TL;DR
Triangular arbitrage is a complex trading strategy exploiting price discrepancies between three assets. The trader exchanges one asset for a second, the second for a third, and the third for the first to earn from price differences.
Introduction
Arbitrage is a trading approach that turns market inefficiencies into financial opportunities. There are several types of arbitrage strategies used by crypto traders, including simple arbitrage, cross-border arbitrage, peer-to-peer (P2P) arbitrage, and triangular arbitrage – all of which seek to take advantage of price differences across multiple markets.
While it’s common to trade two markets in most arbitrage strategies, there is a type of arbitrage that uses the price difference of three asset classes – triangular arbitrage.
What Is Triangular Arbitrage for Crypto
Triangular arbitrage takes advantage of price discrepancies between three different assets – usually cryptocurrencies – in the market. The concept is simple: A trader exchanges one crypto asset for a second, the second for a third, and the third for the first. This is then repeated for as long as the price differences remain.
Execution, however, is another beast altogether. To be done successfully, triangular arbitrage requires identifying price differences, trading different asset pairs simultaneously, and proper risk management. Since the crypto market is volatile, prices fluctuate quickly; traders must also execute triangular arbitrage trades rapidly.
Here’s how a triangular arbitrage opportunity is spotted and what traders do to take advantage of it.
How Triangular Arbitrage Works in Crypto
How to spot a triangular arbitrage opportunity
Let’s assume an experienced trader notices mismatched pricings among three different assets – Bitcoin (BTC), Ether (ETH), and Tether (USDT). How can we tell if there’s an arbitrage opportunity?
A trader buys $50,000 worth of BTC with their USDT. They then use their BTC to buy ETH. Finally, they use the ETH to buy USDT. If the relative value of the USDT held at the end is significantly different from the initial capital of $50,000, then an arbitrage opportunity exists.
How to leverage a triangular arbitrage opportunity
Note that crypto traders often have to make trades at a high frequency to make a significant amount from the pricing mismatches.
Depending on price differences, traders can use different strategies to take advantage of these discrepancies. For instance, they could make either a buy-buy-sell order or a buy-sell-sell order.
Here is an example of a buy-buy-sell strategy with USDT, BTC, and ETH:
In this buy-buy-sell example, the trader would have made 2,000 USDT. A trader will have to work quickly to repeat the steps and buy BTC with the 52,000 USDT, then ETH with the BTC, and so on.
In a buy-sell-sell strategy, for this example, a trader would buy BTC at a lower price using their USDT capital, sell it at a higher price for ETH, then sell their ETH for an even higher price in exchange for USDT.
Triangular arbitrage is a complex, time-intensive strategy that can be difficult to execute manually. Hence, many arbitrageurs use trading bots designed to perform triangular arbitrage trading for them. Such software is programmed to spot price discrepancies and allows traders to automate the triangular arbitrage process. With trading bots, traders will be less likely to miss out on opportunities even while they aren’t monitoring the markets.
Benefits of Triangular Arbitrage Strategy in Crypto
Financial opportunities
Triangular arbitrageurs have another avenue to earn from crypto trading compared to traders who trade in a single market. Successful traders who can identify and execute these types of trades can generate returns from price mismatches and not just price movements.
Reduced risk
Theoretically, arbitrageurs can spread their risk across multiple assets, reducing their exposure to any one currency instead. Diversifying risk can help mitigate the impact of price changes, especially in volatile markets where prices can change rapidly.
However, there are other risks involved in triangular arbitrage, which are highlighted in the section below. Therefore, traders who attempt triangular arbitrage trading should also employ risk management strategies to assess and mitigate risks.
Increased market liquidity
Since triangular arbitrage involves three trading pairs, it increases the trading activity in these crypto markets, potentially increasing the market's liquidity. Because it measures the ability of a crypto asset to be bought or sold without affecting its price, market liquidity is a sign of a crypto market’s financial health. Liquid markets tend to be less volatile, which makes trading more profitable as risks like slippage are reduced.
Improved market efficiency
Like other forms of arbitrage trading, triangular arbitrage targets and corrects market price imbalances. This can help stabilize market prices, increasing market efficiency and lowering trading risks.
Drawbacks of Triangular Arbitrage
While triangular arbitrage may bring some benefits, it is also important to consider its drawbacks.
Slippage risk
Triangular arbitrage brings a higher risk for slippage as it involves frequent trading when the opportunity arises. Slippage describes the difference between the target and realized price that an asset is bought or sold for and often occurs when a market moves too quickly.
Since triangular arbitrage involves multiple trades and is time-sensitive, the price differences might have changed by the time a trader tries to manually execute the last of the three trades in a triangular arbitrage. This would result in diminished earnings or even a loss.
Timing
Triangular arbitrage may be profitable in ideal situations, but traders are up against uncontrollable factors that can affect the timing of trades. This includes exchange inefficiencies causing delays in trade execution and market volatility, leading to price fluctuations before a trade can be completed.
Liquidity risk
If a market is not liquid enough or lacks traders, you may be unable to follow through with the trades needed to complete the triangular arbitrage. If assets are not bought or sold at the desired prices, you may incur a loss.
What’s the Future of Triangular Arbitrage?
The development of technology and the emergence of new financial markets could influence the application of triangular arbitrage. Triangular arbitration could evolve into a more sophisticated form, leading to greater efficiency and precision in the execution of such trades.
However, as more traders adopt triangular arbitrage as a strategy, competition for these opportunities is expected to increase, potentially making it harder to earn from it. Additional factors – such as changes in currency markets and regulation – could also impact the profitability of triangular arbitrage.
As the financial markets evolve, traders will need to be able to adapt quickly to remain profitable when leveraging on triangular arbitrage opportunities.
Closing Thoughts
Triangular arbitrage is a complex trading approach used by competent traders who need to consider various strategies and risks. While there are several benefits to it, this type of trading should not be done by beginners who are not proficient or experienced enough in risk management.
Further Reading
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