit size should be a purchase of $128,000 against the yen. The extra $200 is rounded to off due to position sizing restrictions in the forex market. We are forced to accept the risk on the $200 position
- The entire trade has now executed. The exit will occur when the opportunity reverses itself so that the bid is now below the ask, as you would expect in a market. Exit all open trades at the market.
- No risk the market goes against your position;
- No risk During markets events like news or gaps;
- No Stoploss or Take Profit sent to the broker.
- Frist Triangular Pair (eg. EURUSD, GBPUSD)
- Second Triangular Pair (eg. GBPUSD, USDJPY)
- Cross Triangular Pair (eg. EURGBP, EURJPY, GBPJPY )
- HiFPI - (High Fraction Product Inefficiency Hedge) The higher this number the fewer trades you will see.
- LoFPI - (Low Fraction Product Inefficiency Hedge) The Lower this number the fewer trades you will see.
- Profit in pips - Take Profit in pips
- Stop loss in pips - Stop Loss In pips
- Lot Size - Contract size
- Max Spread to trade
Enjoy the expert