All short term trading strategies must include some technical component. We have sought to provide a somewhat detailed explanation of the various aspects of forex trading strategies.
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Before you make any investment or trading decisions, it is very important that you inform yourself carefully about the opportunities and risk. This includes not only the financial aspects but also legal and fiscal ones.
Experience shows that the most important driver of currency trends is the interest rate differential of central banks. Many financial strategies attempt to capitalize on this knowledge, but the most basic and widespread strategy is the carry trade. In this article we’ll take a look at the basic aspects of this strategy.
The carry of an asset is the return gained by holding it. For instance the carry on a Treasury bond is the interest received. The carry of a bar of gold held at a bank safe is negative, since the owner gains no positive return, but has to pay the bank a fee in return for the perceived security of the asset. Let us note that “carry” is unrelated to the speculative appreciation or loss on the asset value, but is the merely the opportunity cost of owning the asset, positive or negative. In the case of currency trading, the carry is the interest return on the position as it rolls over to the next day. By shorting a currency with a low yield, and paying the negative but negligible carry return, and buying one with higher yield, the trader aims to make a profit which is then multiplied by leverage. The most popular pairs for carry trading are: NZD/JPY, USD/TRY, AUD/JPY, AUD/USD, EUR/JPY and BRL/USD. There are other, more volatile, less liquid pairs that are offered by various brokers, but the beginning trader can at first confine his activities to the most liquid ones above.
Before moving on, we should note here that there are two kinds of situations that lead a central bank to maintain high interest rates, and only one of them constitutes the ideal conditions for the carry trade. These two situations are not in fact independent, but to make matters simpler for the forex trader, we will examine them as if they were. In short, central banks raise rates in response to the risk of both inflation and capital shortage. In the case of capital shortage, the central bank aims to stem capital flight out of a nation’s financial system, and it raises the main interest rate to lure investors and speculators to deposit funds in the nation’s banks. In the case of inflation, the central bank raises rates because there is too much money floating around in the economy, and by raising interest rates it aims to make the cost of borrowing higher, squeezing liquidity out of the system, contracting money supply, slowing the economy down and reducing the risk of inflation.
Of these two scenarios, the trader should only be interested in the inflation-induced one where capital flight is not a problem for the foreseeable future. Attempting to carry trade in an environment where interest rates are going up because of capital flight and panic is an extremely risky endeavor, and should be avoided as much as possible, unless the trader knows what he is doing, is very knowledgeable about the financial status of the country, and is comfortable with the risk he’s taking and the capital he allocates. Not only does capital flight increase the frequency and duration of volatility, but it also has the nature of a feedback loop, in which the situation deteriorates with great speed, and with little warning.
Carry trades depend on the principle that the interest rate differential between two currencies can be amplified by the successful usage of leverage, and that during periods of low volatility, the amplified profits can be compounded and reinvested to create massive returns over the longer term. If you have any experience with currency trading, you are already aware that the carry of an unleveraged account is usually minuscule, and it’s not possible to achieve meaningful returns unless you are willing to wait for a number of years. By utilizing leverage the carry trader aims at quicker profits, and justifies his choice on the premise that he’s always on top of his brief with respect to market developments, and will not be caught in the dark when there are periods of serious, but usually temporary shock and panic.
Since higher yields also attract capital and cause the currency to appreciate against its competitors, the returns are not limited to the leverage-enhanced interest gains that the carry account accumulates. The permanent gain in interest income actually allows the account to react to currency price fluctuations better by adding an interest income generated buffer zone to absorb them. Nonetheless, our general suggestions on sensible practices are valid in carry trading too: leverage higher than 10 is not really advisable, and one should never risk more than his risk capital.
The carry trade is sometimes advertised as a trade based on fundamental analysis in that higher interest rates indicate healthier economic growth, while steady capital flows reflect the underlying strength of the higher yielding currency. Nonetheless, on closer examination, we may not be very convinced by this argument. We know that the carry trader will long high-yield currencies such as the Turkish Lira, or the Australian dollar, and short those such as the Japanese yen, or the Swiss Franc. What do we notice in this type of currency allocation? First of all, many of the lower yielding currencies are reserve currencies as a result of their higher technological advancement and status as financial centers. Secondly, because nations raise interest rates, in many cases, to attract capital, they are likely to suffer higher volatility at times confusion and crisis. Third, the majority of high-yield currencies are issued by emerging markets where political instability is more frequent than it is among more advanced nations.
These observations should alert us to the fact that the carry trade sometimes entails trading against the fundamentals of the currency pair. Buying the currency of a nation with large deficits can hardly be said to be a safe and sound practice, but it may be profitable if there are too many people engaging in it. Similarly, shorting a currency backed by healthy surpluses is not safe under usual circumstances, but government policies, market behavior, and the general economic conditions may, at least on a temporary basis, reverse this rule. The carry trader follows the trend, and in that sense this method is more related to technical than fundamental analysis. There’s nothing wrong with that per se, but it is wrong to have false confidence based on the misleading association between high interest rates and economic strength.
Finally, we should remember that the carry trade is a directional bet. The trader basically forms his opinion, and acts in accordance, without giving much attention to the aspects of hedging or diversification. Since, at least during the past decade, the major carry trade pairs such as USD/TRY, NZD/JPY, GBP/CHF, or EUR/JPY all reacted in a highly correlated manner to fundamental shocks, an account that consists mostly of positive carry generating pairs cannot be thought to have diversified successfully. It is advisable that the trader either keep his leverage low, or hedge through the addition of some negative carry pairs into his portfolio, whichever he finds more comfortable.
The currency carry trade reached the bubble stage over the period between 2001-2008. As Japanese and Asian savers, tax haven-based large hedge funds, and other investors from all walks of life participated in this lucrative activity, at one point the amount of money invested was estimated as high as 1 trillion US dollars. Today the carry trade is still alive and well, but at a quite smaller scale than in the past as a result of the well-known global economic turmoil of 2008. Some of the highly leveraged players such as the aggressive hedge funds have been wiped out during the oil collapse and the successive waves of deleveraging that followed it, but those who were quick to cash out and realize their returns did indeed leave with tremendous profits. And of course we should not forget the massive gains registered even before the financial crisis began in the autumn of 2007. The carry trade did indeed create millionaires of those who were prudent in their choices, and relatively quick in their reactions.
Here are a number of principles that the carry trader can keep in mind:
Follow all the rules of sound money and risk management. Carry trade is just another aspect of currency trading, and all the rules of the latter are valid here too.
Carry trades are very sensitive to periods of insecurity and confusion. Anything that threatens stability and GDP growth is likely to be detrimental to the carry trade, even if the relationship is elusive at first glance. Hurricane Katrina caused a lot of disruption even to non-USD based carry trades, and the difference between stability and instability is often only a function of trader psychology.
Do your research and understand the economy of the currency which you trade. Are you comfortable with the nation’s deficits, its development strategy or the risk level it poses to your portfolio? Manage your leverage in accordance.
Since we desire to minimize the impact of short term fluctuations on our portfolio, the interest bearing positions must be open for months, at the very least. The carry trader must have a long term vision in order to avoid the temporary impact of volatility on the account.
Analyzing the historical volatility of the high-yield currency, examining the usual speed and range of its reactions to important economic events of the past can be very helpful in determining the stop-loss point of the trade. For instance, during the period of 2000-2007 the Norwegian Kroner, despite its fundamental strengths, was prone to react in somewhat stronger percentage terms to news shocks and market volatility in comparison to the behavior of other currencies. Similarly, the Turkish lira, while stable most of the time, could be extremely volatile in reaction to banking sector problems. The trader should make sure that he is prepared for such periods, at the very least on a mental basis.
The trader should be aware of developments of international scale. The health of the carry trade, volatility, and liquidity of the market all strongly depend on the health of the global economy, and the phase of the business cycle. Carry trades can enter long, deep periods of liquidation in response to global shocks, as in the aftermath of 1998 Asian crisis, or the turmoils of 2008. It is therefore a good idea to be up-to-date with the fundamental developments.
On a concluding note, let us remind you that the carry trade is a proven long-term strategy that has the potential to create spectacular returns for the patient, impassionate and diligent trader who is not afraid of realizing profits or taking losses when events, backed by fundamental analysis, dictate that he do so. The carry trade is a trend following strategy, and requires little sophistication from the trader in order to be successful. But it is very important to have a clear idea on what you expect from your carry trading account. Are you confident about your analysis that you’re ready and able to ride out temporary, but severe shocks in return for long term gain? Or are you holding the position overnight to realize short terms returns and exit with quick profits or losses? Your responses to these questions, along with your analysis of the global economic environment, should guide your choices with respect to this popular, proven and profitable trend-following strategy.
Before examining the COT reports and a few ways of using them, let us note two important details:
The COT (commitment of traders) is a report issued by CFTC to update the public on the futures positioning of traders in commodities markets. In the US most futures trading takes place in Chicago and New York, and the institutions covered by the report are heavily concentrated in these locations.
Let’s examine the body of a COT report.
EURO FX - CHICAGO MERCANTILE EXCHANGE Code-099741 FUTURES ONLY POSITIONS AS OF 03/17/09 | --------------------------------------------------------------| NONREPORTABLE NON-COMMERCIAL | COMMERCIAL | TOTAL | POSITIONS --------------------------|-----------------|-----------------|----------------- LONG | SHORT |SPREADS | LONG | SHORT | LONG | SHORT | LONG | SHORT -------------------------------------------------------------------------------- (CONTRACTS OF EUR 125,000) OPEN INTEREST: 111,077 COMMITMENTS 33,657 42,696 548 37,055 34,864 71,260 78,108 39,817 32,969 CHANGES FROM 03/10/09 (CHANGE IN OPEN INTEREST: -69,201) -273 -1,466 -1,371 -67,685 -64,551 -69,329 -67,388 128 -1,813 PERCENT OF OPEN INTEREST FOR EACH CATEGORY OF TRADERS 30.3 38.4 0.5 33.4 31.4 64.2 70.3 35.8 29.7 NUMBER OF TRADERS IN EACH CATEGORY (TOTAL TRADERS: 99) 38 30 7 19 17 60 51
Open interest describes the amount of open futures contracts that are being held. In other words, it is the total volume of open contracts in the market, but not the transactions.
Reportable positions are the positions held by institutions that meet the reporting requirement of the CFTC. These are the major players in the CBOT, and their choices are usually backed by hordes of analysts and their studies.
Non-reportable positions cover everyone who do not suit the above criteria, and they are also termed small speculators. Of reportable positions, non-commercial includes all actors who do not possess any interest in making use of the underlying currency or commodity, such as hedge funds, brokerage firms, investment banks and other related firms. Commercial open interest is created by firms that have the desire to receive or deliver the underlying. Thus the roles played by the two categories of traders is quite different.
Spreading covers those trades who hold an equal number of long-short positions on the future contracts.
The report provides data on the percentage of long or short contracts to the total, on the number of traders in all three categories with positions on a currency, and finally the changes in open interest in comparison with the previous reporting period.
Over the years the COT report has become quite a popular tool for all kinds of traders. Here are a number of ways of exploiting the data provided by the COT report.
We can use the COT report data to create a diversified currency portfolio. By examining the COT report, we can have a good idea of the attitude of major traders toward the USD, but to make real use of the the data we must create a portfolio of currency pairs, such as AUD/USD, EUR/USD, USD/JPY. Since the market can be, overall, long the USD, but can be short the USD against one or more currencies, we do not want to be caught holding a pair in which the USD will lose value, while the COT is still long. Let us now suppose that the non-commercial sector is overall long the USD in our example.
What should be the criteria in deciding the currency pairs that will be included in our portfolio in such a situation? In general, it’s a good idea to make our portfolio interest-neutral, so as to express in our currency allocations our USD-positive idea, while declining to say much about the currencies we will short.
For instance, we will short AUD/USD and EUR/USD (and the carry is negative) and long USD/JPY and then we will manage our currency pair ratios in such a way that the total interest received will not exceed the Fed rate. Why do we do this? Because all we want to do is to gain from the appreciation of the USD while limiting the volatility caused by the carry trade. By making our position interest-neutral, we will, we expect, be able to ride through such disruptions. This will reduce the volatility of our portfolio, and will also reduce the potential return from our investment, but it does create a longer-lasting, more resilient position.
Another, but much riskier way to create our COT-report based portfolio would be to simply long what the commercial sector is long, and to short the commodity or currency in which the non-commercial traders are long. Thus, for instance, if the commercial sector is long the EUR, and the speculative sector is long the AUD, the trader would simply arrange his portfolio to reflect the market’s choice by assigning a large part to EUR/AUD. And one can go on with this method, to create an interest-neutral portfolio in the previously described way, thereby limiting the volatility of the position, and ensuring a more successful long-term strategy.
It’s also possible to arrange the above mentioned portfolios to profit from trend reversals as signaled by COT reports, but we caution against this method, unless the trader carefully hedges his position by trading uncorrelated(or negatively correlated) pairs. Correlations statistics of currency pairs are available from most major forex brokers.
It is nonetheless true that major changes in the strength of a trend, or its reversal on a permanent basis, are indeed noted by changes in open interest, and institutional positioning. Our only suggestion is that the trader be aware of the potential of false signals, and, as per the usual principle, avoid trying too hard to catch bottoms and tops.
An exceptionally useful and prudent use of the COT report is regarding it as a volume complement to the price studies generated by conventional technical analysis. The trader can simply refuse to act when a technical signal fails to be confirmed by a similar movement (signaled in increasing open interest) in the COT report. For an uptrend, he would expect a corresponding rise in open interest, and for a down trend, a corresponding fall. It is also possible to devise indicators for this purpose, and MACD, Williams Oscillator, or Stochastics can all be drawn on the COT report data.
This approach is akin to using volume and price data simultaneously while exploring stock market charts, and those with experience in that field will easily grasp the importance of the COT report. Nonetheless, those with little knowledge of other markets can still greatly benefit from its utilization, especially when trading on a purely technical basis.
In the sample COT chart above, non-commercial net positioning for Euro is short, since 38 percent of traders are holding short positions, while thirty percent hold longs. One way of exploiting this segment of the COT report is by taking note when net positioning switches from long to short and vice versa, and predicting forex market reversals on that basis. In the above example, when net positioning of the non-commercial sector switches to long, we would use the development as a signal for buying euros, coupled with some input from other sources of technical analysis.
While this method can produce results that are much more reliable than those generated by pure technical analysis, the trader should still be aware of whipsaws and unpredictable spikes and collapses that can sometimes arise. Percentage values are easier to recognize, and are easier for recognizing position flips.
Comparing long or short positioning with historical extremes can also be beneficial in identifying market extremums. Experience shows that there are absolute values which indicate a bought-out, or sold-out currency, and as the COT positioning hits these values, there’s a significant chance of a rapid reversal.
Extremums can also be termed bubbles, as they characterize a market that is already in an unsustainable phase of rise or fall. The problem with this method lies in the fact that it’s always hard to pick up tops and bottoms: there’s no reason to expect that positioning cannot exceed a previously registered high, before collapsing. Still, if one has the determination and the resilience, extremums reported by the COT report have much greater value than that reported by price based technical analysis.
It is possible to confirm the absolute extremes on the COT report with extremes on moving averages or oscillators on the price chart.
The COT report is a very useful tool which can be substituted for the volume indicators of stocks analysis. Absolute long and short positioning and historical comparisons can be useful for identifying market extremes. Percentage changes in open interest can be valuable in noting position flips and predicting market reversals in the medium term. If there ever were an ultimate technical indicator, its seekers have their greatest luck in COT data. But the old advice on not putting all eggs in the same basket is still valid: it’s better to confirm signals from the COT report with data from other aspects of TA, and of course fundamental analysis, before reaching decisions.
Managed currencies are those such as the Singapore and Hong Kong dollars, the Chinese yuan, the Russian ruble, where the Central bank doesn’t control the day-to-day fluctuations of the currency, but attempts to manage the direction of the trend by periodical interventions. The interventions are usually formulated through a floating or fixed currency band where the price is allowed to move within a range around a central point which are both set by the Central bank. Usually, only those central banks or monetary institutions with a significant reserve accumulation can aim to manage their currencies effectively, as countering the actions of the market can be costly.
The midpoint and the percentile range within which the price moves are sometimes held as a secret by central banks, and sometimes they are public. It is also possible that the central bank possesses no solid numerical long-term plan for the price range, but moves as the fundamental data flow and the political authority dictate. The policy choice is a secret in the case Singapore, is open in the case of the Hong Kong dollar and is partially public according to data in the cases of both the ruble and the yuan.
Before further explanation, let us say that the predictive power of government policies tends to diminish during periods of volatility and economic turmoil. Central banks are not run by wizards with crystal balls, and usually they do not possess confidence or willpower greater than that possessed by the experienced trader. As a result, policy errors, zigzagging, and conflicting signals generate a lot of noise through which the trader must wade his way to success.
The word “managed” in the phrase managed currency encapsulates the core of our strategy in trading this section of the market. The authorities make a commitment not to allow their currencies to move beyond the limits of a band, and they are ready to intervene when such a movement occurs as a result of chaotic market action. And, to the further benefit of the trader, newspapers, forex websites, and market news providers all declare the presence of central bank authorities when they do intervene. In many cases, the central banks also encourage the publication of their presence as they seek to intimidate and discourage those who want to counteract their policies. All that the trader would have to do to profit from such interventions is noting the direction of the intervention, and acting in accordance with it. Thus when we know that the technical indicators are showing extreme values (for instance RSI is at 20 or 80), there’s news flow speaking of intervention, and the central bank has already made its intention to prevent extreme price fluctuations clear, the trader can, with great confidence, make a counter-trend move with a reasonable stop-loss order, and expect to return a meaningful profit. This is a proven and well known method, with very high odds of success.
The behavior of the Monetary Authority of Singapore between October 2007 and April 2008 provides countless profitable examples for this method. In many cases where the RSI registered extreme values, the MAS would intervene, and as traders used the opportunity to pile in, large amounts of profits were made. Counter-trend interventions by MAS were usually easily detectable because of the very large movements in spot within seconds, and they were also noted by Bloomberg and financial news providers.
Conversely, between November 2007 and April-May 2008, the People’s Bank of China allowed the yuan to appreciate in a very regular, and predictable fashion, providing currency traders with a unique opportunity to register risk free profits. Because the central bank manages volatility in a punctual and strict fashion, the risk of any significant reversal was almost non-existent, and policy direction was communicated clearly and decisively by the chief of the institution.
Where do the pitfalls of this method lie? Obviously, the first and foremost obstacle to the success of a central bank is insufficient reserves, or lack of political will. Usually, a central bank will do all that is in its power to ensure credibility but if the market does not find its declarations credible, it has the power to invalidate the schemes of the institution. Similarly, markets are quick to punish those nations where financial policies are and improvised and revised in response to temporary developments. In spite of all this, given the very high level of uncertainty that the forex trader must be used to live with, following interventionist central banks can be a relaxing experience.
Currency interventions are especially difficult when they occur on an isolated basis against prevailing market conditions with insufficient reserves. Given how liquid and vast the forex market is, only exceptionally reserve-rich nations, like China or Singapore, or those with little need of external financing, like Saudi Arabia, can be confident that they have the clout to make their interventions work. On the other hand, markets treat those few Central Banks with respect, and they are unlikely to suffer from short term shocks, and their interventions and currency policies have credibility that is not found in other, less financially sound nations.
To repeat, managed currencies can be a source of great profit if they are traded with patience and consistency. The risks involved are usually much lower than those faced when trading floating currencies, with the one caveat that currency crises can quickly wipe out the gains of a long-time if the trader is not sensible with his stop-losses. The principles of sound money management, and low leverage are still valid when trading this type of market. One should avoid bubbles, and it’s not a good idea to chase excessive price movements, especially because the managed currencies tend to absorb a lot of tension by resisting market pressure, and if they break, the reactions can be very violent and fearsome.
We strongly advise the trader to concentrate on one or two managed currencies, if that is the method he would like to employ, to absorb the policy choices and principles of the Central Bank in question, and act in accordance with global developments. The transparency and independence of the Central Bank are both exceptionally important, because we would not want our guiding institution to zigzag or bow to political power, in essence invalidating its statements and policy declarations. Singapore and HK are good choices to begin trading this method.
Here is a list of some currencies with their Central Banks and their policy preferences.
USD/SGD: Controlled by the Monetary Authority of Singapore, this pair is one of the more predictable and easier for those who prefer this strategy. Because of the status of Singapore as an importer of necessities like food, the monetary authority of Singapore aims to control inflation through the currency rate, and its policies are regularly and clearly communicated at its website.
USD/CNY: Controlled by the People’s Bank of China, the yuan’s value depends on two important factors: the trade surplus of China versus the Euroland and the United States, and the unemployment situation of China’s rural regions. The central bank does not zigzag, however it’s policies are greatly influenced by the supreme leadership of the nation and their relations with the US government. PBoC allows the yuan to appreciate at times of economic boom and inflation, and generally holds it stable during recessions and economic turmoil.
USD/HKD: The HKD is pegged to the US currency at 7.8, but is allowed in a band of 7.75 to 7.85. Hong Kong’s economic policies are influenced greatly by developments in mainland China, but the nation has a currency board policy, and is mostly independent in its policy choices. The nature of the peg suggests an almost risk free trade in buying the HKD at 7.75 and selling it as it appreciates.
USD/RUB: The ruble is managed by the Central Bank of the Russian Federation. Its policy choices are determined by Russia’s external balance, and the price of oil and other commodities.
Trend following is perhaps the most popular long-term strategy in all financial markets. It is exceedingly effective and profitable when the conditions are favorable, is quite straightforward in its methodology, and there are many individuals, past and present, famous or obscure, who have used this strategy to success and riches. We should note that the technical aspect of trend following is in fact quite simple, but also that it requires, before everything else, discipline, sound money management, and patience from the trader. Trend following is not a short-term method, and patience and determination are as important as correct analysis as a result.
Trends are created by powerful underlying economic factors which may not be all that clear to those who are not very familiar with fundamental analysis. But the simple patterns created by the price action in response to the economic events can often be identified through methods that are easy to learn and apply. Thus, the retail trader has as much potential of success as the most experienced analyst if he can control his emotions and behave logically.
To apply this strategy we must first be aware of the existence of a trend. Without identifying a trend we would be gambling, and that’s not the purpose of trading forex. Both fundamental and technical analysis can be employed for identifying a trend, and both of them have their advantages and drawbacks. It is in general a good idea to use a combination of them for deciding on the trend’s character, and deciding on our entry and exit points.
From here, let us use the dialogue between the successful trader and the beginner in order to explain the principles in an easier way.
B: I want to use the trend following method. How do I do it?
ST: You must first choose whether you want to employ technical or fundamental analysis for your method, or a combination of both.
B: Is there a difference between these methods?
ST: Yes. Fundamental analysis can provide you with information which can predict the strength and length of a trend., while technical analysis can show you how it develops. It is possible to base your strategy on one of these to the exclusion of the other, and it is still possible to turn a profit if you are lucky enough, but our principle has always been to reduce the role of luck to as little as possible. Fundamental analysis is more reliable than technical analysis in defining a trend that has long term potential, but without technical analysis it would be extremely difficult to decide when or how to trade. Technical analysis can suggest the beginning of a trend, but it’s unlikely to tell much about the length or strength of the same. Thus, I suggest that you use both technical and fundamental methods for your trend following strategy, with fundamental factors eliminating the false signals of technical analysis, and technical tools providing you with a time-price frame for deciding on entry points.
B: How do I decide on the existence of a trend?
ST: There are many technical tools that can signal the phenomenon, but there are an equal number of false signals generated by them. Remember that there are only three kinds of trends that can exist at any time: flat, up or down, and it is possible to speak of trends between any two points on a price chart. Simply take two random points on a chart, draw a moving average on it, and the pattern that arises can be analyzed as a trend. Thus it is always necessary to have at least a basic of understanding of the economic factors that can create trends, before deciding on the validity of a chart pattern.
B: And how do I do that?
ST: Familiarize yourself with the big picture; understand what drives market participants; recognize the stage of the business cycle.
B: What kind of price pattern will create a trend?
ST: The trend that we seek to trade is different from random fluctuations, range patterns and similar price movements in that the price itself, in the absence of any technical indicator, can still be recognized as showing a trend. In other words, there is some driving conviction behind the price action which allows the trader to easily identify it visually. Depending on the type of the trend (that is, an up- or downtrend), successive highs and lows should constitute a rising or falling pattern, with relatively few irregularities. But such a case is often a rarity, and the trader will have to back his technical patterns with conviction that can perhaps only be gained through fundamental analysis.
B: If the trend can be identified visually, why use technical tools?
ST: Even though we can notice the existence of a trend, we still need technical tools to trade it, and time it.
B: So will you try time the market? I’m told that never works.
ST: Market timing never works when one is trying to predict reversal points on a technical basis. However market timing in the context of a trend, with the purpose of picking the counter-trend extremes, and using them to enter a trade, is necessary and profitable. And there lies the main principle of a trend following strategy: recognize the trend, identify counter-trend moves, and use them to enter a trade in the direction of the trend.
B: In a sense, then, you’re behaving as a contrarian of short scale moves, and the follower of the long-term trend
ST: Yes. Indeed, there lies the soul and spirit of all trading. To utilize short-term irrational behaviors of the market in order to enter into long-term positions in positive alignment with fundamentals (or, sometimes just the trend), is the core of all successful trading.
B: How long should the trend follower maintain his position?
ST: Forever, or to be exact, for as long as the fundamental reasons that back the trend are dominant. If the trader cannot identify those reasons, if he’s unwilling to do so, or if he doesn’t believe, for some unfathomable reason, that they are useful, he can use technical patterns to time his exit point. Even if the trader is aware of the fundamental factors, and is able to evaluate them correctly, technical analysis can still provide him with a very useful early warning system. If the price action is suggesting strongly that there’s some error in the trader’s fundamental outlook, he can use the technical signals as an occasion to reevaluate and reexamine his fundamental picture.
B: How do I time my trade with technical analysis?
ST: The best tools for trend following are supplied by moving averages and simple price charts. Bar charts, candlesticks and many others can be equally useful if employed with moving averages. For example, between October 2007 and April-May 2008, the price action of USD/SGD always remained below the 100-day moving average. When the pattern broke down, in June of the same year, the trend had also broken down, and the price went on to break the 200-day average, and a medium-term upward trend was established. It is also possible to use moving average crossovers, and myriad other methods, but whichever you choose to use, you should ensure that you do not complicate the main aspect of your strategy, which is trend following.
B: Which time frame do you recommend for the moving average?
ST: If you want to trade on a weekly or daily basis, the 100-day MA will probably be able to capture most of the important trends for you. Anything with a longer period is likely to be meaningless because of too much data discarded , and any time frame that is too much below the 100-day period may be too sensitive to price action. But as usual, one can use other timeframes below 100, provided that he doesn’t clutter his screen with lots of indicators, charts, tools.
B: When trend following, where should I place my stop-losses and take profit orders?
ST: This partly depends on the term and nature of your trend following method. A stop-loss order can be placed a short distance above or below the trend line, whether it is provided by the moving average, or a simple line drawn on the chart. In our opinion, the trend follower should not realize his profits until he has a good reason to do so. The purpose of this strategy is to focus on underlying price dynamics by stripping out volatility and short term movements, and there is little logic to realizing profits in response to fluctuations which are irrelevant to the main action of the trend.
B: But I still have to take profit at some point. Where should I do that?
ST: Go as far as the trend goes, then stop. There you can take profits.
B: How do I know how far it goes?
ST: As we just explained, you can use the MAs to decide on that, but it’s far better to identify the fundamental causes behind a trend, and then to exit the trade once those causes are eliminated.
To sum it up, we can repeat that trend following is the easiest and most straightforward way of making money in the forex market. But successful trading requires the foresight provided by analysis and the patience that only comes with confidence. Those of us who prefer quick profits and instant ratification will find the method uninspiring, but it is reliable and will work wonders if you give it the chance.
Options are contracts that give the buyer the right to buy or sell an asset at a pre-specified time and price. In return, the seller receives a fee for writing the contract which is termed a premium. A put option is one in which the terms of the contract grant the right to sell the underlying, and a call option is one where the right to buy is granted. Since we will only explore the exploitation of options market data for the benefit of the spot trader, there’s no need to examine the details of this trade. Here we invite the trader to regard the currency options market as a closed box, and to concern himself merely with the aspects that we will utilize to predict the movements of spot.
The strategies we will discuss are simple and easy to use, and depend on the exploitation of implied volatility for long term trades and expiration data for short term use. To utilize these methods we only need to understand a few simple concepts.
Data on open currency options contracts that are close to expiry is regularly provided by IFR and the information can be acquired by registering with brokers that offer the service. Most major forex brokers will offer at least one financial news provider on their platform or website, and the news flow provided by open interest on CBOE options is also available from COT reports which the trader can use to form an opinion on trader positioning, and therefore the potential impact of the option on the market. How to use currency option expiration data to trade the spot market?
One of the easiest and most successful ways of trading the spot currency market is through the use of option expiry data. Options contracts are typically for sums of anywhere between 100 million to 500 million USD, and values beyond the range are not uncommon. Since these are relatively large sums to be concentrated in a few minutes before the expiration, the traders of these options will do all that they can, within reasonable limits, to move the quote to the strike price of the option, provided that the quote is within about 20-30 pips of the strike price at the time of expiry.
One important point that the forex trader can keep in mind is the distinction between the European style, and American style options. Since European style options can only be exercised at their expiration date, they are likely to be defended more vigorously if the quotes happen to be close to the strike price. In addition, at the beginning the trader is advised to utilize non-exotic expiries (so called, vanilla put or call options) for the strategy, as he betters his skills by examining contract types and similar details provided by the news providers. As usual, there is no need to trade every option expiry that is reported. One can simply begin with smaller sums to test his knowledge, and then increase the size and scope of his trades as he gains experience.
The ideal conditions for this method are:
But even without the realization of these conditions sizable profits can be made with this method in a calm and unexcited market. But these overall conditions, along with the significance of the news release, are the main determinants of the market’s mood which will in turn influence our stop-loss and the profit potential.
What happens during an option expiry?
If the price quote is close to the strike price of the option, option traders and other market participants will attempt to steer the quote in direction they desire.
A strong sign that the option traders will defend their position is the early gravitation of the price quote to the strike price. In an example scenario, if there’s a European EUR/USD vanilla put or call option with a strike at 1.2540, and the quote is at 1.2570 at 7:30 am, the quote will be steered to sit on the option strike value at about the news release at 8:30 am. After that, as the price reacts to the news, the quote may move away from the strike price in an unwanted. To successfully profit from this pattern the trader would need to join the option traders as they try to move the quote back to the strike value, and since a lot of people play this game the odds of success are quiet high.
As long as option expiries are proclaimed by news providers, and as long as large expiries tempt option traders to risk relatively small sums to ensure that they receive their payouts, this method will keep paying dividends. An important point that we should keep in mind is the momentum created by option expiries. As option traders buy or sell, their actions will be joined by all sorts of other traders and snowballing effect creates its own power as a mini-bubble is generated. Needless to day, right after the option expiry occurs, the strike price will be just another number on the charts, and will lose all its significance.
Suppose that we have a trading method which gives us great confidence, produces satisfactory results over a long time, and which refined through a long period of study and experimentation. We are aware of the risks of high leverage, and do not gamble by entering trades which do not fully meet our requirements. We are pleased with our results, but still unsure about how much we should risk. What can we do to solve this problem?
One of the major issues with any trading method is the length and frequency of streaks of wins or losses. A win streak is a period during which consecutive gains are registered in an account, and a loss streak is the opposite. What kind of bearing do these series of wins and losses have for trade sizes? Obviously, if a style generates wins and losses in streaks, the results are not independent of each other. A profitable trade is suggesting the likelihood that there will be more gains in case the trader increases his position size. Conversely, if a loss warns us that it will be followed by more losses, and we should discard our original approach and seek our wealth at other occasions. In other words, heads in one flip tells us that following coin tosses will bring us more heads, and tails will lead to more tails in subsequent trials. This knowledge may allow us to increase the size of our position with reasonable confidence, or to eliminate it in the case of loss.
Z-score is the mathematical tool used for calculating the capability of a trading system for generating wins and losses in streaks. The simple formula allows us to test our performance, and to check if the streaks generated present a random pattern or not. If the pattern is random, or at a non-significant confidence level, our results are independent of each other, and there's no point in trying to scale in, or build up a position in successive trades. On the other hand, if our strategy is prone to generating streaks in a non-random fashion, we can use this knowledge to maximize our profits.
The formula of the z-score is
Z=(N*(R-0.5)-P)/((P*(P-N))/(N-1))^(1/2)
where:
N - total number of trades in a series (for example, in a string of (+++----++----++) we have 15 trades (++++), and the N is 15 )
R - total number of series of profitable and losing trades (if we have a run for our method, and we have a string of (+++----++----++), there are five series S1(+++), S2(---), S3(++), S4(----), S5(++). So R is 5)
P = 2*W*L;
W - total number of profitable trades in the series;
L - total number of losing trades in the series.
A series is simply an unbroken string of wins or losses. For examples, (++++) is a series, as is (---), but (+-+) is not.
So all that we need to do, in order to understand if our strategy allows us to repeat our profits or losses in a non-random way, is to check its z-score, and to compare this to a series of numbers which we will call the confidence level. The confidence level is simply the normal distribution equivalent of the z-score we receive from our tests. If this sounds complicated, all that the trader needs to know is that in order to be considered suitable for profit maximization y money management methods our test must produce results that are greater than 1.96 or less than -1.96 (corresponding to the 95 percentile of normal distribution).
In this article we will discuss the relationship between market cycles and forex through a dialogue between a beginner and a successful trader. The successful trader is ST, while the beginner is B:
B: What is the business cycle and how can I use it trade forex?
ST: Business cycle is the name given to the growth and contraction phases of economic life. It is one of the most important determinants of economic trends; no trader can be called a trader without understanding the inevitable nature of cycles. Since it is one of the major drivers of all trends and economic events on global scale, it plays a very important role in determining currency prices and their trends.
B: How does the cycle determine forex trends?
ST: On the most basic level, the cycle is the most important driver of money supply growth. Since money supply is closely related to currency values (the more there is of a currency, the less its value will be) forex trends also respond to cyclical developments. But this is just a tiny portion of the power of the business cycle. The nature of the cycle also defines such variables as unemployment, consumer demand, industrial production, availability of credit, and these variables in turn lead international capital to shun or favor a currency.
B: And how does that happen?
ST: When a nation is going through the boom phase of the cycle, international capital will flow there in search of better returns on investment, through channels like foreign direct investment, or international loans. Those will create inflows of capital, and cause the nation’s currency to appreciate. Conversely, when a nation is going through the bust phase of the cycle, international capital will shun it, dry up forex flows, and cause the currency to depreciate. As with Newton’s First Law, these developments will keep going on until they’re exhausted through market developments, or are contradicted by government action.
B: How can I benefit from this knowledge?
ST: You can short the currencies of nations that are going through the bust period, and long the currencies of those that are just entering the boom period, with the caveat that those nations that are net-creditors (external assets are more than liabilities) will see their currencies appreciate, regardless of the their domestic economies.
B: Is there a way to anticipate the beginning of these periods?
ST: The boom and bust phase of the cycle can be initiated by any sector of the economy. When the problems begin among financial sector firms, these will contract credit to overcome their own problems. When the troubles arise in another sector of the economy, the banking sector will contract credit in anticipation of defaults and bankruptcies. In either case, the result is contracting credit, and this can be observed, usually before the crisis begins, in Central Bank statistics, corporate loan rates, and news reports that speak about layoffs and bankruptcies. Of course if the phase is a boom, the developments will be in the opposite direction, with expansion replacing contraction, but the process is similar. The boom and bust both develop through contagion; as the dynamism, or rot in one sector spreads to others, general economic activity is buoyed or suppressed, and the boom or bust is underway.
B: All that theory is good, but where do I actually look to see the beginning or end of these phases?
ST: There are two types of indicators for that purpose, lagging, and leading. Unemployment numbers, central bank policy actions, bankruptcies are all lagging indicators for a bust, and cannot be used to predict anything. The best leading indicator is supplied by careful analysis of the economy and identification of the areas where the greatest imbalances accumulate. I know that this will be difficult for you, so you’re invited to seek your leading indicators in the loan surverys of the central banks, as we had discussed before, and delinquency statistics. These are not exactly leading indicators (since they also respond to some already existing malaise in the economy) but they are close to being such, because banks are one of the earliest actors in any economy in feeling the pain of impending recessions. They are the first to hear of loan delinquencies, and loan delinquencies lead to credit contraction, which leads to contagion, as we discussed, and a deepening crisis.
Another important indicator for anticipating a recession is the status of inventories. GDP growth that is mostly created through inventory accumulation is one of the safest signs of an impending recession. Firms have to liquidate inventories, and if they find out that they cannot do so through patience, they will simply begin to reduce capacity and eventually eliminate jobs.
For predicting the boom phase, most of the above data can be useful, but for a healthy and long lasting boom all of them must eventually be pointing in the same direction. For instance, first the central bank rates must come down, then unemployment growth must level off, industrial production must begin to strengthen, and so forth. Usually, central bank rate reductions, followed by easier credit conditions, are some of the more reliable indicators for predicting a boom, but a financial crisis may make these indicators irrelevant. In such a case, the trader must focus on the real economy, and unemployment, to get an idea on the stage of the economical development.
B: So you say that I keep my eyes on the financial sector always, and on inventory statistics for detecting a bust, and for a boom I wait for a number of areas of the economy to find vigor and strength.
ST: Yes. This is not the best way of anticipating the circles, but at least you will never be in denial when a recession strikes.
B: How does globalization impact the nature of cycles, and what is the implications of this for currency trading?
ST: Globalization causes the booms and busts to be synchronized across economies which results in the phases of the cycle both being stronger and deeper than it was in the past. Before the end of the cold war, for example, a large part of the world would be relatively immune to the effects of speculative bubbles in the western world due the nature of socialist economies. Before that era, regional and national economic activity was always somewhat isolated from the world at large as national authorities sought to maintain a degree of economic independence. As globalization brought all these phenomena to an end, we now have global booms and busts. What this means for the forex market is that while volatility dissipates to extremely low levels during the boom phase, it rapidly skyrockets during the bust, and makes leverage an even more sharper sword than it usually is. So in that sense, in a globalized economy the currency trader can increase leverage during the boom phase, while lowering it significantly during the bust.
B: So if booms and busts are correlated on a global scale, how can I find abnormalities in the market to exploit?
ST: This is not difficult, because the cycle is driven through the accumulation of imbalances at the micro-level, such as that between a bank and a mortgage borrower, right up to those at the macro-level where some nations run forex surpluses, while others suffer from deficits. Thus, at the end of a bust phase nations with sound and conservative economic policies will have absorbed too much capital, which then flows to risky assets in the boom phase. Conversely, towards the end of a boom phase, too much risk taking will have caused nations with weaker fundamentals to possess either a swollen real sector, or an artificially expensive currency, which are then normalized in the bust. The cycle readjusts these imbalances, and the trade opportunity lies in the exploitation of this correction.
B: You mean that during the bust you sell the currencies with high deficits and non-conservative policies, and during the boom you sell the sounder ones which cannot create enough activity to satisfy the risk appetite of investors and speculators.
ST: Booms and busts are correlated across the globe, but that doesn’t mean that all currencies behave in the same way. Currencies of capital importers behave in the opposite direction to those of capital exporters during both the boom and the bust phases of the cycle. The trader can exploit this divergence for profits, for example by selling the Euro (current account balance, prudent fiscal policies), and buying the Turkish Lira (real estate bubble, external dependency, large deficits )during a boom, and doing the opposite during the bust.
News and economic data are the main drivers of market developments, but in a little different way than many traders think. While many novice traders expect important economic events and news releases to be reflected on the price immediately, complain about the irrationality of the market when that doesn’t occur and protest that trading the news is not possible, in fact it is possible, and extremely lucrative in the long term, if one is willing to wait for the payback to arrive. In this article we will take a look at various data types, and attempt to classify them according to a few basic criteria. We will also try to explain how news releases determine market prices in the long term, especially those of greater value and impact on the market. Finally, we will say a couple of word on short term news trading, and how this could be achieved on the basis
In the US most major news releases occur between 8:30 am and 10 am New York time, and consequently trading is also most active and volatile in this period. Option expiries, and market openings take place during this period also, when traders are busy at their desks absorbing and evaluating overnight data, attempting to place all the developments in a general context for usage later in the day. Since volatility is so high in this period, the profit/loss potential is also the highest. It is obvious that proper risk controls and money management techniques will play a major role in our trading method, if we want to avoid being caught in false breakouts and whipsaws.
The markets’ reaction to any type of data is unpredictable. This is not only the case when the news release is in line with analyst expectations, as published by news channels and financial news providers, but also when the release surprised significantly. Sometimes it’s not even possible to predict how volatile the markets reaction will be to the news release. Sometimes the market will move within a range of fifty or more pips in response to data released. Sometimes a 100-pip movements in the span of one or two minutes will be reversed and completely negated by the price action during the rest of the day. Conversely, while news releases are usually the most volatile periods of a typical trading day, a very unusual release may be welcomed with relative calm if the market decides to do so. What is the cause of all this great unpredictability?
During a news release a number of speculators will react immediately, hoping to gain a quick profit and exit. These will create a very brief ballooning of spreads and volume in the immediate term, but also will distort the underlying technical picture greatly. As these initial buyers or sellers exit, momentum traders will attempt to join in and fuel a more sustainable short-term trend with their actions. Depending on the time and liquidity in the market, they may well be successful, but sometimes they too are checked by previously unknown order layers that check the advance of the price. When these absorb the momentum traders, and short term speculative entrants, the initial reaction of the price may be reversed or negated also.
But while this is so, we do not imply that it is not possible to trade the news in the forex market. All that must be born in mind by the trader is that he’s engaging in a game of probability; he must be very well aware that there doesn’t exist a news release that will ensure that the market will move in this or that fashion. Stop loss orders must not be very tight, and leverage must be kept quite low, so that the order we enter can survive more than a few seconds of the initial shock reaction by short-term actors.
The two major problems of trading the news arise out of the difficulty in gaining timely information, and evaluating that in a fast enough manner to facilitate quick entry into a trade. Hence, it is clear that the trader must have a very good idea of what he expects from the news release. Will he only open a position if the data shock the market? What is the threshold value for the data, above or below which a trade is justified? How long will the position be held? Which technical levels constitute the take-profit, or stop-loss orders for the trade? All these must be discussed and determined even before a trade order is entered. News releases must not be periods when the trader will be hesitating and vacillating between the various paths he can take. Instead, he must act like a machine, with almost automated movements, so that he can be immune to the emotional pressures created by the irrational short-term behavior of the market.
The last issue with trading news releases is born of the unreliable nature of the first versions. In fact, studies have shown that the BLS (the Bureau of Labor Statistics), for instance, consistently underestimates job losses in a recession, and underestimates job gains at the beginning of the boom. Nor does the experienced trader have any trouble in acknowledging this fact: revisions which reverse the meaning and character of the initial release are not at all exceptional in the markets. The short-term trader is not much bothered by this fact, but it has great significance for decisions on the long-term positioning.
There are two ways of trading the news.
1.Long term: Several academic studies have established that the impact of some news announcements have their immediate impact spread over a period of weeks and months, instead of the single day in which the markets are thought to discount them. Non-farm payrolls, and to a greater extent, the interest rate decisions of the federal reserve are good examples for this kind of news flow. While the markets react violently and unpredictably in the short term, the mechanisms set up by low interest rates, and full employment (or conversely, high unemployment) have consequences that are relevant to many sectors of the economy, and trading them on a long term basis is certainly possible. The trader who uses this strategy will build up his positions slowly, and will attach greater value to low frequency releases (such as GDP reports), and will wait until the overall picture offers clarity, before he makes his trade decisions.
2.Short term: To trade news on a short term basis, the trader must have a clear criterion on what kind of news will justify a trade. Many news traders seek at least a 50 percent surprise in the data to consider the release tradeable. The novice trader, in turn, can use the initial period of his trading career for perfecting his money management skills. Trading the news on a short term basis can be easy and lucrative if the trader is disciplined enough to cut losses, and accumulate profits, but panic and mood swings, and undisciplined methodology will quickly erase all the gains through shocks and volatility.
These are the various types of indicators which have the potential to cause the greatest short term movements in the markets
While very important, the severity of market reaction to CPI releases partly depends on the health of the general economy. In a booming economy, a string of uncomfortably high CPI values will force the central bank to raise rates in order to subdue growth. In a contracting economy, a high CPI value may prevent the central bank from realizing counter-cyclical interest rate reductions. Since central bank rates are so important for determining the tone of economic activity in the long term, markets pay great attention to the value of this indicator. On the short term, of course, these considerations have no relationship to the motives of speculators, but they do present the justification for violent short term price spikes for momentum traders and short-term speculators, if the data surprises in either direction.
Depending on the nature of the decision, and how surprised by it the market is, the price swings can be very large and the immediate reaction meaningless with respect to the long term direction of the trend. Fed decisions are one of the most anticipated events in the market, and their macroeconomic significance certainly justifies this attitude. The Fed meetings typically last for about two days, beginning on Monday and concluding on Tuesday. Then the decision is released to the public at around 9 pm New York time.
Fed rate decisions can cause large movements if the rate change is different from what was expected by market consensus. In the absence of such a surprise, traders will concentrate on the tone of the statement accompanying the interest rate decision. Depending on how dovish or hawkish the statement is, the markets will readjust their future interest rate expectations, and on that basis they will reprice currency pairs. The repricing period can be quite long, and it’s unwise to expect this process to be completed in the course of a few weeks.
European central banks and the US Federal Reserve usually release their rate decisions during the first week of each month. As most of the important data are released during this first week from around the world, traders are exceptionally nervous and excited, amplifying volume greatly, but also increasing volatility, as the large amount of short term speculative money opens and closes very short-term positions. In fact, some traders turn the typical movements of this period into a trading strategy.
Sometimes called the mother of all data, on a typical month the time of this release coincides with the most volatile market action. Non-farm payrolls measure the payroll change of the non-farming private and public sectors. Since economic cycles, consumption, and consequently interest rates all depend on the employment situation of the US economy, the non-farm payrolls release is the most closely watched of all indicators.
For the most part, most experienced traders will avoid trading the immediate aftermath of this release, due to the somewhat nutty price action that follows it. If you’ll forgive the expression. On the other hand, if the trader is satisfied that the data release strongly suggests price movement in a direction, he will use the short term fluctuations that occur as a trading opportunity by entering orders that contradict the market’s short term direction.
While this data is so crucial to a nation like the US with a large domestic economy that is less dependent on trade and commerce, its equivalent is not as important for nations like Japan where the dynamics of the domestic markets is closely correlated to the situation of the global economy.
The non-farm payrolls data is typically released by the Bureau of Labor Statistics on the first Friday of each month.
The PMI provide a very quick and accurate snapshot of the status of the various sectors of the economy. They do not create as much volatility as the other major releases (such as the non-farm payrolls data, or Fed decisions), but as a result they are also more tradable and safer as entry points. Needless to say, a very extreme value can create massive price shocks in either direction, but the real use of this data is for the guidance it provides for predicting the much more important data that is released towards the end of the week. We can trade these releases both on a trend following, or contrarian basis, depending on what our analysis is telling us about market positioning and the fundamental picture.
There are many more releases, and the trader can study each of them for creating his own strategy. The key point is protecting ourselves from emotional extremes, and making sure that we only open positions when we are really satisfied with the data release, and are confident that the scenario offers a reasonable profit potential.
Options have long been popular with forex traders for hedging, for directional bets, maximizing profit or for more complex strategies that are out of the scope of this article, but over the years, the record of options trading for buyers has not been stellar exactly. Predicting market direction in a specific time frame is always a difficult endeavor, and when the options trader must make those predictions in strict adherence to the terms of the options contract, the chances of success plummet. About 90 percent of option buyers eventually lose money, in sad testimonial to the difficulty of market timing.
Option writers have been increasing the types of available contracts to satisfy the hunger of the crowd for these instruments, and if not for the recent economic crisis, the volume and diversification in this market would certainly have continued to accelerate. In spite of all that, the basic puts and calls remain the most popular tools for the trader who desires to try his luck in this field, and there’s always a great deal of demand for the ever increasing supply coming from option brokers.
The attractiveness of various types of options to the trader mostly arises from the limited nature of the risk. For instance, a stock trader who shorts the firm X will face unlimited losses if the firm’s price moves in the other direction, but if he simply buys a sell-option on the firm’s stock, the maximum amount he could lose will be limited by the value of the contract ( in the same case, the option writer’s risk is unlimited, in theory). But that aside, there’s no reason to think that on a basic level options trading is any different from spot trading, and the similar nature of the spot forex market to the options market will be the basis of our market predictions.
Before examining the nature of the put/call ratio, and its significance for forex, let us remember that a put option is a contract that allows the buyer to sell an underlying asset at a specified price, and a call option is the kind which allows the buyer to buy the underlying asset. Thus, a buyer of the call option is expressing a view that the price will be higher at a specific point in the future, while the buyer of the put option believes that the price of the underlying asset will fall.
Now, what happens when euphoria (or panic) overtakes a market , and a bubble is created, as spot traders of any asset flock to grab a share of some security or futures contract on which options are available? How will the options trader’s reaction to the bubble be? Of course, the option trader is no different from the spot trader, and the bubble in the spot market has its mirror image in the options market as well. In other words, it is possible to identify extreme values in the spot market by looking at how ebullient option traders are, and the put/call ratio is utilized in a contrarian fashion to identify and exploit these extreme values for profit.
As most of us know, a contrarian strategy focuses on finding undervalued or overvalued assets in a market, and betting against the market in those assets to exploit the correction that will inevitably occur. It is always possible to define oversold or overbought values on the raw price data, and to make counter-trend wagers on that basis, but the highly volatile nature of the forex market makes this a relatively risky effort. That is why the trader always attempts to confirm his positioning with reference to more than one type of data, and with the volume data gained through the usage of the COT report, and the put/call ratio options market extremes can help traders identify opportunities in the spot market. We calculate the put/call ratio by dividing the total amount of puts by the amount of calls and on that basis get a value that reflects the bias of the market. For example, if there are 24000 put options on EUR/USD, and 60000 call options, the put/call ratio would be 0.4 implying a bullish market. The put/call ratio will rise as sellers drive the trend, and it will fall as the buyers are more numerous. As positioning reaches extreme values, so will the put/call ratio, until a point is reached where the drivers of the bubble are exhausted, which is usually followed by a violent collapse. We can identify the values registered during past collapses, and by comparing the value of the put/call ratio with past data, we can gain an idea on the market direction in the near future.
Trading the put/call ratio depends on identify the put/call values registered during past price extremes, and comparing that with today’s values, as we mentioned before. If a breakout or spike is not confirmed by an equivalent change in positioning in the options market, we will be reluctant to act in the direction of the trend. Such a situation would signify that options traders are not convinced by the action in the spot, and do not believe that it will lead to a sustainable price action. Since many speculative deals in the spot market are hedged in the options market, lack of a confirming movement could suggest that the price action is driven by less-informed, smaller players. For contrarian trades, we will take note of extreme values in options positioning, and will enter counter-trend orders in anticipation of the collapse. This method is really straightforward, allowing the trader ease of mind and clarity of analysis.
Let us also remember two of the difficulties which this method poses for the trader.
1. Needless to say, the definition of extreme value is arbitrary, and there’s no way of knowing which of the previous peaks will hold, or if a new peak in the put/call ratio will be registered as a result of market action. This means that the trader should be cautious about using options market data for the exact timing of market reversals. There’s no magical quality to the put/call ratio, since quite often option traders also trade the spot market in forex, for the reasons mentioned at the top of this article.
2. Options traders are just trader, and there’s no reason to expect to be any smarter than spot dealers. Indeed, studies show that, if anything, they are more likely to suffer losses as a result of directional bets.
We conclude this section by noting that the data on put/call ratios, and trader positioning can be obtained from the CBOT website.
Clustering Illusion is the tendency to see non-random sequences in a string of random data. It is especially dangerous for traders, because perceiving a non-random pattern in a random string of wins or losses may lead us to increase leverage or trade sizes, which could eventually lead to large losses or the wipe-out of an account.
X being heads, O being tails, the string XXXOXOOOXO appears non-random to many of us at first sight, as it has two large clusters of OOO and XXX, but in fact the total number of Xs Os are equal, and the clusterings could just be the small part of a larger, more evenly-distributed sample. Many traders mistake strings of random groupings for a non-random distribution of results, and decide on the value of a trading strategy on this basis. However, we need quite a bit more than visual identification to prove to us the non-random character of a data stream.
The gambler's fallacy is partly a result of the clustering illusion. Due to the clustering illusion, the gambler sees non-random streaks in a random pattern, and concludes on that basis that a long streak of tails or heads implies a higher likelihood of the streak being broken on the next coint toss. Of course, a streak of XXXXXX is perfectly possible in a long streak of coint tosses, but if we were to hit six heads in six tosses in a row, our friends would all clap their hands and congratulate us on our grand streak of luck. In this context, luck implies that the coin tosser somehow has caused the results to become dependent on each other, that he has the "flair", that his string of incomes makes it likelier that he will make even more winning bets. However, we have already stated the above pattern is perfectly possible in a random string. Thus the coin tosser, and his friends are all wrong about the luck of the coins or their owner.
When evaluating trading results, the clustering illusion is the worst foe of a trader. The appearance of strings of wins or losses by no means suggests that the strategy we use is providing us with superior returns. Similarly, such strings should never constitute enough reason, by themselves, for increased leverage, or larger trade sizes.
How do we avoid the clustering illusion?
From the above discussion, it is clear that the clustering illusion is a dangerous phenomenon, due to its tendency to lead to false signals and unjustified confidence. It is especially detrimental to the success of a trading strategy, because the success or failure of a technical method is only measured in terms of its wins or losses.
There are two ways of avoiding the problems associated with the clustering illusion. One is to use mathematical tools, such as the z-score, to gauge if the concatenation tendency of our profits and losses constitute a random pattern or not. The other method is to trade less, and use long term methods in order to reduce the total number of "coin tosses" we do, and to altogether reduce the role of volatility and short term swings on our portfolio.
Volatility in the currency markets is influenced by a number of factors foremost among which is the risk perception of financial actors. Risk, of course, can be defined in terms of many different variables including politics, natural disasters, in addition to the usual economic factors that always go into the calculation. But among those factors, arguably nothing is as important as interest rates in determining the level of long–term volatility in the forex market. Of course, this is not a one way relationship. Interest rates are themselves influenced by volatility, since the fluctuations caused by ongoing and long-term volatility strongly influence the decisions of central banks. Here we will take a look at the causes of the relationship between interest rates and volatility, and will attempt to determine its role in our choice of leverage and margin.
Volatility is a reflection of uncertainty. In a market where there’s no new information, volatility itself would be low or non-existent, but it is clear that the mere existence of a large number of market participants by itself creates volatility. Thus, there probably exists a state of minimal volatility below which no market activity would be possible. In other words, ordinary transactions necessary for the conduct of business and minimal economic activity would itself necessitate a minimal level of volatility in even the calmest markets. The question that we want to discuss here is about the impact of interest rates on the trade decisions of speculative actors and the bearing of their decisions on market volatility.
At first sight, it is clear that interest rate differentials increase the number of transactions in the market. Clearly, gaps between the interest rates of different central banks create opportunities which are exploited vigorously by speculative actors of all kinds. But at the same time, we know from experience that the widening gap between emerging market and developed market interest rates was coupled with a decrease in forex volatility, as part of the so-called and by now disproven Great Moderation discussed by some economists. This is partly due to the fact that rising liquidity causes lower volatility. But the relationship between increasing liquidity, and a widening gap between interest rates is not that well understood. First of all, since interest rates and risk perception are closely related to each other, it is counter-intuitive that a rising interest rate gap between nations would result in lower volatility, and lower risk perception among market participants. We can illustrate this better by making an analogy with the interest rate gap between bonds of investment grade firms and speculative grade junk bonds. When this spread widens, it is coupled to increasing volatility in the bond market. During the same period when the widening gaps in interest rates among nations led to reduced forex volatility, reduced volatility in the corporate bond market was coupled with a contracting gap between the bonds of speculative and investment grade firms. Clearly, there is some discrepancy here.
A way of explaining this is by separating the period between 2000 and 2007 into two phases. The first phase was dominated by falling interest rates around the world, initiated by Alan Greenspan’s choice to bring the rates down to 1 percent and keeping them there until they were raised by Ben Bernanke four years later. During this period, volatility came down from higher levels as dormant money found its way to stock markets and other kinds of investments around the world. During the second part of this era, again initiated by the US Fed, interest rate gaps actually widened, but there was no corresponding rise in longer term forex volatility, apart from a few blips that occurred, for example, in February 2007. Was it then a sign of the coming turmoil in 2008 that these widening gaps between emerging markets and developed economies were not reflected in the forex market? We would argue that it was. For one, the rise of inflation has almost always been coupled to a subsequent cooldown period, or even recessions in all economies. No economy can afford to run at full speed in an inflationary environment. And since many emerging markets were raising rates to fight inflation in this period, historical experience strongly suggested that a period of slowdown was likely which would have necessitated a rise in volatility, as it often happens. But market participants refused to adjust themselves in accordance with this fact, driving the currencies of emerging markets higher, being content with lower risk premiums, until volatility returned with a vengeance in a series of events that all of us are familiar today culminating with the Lehman bankruptcy, and its aftermath.
The common paradigm suggests that widening gaps in interest rates should be coupled to rising volatility. However, as with all fundamental changes, it may take a long time before market participants recognize the changing risk profile, adjust their positioning in accordance, reconsider their leverage ratios and margin arrangements, which all lead to a contraction in liquidity and the consequent rise in volatility. Sometimes there’s no gradual arrangement at all. Instead, market shocks and related events create dynamics which force traders to reconsider everything in panic, creating massive volatility in a very short term, followed by periods of calm. Eventually, the pattern of rising and falling volatility creates the familiar zigzagging pattern we’re used to seeing in shallow markets where swings are sharp and deep.
The relationship between the interest rate gap and volatility is not very difficult to explain. Of course, the gap that we here speak about is a general measure of the gap between the weighted average of developed nations’ central bank interest rates, and that of developing nations. Low interest rates in a single group of nations is not enough to draw down volatility, for the simple reason that low risk in developed countries, that is, low risk in financing, does not translate into low volatility in forex unless it is coupled to low investment risk, as measured by developing nation rates. To illustrate this further, we can consider the example of the investor who borrows at very cheap rates in Japan, and invests the funds in a commodity project in Russia, where interest rates are high due to many possible reasons. Although the risk perception in Japan is low due to the (past) fundamental strength of the economy, and consequently, the risk on the financing side is small, the high rates in Russia would suggest that the investment in Russia has an unfavorable risk profile. Since these relationships are bilateral, the gap among interest rates, rather than the rates one nation, or a group of them is what determines risk perception and volatility.
Another aspect of wide interest gaps that causes volatility to rise in the long term is the carry trade. While carry trades are most active towards the end of a low volatility environment where the gaps are widening, by definition, the highest amount of activity in this field is coupled to the greatest risk. In other words, the low volatility environment under which the carry trade thrives is irreconcilable with the widening of the interest rates, which also means that the higher the profitability of this trade, the higher its risk, and the greater the imbalances created by it. Indeed, the carry trade itself is perhaps the greatest driver of all economic activity in a low interest rate gap, low volatility environment wher money flows easily. When it is considered as the sum of all investments that are made in search of high yield (and not just high yield in the form of interest rates, but including FDI, cross-border acquisitions, and everything that is driven by a low perception of investment risk), the carry trade is clearly the major driver of activity in a low volatility environment. The paradox created by the irrationality of those taking part in it is one of the most important causes of the eventual spike in currency market volatility and similar sharp changes in market trends and dynamics that announce the end of interest rate rises.
All of the above discussion would lead its logical consequence that ties volatility to gaps in interest rates. It is rare to have high volatility in a situation where interest rate gaps are closing. Conversely, it is infrequent that a widening interest gap among nations results in a low volatility environment. But it must be born in mind that markets can remain irrational, and refuse to recognize facts for periods longer than what would be required by analysis. Thus, although volatility and interest rates are closely related, the momentum of trading and economic activity can distort this picture greatly, creating periods where the relationship seems to break down. This was clearly the case, for instance, during most of the 2005-2007 period. As of the writing of this text, it seems that we’re going through a similar phase where decreasing interest rate gaps are coupled to higher volatility. It is unlikely that this situation will be long-lasting.
How should traders use this information for trading choices? First, for long term traders, here lies another indicator that can be utilized to identify imbalances in the market which can then be used for profit. Small positions opened against the market as soon as the disparity between the actual rise or fall in volatility and what would be demanded by theory can be maintained until the eventual realignment occurs, and the market moves in the direction anticipated. After that, increased leverage, and greater positions may allow the exploitation of the new situation. For short term traders, the alignment between fundamental analysis(theory) and market conditions can be used as a gauge for determining the best trade. In short, the trader would open a position that would be suitable to a low volatility environment (such as the carry trade) when interest rate gaps are closing (which often happens in an environment of falling rates), and vice versa.
Of course, in this discussion we are neglecting the impact of velocity of money on the dynamics created by interest rates. The impact of the interest rate gap is greatly influenced by the velocity of money, but the factor is even more important when interest rates are falling. The impact of the falling gap can be negated if falling velocity of money results in reduced liquidity finding its way into the markets. In that case, volatility may not fall much, as the availability of credit doesn’t become reflected in an increasing number of transactions which could fuel increased activity in the forex market. Our discussion in this text presupposes only a moderate fall in the velocity of money, that is, banks reduce lending, but only moderately during the period that leads to the lowering of gaps between central bank interest rates. If the reduction in velocity were severe, the outcome would be serious enough to invalidate our scenario.
The relationship between higher volatility and money management is evident. High leverage and high volatility is an explosive cocktail that can easily wipe out a large number of accounts in a short time, but increasing leverage in an environment of lower volatility is not an extreme decision. Understanding the relationship between interest rates and currency market volatility can be helpful in adjusting our portfolio accordingly.
Currencies are the basic building blocks of all economic activity. A grocery, a military contractor, a mortgage borrower, and even gangsters evaluate their economic plans in terms of currencies. Consequently, the forex universe encompasses all the other fields of financial activity including the bond, commodity and stock markets.
Most traders possess at least a basic conception of the relationship between forex and the stock markets. As large amounts of money is injected into the stock market, the resulting currency flows cause the value of currency pairs to fluctuate simultaneously. Similarly, commodity market trends have an easily demonstrable impact on the short term fluctuations of commodity currencies, and a slightly less clear impact on those of others. The same dynamics that cause these markets to influence currency quotes also ensure that fluctuations in the bond market affect the short and long term dynamics of the forex market powerfully, but there are also certain aspects peculiar to the bond market which we’ll try to examine in this article.
The bond market is very large, with the US treasury market reaching a size of about 10.7 trillion dollars as of December 2008. Needless to say, bonds are not issued by government entities alone, as townships, corporates, and many other types of institutions regularly issue their own papers to benefit from this vast and liquid market. Actors in the US treasury and corporate bond markets range from small individual savers to foreign governments with gigantic amounts to spend, and the impact of all kinds of economic developments is felt in the bond market on a daily basis.
What is the use of the bond market? For buyers of corporate bonds, the purpose is benefiting from the various yield options available while controlling risk exposure through bond ratings, and the maturity term of the paper bought. As bond investors are always higher in the payment structure in case of default or bankruptcy, many investors and traders choose to purchase bonds in place of stocks in order to achieve a favorable balance between risk and yield. Purchasing the bond of a corporation allows us to benefit from the growth of the firm while taking minimal risk, but at the same time minimizes our control over the capital lent, since bond investors have no say in how the management of a firm uses the borrowed funds. The significance of the corporate bond market is more limited for the retail forex trader than that of the treasury market. On the other hand, as corporate bond rates are powerful indicators of risk perception in the markets in general, the forex trader is well-advised to adjust his leverage in response to spikes in the rates of speculative, or low level investment grade corporate bonds. If sustained, such spikes would have long-lasting and deeper consequences for the economy at large, and recessions are often preceded by turmoil in the corporate bond market.
The role of the government bond market is different in a number of ways. First of all, we must keep in mind that, as long as a government possesses the legal right to create money, it is in no danger of defaulting on its obligations. Consequently, if there is anywhere a risk-free investment, it is clear that a government bond is the most credible candidate. Secondly, since government bonds are almost certain to be paid in time, they serve as a general benchmark against which all other kinds investments are measured. The success or failure of a professional money manager, for instance, is not measured in the absolute value of dollar gains or losses, but in comparison to the yield on the treasury bond of a comparable term. This method is useful because it allows us to evaluate the risk/reward ratio of an investment in a much more constructive way: if by holding a three-month government bond we can achieve greater returns than that offered by our forex manager, what is the point of investing anyway? Thirdly, the government bond market finances the spending of governments. Thus, fluctuations in this market have far greater significance for the value of a currency, since the changes directly influence the credibility of the government’s policies, and the sustainability of its deficits. And finally, since bond yields are strongly dependent on inflation, and inflation is closely related to growth, the term-yield structure of the government bond market provides a very powerful early warning system for predicting periods of boom and bust.
Forex traders with some experience will be quick to recognize the intra-day relationship between treasury bond yield, stock prices, and currency values. This is not surprising, since in many cases, the fluctuations in the value of a currency represents the movements of foreign investors between bonds and stocks as the events of the day progress. In addition, the strong relationship between inflation expectations and bond yields makes government bond yields a very useful indicator for evaluating the financial world’s opinion on the success or failure of US Federal Reserve in controlling inflation. As inflation is a significant component of the equation that decides currency values, the importance of the data provided by the treasury market is evident. But beyond all the short term sound and fury, developments in the bond market have important long term implication for currency trends too. As an important component of the financial account, external flows into bonds have a direct role in establishing long-term currency trends. The fact that the US dollar still has not collapsed in spite of the massive spending and borrowing of the US government is in part explained by the continued health, at least on surface, of the US Treasury market. We hope to return back to this subject in future articles, and examine the bond market in greater detail.
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