In the world of finance and economics, arbitrage allows traders to take advantage of discrepancies between markets to make a profit. One approach used in this regard is called Delta arbitrage (also known as triangular arbitrage, three-point arbitrage or cross currency arbitrage). The strategy exploits price imbalances that occur among three different currencies resulting in a mismatch. A trader will then use the mismatch or inefficiency to generate profits.
How it Works
Triangular arbitrage basically works in three main stages:
Stage 1: Use currency A to purchase currency B
Stage 2: Use currency B to purchase currency C
Stage 3: Sell currency C to get currency A
For the strategy to work, a trader would need to identify a discrepancy between the implicit exchange rate of a given currency and its actual market cross-exchange rate. Under normal circumstances, the rates of any three currencies should hold to this basic formula A/BxC/A=C/B. Anytime the equation fails to hold true, there is an opportunity to employ this trading approach.
In the real world, a mismatch usually results from situations in which one market is undervalued and another is overvalued. However, such situations are rare and will only occur in form of cents or smaller fractions. Therefore, a trader looking to benefit from this form of arbitrage will need to execute a high capital trade.
Illustrating Delta Arbitrage
To illustrate, take an example of a trader who has $100,000 and identifies a three-point arbitrage opportunity in the cryptocurrency market.
Step 1: Current BTC/USD rate = $3,600.95
Using USD $100,000 to buy Bitcoin at this rate will get 27.77 units.
Step 2: Current BTC/ETH rate = 0.0326
Using BTC to buy Ethereum will get 851.85 units.
Step 3: Current ETH/USD rate = $118.19
Sell ETH for USD to get $100,680.6571
In this case, the trader gets a profit of $680.6571. If the trader had invested a larger amount of capital, the profit would have been significantly higher. Take note however, that this example has not taken into consideration such factors as transaction costs.
How it Differs from Other Forms of Arbitrage
One of the main differences between this strategy and most other forms of arbitrage is the number of trades involved. Both merging and plain arbitrage involve taking advantage of price variances in two markets, and they therefore involve two trades, not three. But all share the same basic principle of exploiting price differences.
Real Life Opportunities for Triangular Arbitrage
Due to the size of the foreign currency exchange market, opportunities for this form of arbitrage are few and far between. This is due to the high competition that exists in the market, resulting in a constant correction of inefficiencies. Even in the rare cases that such opportunities arise, they disappear in seconds or milliseconds.
In order to exploit such opportunities, traders make use of automated algorithms that have the capacity to execute required trades within the limited time frame.
However, the emerging cryptocurrency market is still in its early stages and therefore not as efficient as the traditional one. As such, it still has opportunities for cross currency arbitrage.
How to Succeed
As is the case with most forms of arbitrage, any time traders use delta arbitrage to take advantage of pricing inefficiencies, the market will usually self-correct. To succeed with this strategy therefore, a trader needs a high speed system to identify and act on such opportunities while they last.