The color of the arrow represents how optimal the angle is for the torpedo to follow. You'll get a green arrow when the torpedo only has to turn 5° or less (to either side of its original direction) to hit the target. Yellow is less optimal (I forget exactly what angles) and red is just plain bad.
It turns out that torpedoes can't turn in any old direction, so it is best to aim by maneuvering your U-boat to get the green arrow.
If you fire with a less optimal condition, the torpedo will be more likely to fail (either by being a dud or by veering off-course, I'm not sure which).
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