Triangular Arbitrage: Exploiting Market Inefficiencies

Introduction

Crypto trading offers numerous opportunities where investors can turn their thousands into millions. But it can also be other way round, and you can lose a substantial portion or all of your investment in a bad trade. In such a highly volatile market, traders devise methods that could be as safe as possible. When the preservation of the capital is the foremost concern, traders turn to exploit market inefficiencies which present themselves in many forms. Of these forms, one is arbitrage trading.

What is arbitrage Trading?

Arbitrage trading is a type of trading in which you see a price gap in the prices of the same asset on different platforms and then proceed to buy at a lower price and sell higher. To understand the concept from an example, let’s suppose that looking at the markets closely, you observe there is a minute difference between the price of $BTC on Binance and Coinbase. Since the prices of cryptocurrencies are likely to match on exchanges sooner or later, you try to exploit the price gap by buying low and selling high.

What is Triangular Arbitrage?

3 prominent types of arbitrage trading are there in the market: funding-rate arbitrage, exchange arbitrage, cross-border arbitrage, peer-to-peer arbitrage, and triangular arbitrage. The present article is mainly concerned with triangular arbitrage. In triangular arbitrage, you switch between three assets by using either buy-buy-sell strategy or buy-sell-sell. Having understood arbitrage trading, it is quite straightforward to grasp the concept of triangular arbitrage.

Buy-Buy-Sell Triangular Arbitrage

In a buy-buy-sell strategy, you start with 1000 $USDT in your wallet. You notice that the prices of different trading pairs on the exchange do not align exactly. For example, $BTC/$USDT pair is trading at a price different from $BTC/$ETH. You go ahead and buy $BTC with your $USDT balance. Subsequently, you buy $ETH with your $BTC balance. Finally, you trade your $ETH with $USDT. If the price discrepancy was significant enough, you end up with more $USDT than you started with.

Buy-Sell-Sell Triangular Arbitrage

The starting point and trigger is the same as that of the previous type. However, only the nomenclature for the second step is different here. Instead of saying that you are buying $ETH with your $BTC balance, we say that you are selling your $BTC for getting $ETH. The difference may arise from the fact that the trader practically gets profit twice, which is realized only in the final step when $ETH is swapped for $USDT. Arbitrage trading is usually a job suited to professional traders who have high levels of expertise in the field.

Benefits of Triangular Arbitrage Trading

Triangular arbitrage trading offers an additional way to profit from the crypto markets. Normal trading generally extracts profits from price action, i.e. buying is beneficial when the market is in uptrend and selling is advantageous when bearish trends set in. Conversely, arbitrage trading provides you an opportunity to make profits even from a stagnant and range-bound price action.

Risk Cut Short through Diversification

You cannot be sure of profit despite very strong technical indicators in favour of your trades. There are numerous instances of unexpectedly opposite results on platforms where traders interact. As has been seen, arbitrage trading spreads your risk in three assets, so the risk is automatically reduced.

Increased Market Liquidity

You can understand liquidity by the ease of trading an asset. When there are insufficient orders in the order book of an asset, you will have a hard time selling or buying it. Therefore, traders and analysts regard liquidity as the very heartbeat of the market, without which it becomes lifeless. Also, liquid markets have less volatility. You see wild wicks in the price charts of less liquid assets. Arbitrage trading provides additional liquidity to the market in three different coins or tokens.

Correction of Price Gaps

When traders opt for triangular arbitrage trading, they exploit the price gaps existing in different trading pairs. Prices adjust quickly to fair values as an inevitable result of traders’ action. Triangular arbitrage increases demand for the cheap asset and thus pushes its price up. It also increases supply of the expensive asset and brings its price down. The buying and selling naturally closes the price gap, so prices move toward their fair value without anyone manually changing them.

Risks in Arbitrage Trading

Complicated Option

As compared to other types of trading benefiting from price movements, triangular arbitrage requires a lot of calculation before starting. The process is so complicated that traders often use bots for this type of trading. The trading bots monitor prices constantly and alert the traders, or even execute the trades themselves without any human intervention. Now, trading bots is not easy or affordable to deploy for every trader, so it is mostly opted by those who have enough experience and capital.

Margin of Profits

Most of the arbitrage trading requires you to be a high frequency trader because price discrepancy is not as substantial to grant you attractive profits. You can make good profits only when you repeat the process described earlier in this article. But the repetition is also not possible as frequently as required because gaps are filled when you execute first few trades.

Slippage Risk

Slippage refers to the difference between the ordered price and the executed price. The price gap is often so small that you cannot afford your orders to slip even slightly. But it can happen despite all human efforts due to the sensitivity of time factor. You need to be extremely quick.

Liquidity Risk

Where triangular arbitrage trading is beneficial in providing useful liquidity to the market, it can also suffer owing to shortage of liquidity. You cannot sell or buy when there are no corresponding orders already placed by other traders.

Conclusion

In a nutshell, triangular arbitrage trading is an ingenious way to make profits from the market by utilizing very small price gaps. But before trying, you must read all the merits and demerits.