Currency triangulation allows foreign exchange traders to take advantage of disparities in the currency market. The idea behind triangulation is relatively simple, although finding actual opportunities for profitable triangulation is relatively difficult and rare. Therefore, the individual currency trader should not rely on triangulation exclusively for income.
Currencies are traded in pairs. If the currency you have at hand cannot be directly converted into the currency you wish to obtain, you must perform a process of triangulation. Assume, for instance, that you have British pounds and wish to convert them into Swedish kronas. However, no institution quotes a price of kronas denominated in pounds. In this case, you may have to convert the pounds into euros and subsequently convert your euros into kronas. This way, you can start with pounds and end up with kronas, even if no bank or currency trading counterpart is willing or able to perform a direct exchange between the two currencies.
Profiting From Triangulation
When traders perform triangulation trades for a profit, their purpose is not to accomplish an otherwise impossible conversion but to make money from market imperfections. To perform successful triangulation trades, all three currencies in question must be directly convertible one another.
Assume you have 100 pounds and each pound buys two euros. Also imagine that each euro buys 1.5 kronas. Starting with 100 pounds, you can buy 200 euros and then buy 300 kronas. Now here is where it gets interesting. If the exchange rate between kronas and pounds is such that 2.9 kronas buys one pound, you can convert your 300 kronas into 103.4 pounds. In other words, you have just made 3.4 pounds.
A profitable triangulation trade is only possible if there are market imperfections. Had the exchange rate between pounds and kronas been 3 to 1, no such profit opportunity would exist. In reality, profitable triangulation is very rarely possible because when such opportunities arise, traders execute trades that take advantage of the imperfections and prices adjust up or down until the opportunity disappears. In the previous example, kronas was too expensive.
As we saw, taking advantage of this opportunity involves selling kronas, which will result in price depreciation for that currency and the triangulation opportunity will soon vanish. Therefore, the most important element of a successful triangulation strategy is speed. You must capitalize on opportunities as soon as they arise because they will likely not last for very long. Professional traders use computer programs that constantly look for opportunities and in some cases automatically execute profitable trades.
Another characteristic of triangulation trades is the extremely thin profit margin. A profit of 1 percent from a triangulation trade is almost unheard of. In fact, one-tenth of 1 percent would bring a smile to most traders' faces. Therefore, you must ensure you pay the absolutely lowest possible commission. Otherwise, your commissions will erase all of your slim profits and possibly result in a loss. Be on the lookout for the broker with the lowest commission rates and negotiate aggressively to further lower any commissions. Watch your other costs, such as subscriptions to news services, computer systems and staff-related expenses.
Hunkar Ozyasar is the former high-yield bond strategist for Deutsche Bank. He has been quoted in publications including "Financial Times" and the "Wall Street Journal." His book, "When Time Management Fails," is published in 12 countries while Ozyasar’s finance articles are featured on Nikkei, Japan’s premier financial news service. He holds a Master of Business Administration from Kellogg Graduate School.