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Looking at Random Trading

Every once in a while, the topic of random trading comes up. Normally, it’s part of a discussion about whether you could go long or short based on a coin toss and trade profitably because of a good exit and money management strategy. Let’s take a look and see if there’s any truth to that assertion by running some tests on EUR/USD daily data going back to when the euro was launched in 1999.

Random in, Random out
As a base line, I’m going to start with a totally random system – one which uses a coin toss to get into a trade and a coin toss as to whether to exit an existing position. The rules are very simple. Start with the coin toss to figure out long/short at the end of the first day’s trading. At the end of Day 2, we do a coin toss to see if we’re going to stay in the position we put on Day 1, or close it out. If we stay, we do the coin toss again the next day. If we exit, we start the process over at the end of that next day (so if we exit on Day 2, we do a coin toss as to whether to get long or short at the end of Day 3).

I ran 1000 tests on the data set to get enough information to make a reasonable conclusion. The results were pretty predictable. On average, the test resulted in a 26 pip loss, which is basically the same as being flat over more than 10 years of data. The standard deviation was 3668 pips, giving you an idea of how wide the distribution of results was over the 1000 test sample.

Random in, Strategy Out
The totally random system didn’t cut it, so let’s look at a random entry system that has a non-random set of rules for exit. I used the same coin toss entry as noted above, but for the exit I tested a reverse break approach. Specifically, the rule was that longs would be exited if the current day’s close was lower than the close from N days prior, and shorts would be exited on a close higher than the one from N days prior. I tested a range of look-back periods of 1 to 10 days. Here’s what it produced.

What the chart shows is the average result (the tick on the bar) and the range containing results one standard deviation above and below the average. So in the first bar we’re looking at an exit strategy which says get out of a position if today’s close is lower/higher (if we’re long/short) than yesterday’s. The average outcome was a loss of 3602 pips, with a standard deviation of 1846 pips. That means the 1-day test was a losing one in all or nearly all cases, and by a pretty sizable amount, generally speaking.

It is clear from this data that a random entry system can be profitable, though. We need look no further than the middle of the chart to see the performance of the longer look-back periods. The 6-day look-back provided the best result with a 5446 pip average gain and a 1236 pip standard deviation. Eyeballing the 1000 sample test results, I don’t see any negatives among them.

Maybe we’re looking at things backwards
Looking at these numbers, it’s hard not to think that maybe traders need to look at things the opposite way around from how they usually do – to think about exit first, rather than the entry. OK, I’m not really suggesting that we all just start trading random entry systems, but it certainly does provide fodder for further testing and analysis. We can use random entries to test the performance of different exit strategies. One caveat there, though. You have to make sure when you do something like that that you’re getting the same entries for each different exit approach, otherwise the results won’t be comparable.

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The Best Forex Market Analysis in the World!

Yesterday, at the FX Week awards event in London, the forex market analysis product I work on within the IFR Markets group at Thomson Reuters was presented with the coveted Best Vendor for FX Research and Strategy award for 2010. Basically, that means we do a better job than any other 3rd party provider (non-bank, non-broker, non-dealer, etc.) of providing insightful and useful market commentary, analysis, and trading strategy according to the voting of users.

We’re #1! We’re #1! We’re #1! 🙂

While most of our customers come from the institutional trading world (banks, hedge funds, etc.), our content is also available for free to retail forex traders through Oanda, FXDD, dbFX, and FXCM (to a limited degree). If you broker isn’t on this list, tell them you want IFR Markets. IFR Markets forex coverage is also available to members of the Currensee community through that platform.

Here’s the release:

IFR Markets wins prestigious industry award for FX commentary

IFR Markets, the real-time markets commentary service of Thomson Reuters, has won a prestigious FX Week Award for its agenda-setting coverage of the foreign exchange market through a year of great turmoil.

IFR Markets Forex Watch won the Best Vendor for FX Research and Strategy, 2010 award, which is decided by votes from the foreign exchange industry and recognizes the expertise, commitment and flair of the editorial team.

The team consistently provided incisive commentary and winning trade ideas through a stormy year for currency markets that included a yuan revaluation and Japanese intervention, a euro crisis, multiple dollar slides and a surge in emerging currencies. They faced stiff competition from players such as Informa Global Markets and 4Cast who value this accolade above all others.

IFR Markets Forex Watch is a commentary service run by analysts in London, New York, Boston, Sydney, Tokyo and Singapore who cover majors and emerging FX around the world, around the clock. Packed with flow and order information, technical trading strategies, options flow and volatility data and regional/country focus reports, Forex Watch complements Reuters News and Reuters Dealing, giving Thomson Reuters customers a complete offering in the foreign exchange space.

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Reaction to the “worst analysis” post

My post from yesterday, Some of the worst market analysis ever!, generated a bit of a response (I’ve also noted that another blog picked up the post to which I was reacting). While my main focus was on showing readers of this blog the sort of analytic pitfalls one can fall into, I’ll admit that picking a bit of a fight with Zero Hedge was on my mind as well. I didn’t really expect a reaction, as I’ve written about the posts there before without any, but this time someone actually made note of what I said in the comment section of a ZH follow-up post on the same subject. That generated a few reactions there.

Actually, one reaction was left as a comment on my post. It was left by someone who apparently is very shy because he/she left no name and a bogus email address. The comment was

“um you trade them in a ratio, the author assumed you would get this.”

I can perhaps understand the commentor’s reluctance to attach their name to this brilliant bit of insight which has absolutely nothing to do with the problem I have with the analysis in question. It speaks not at all to the whole “risk free” question, nor does it address the viewing of converging lines on a dual-scale chart as representing a spread going to zero.

On the ZH site the author left his own reaction to someone named sumo posting my assertion “There is absolutely no mathematical or other direct linkage between the S&P and EUR/JPY.” At least I think it’s the author. As I understand it, several people actually author on ZH under the same nom de plume (that’s pen name), so it could have been someone else on the staff. In any case, the response was:

“I assume the gentleman has never heard of the carry trade and its implications.”

Hah! We’ll leave out a discussion of the fact that I was in the forex market long before “carry trade” became common parlance and focus on the mechanics.

The assumption implied by the above statement is that all carry trading is done through stocks. It most definitely is not. In fact, the simplest and easiest carry trade is to just borrow the low interest rate currency and invest the proceeds in a debt instrument of the higher interest rate one. The carry trade need not have anything at all to do with stocks. That means, as I indicated, there is no direct linkage between the S&P 500 and EUR/JPY, meaning carry trade related movement in the likes of EUR/JPY need have nothing at all to do with the stock market. It can move independently. The current market environment is such that the risk tolerance of traders/investors creates a common driver of action in the forex and equity markets. Were something to happen like a Bank of Japan rate hike, however, there could be a very serious sell-off in EUR/JPY on yen appreciation which probably would have a very minimal impact on US stocks.

I’m not sure whether this comment by aldousd was directed at me:

“it’s ridiculous to say that it isn’t related. it’s been going on all day. I keep reading people saying that it’s a coincidence… a second by second coincidence.”

In case it is, though, I certainly never said anything about “coincidence”. In fact I noted that the drivers for the comparable moves are similar.

There’s another reaction offered up by BeerGoggles to the first comment posted:

He’s going on about zero prices as well and clearly has never looked at the ATRs of EJ and S&P.

I have no idea what this person is going on about. I definitely didn’t say anything about zero prices. Maybe he’s referring to the author, but aside from talking about a zero spread (which I contend is incorrect) I don’t recall him saying anything about zero prices either. For the record, though, as of June 7 the normalized 14-day ATR (meaning ATR expressed as a % of the 14-day average) was about 2.8% for the ES and a touch under 2.5% for EUR/JPY.

Here’s a comedian:

Does he use charts for his trading, or some secret method of essentials we haven’t yet heard of?

Whitty, but the incorrect application of the charts is exactly the problem I have with the analysis. For the record, I use charts all day, every day.

Here’s someone who gets it:

I’m not a trader or an FX expert, but I do know maths and you guys are missing the point.

What the “non-fan” is saying, is that a graph of two variables NOT on drawn on the same scale, is going to lead the observer to false conclusions about trading opportunities when they see a gap. It’s perfectly possible (and in this case highly likely), that you’d loose money by trading ONLY based on the existence of a large gap.

By all means do all the carry trades you wish, but not based solely on this gap information. You need more information to guarantee an easy trade.

Thank you virgule (commentor’s handle)! In case you were wondering, “non-fan” is me. 🙂

As I said in my post yesterday, it’s not about whether doing this kind of pair trade is the right thing. It’s about not employing faulty analytic methods to get there, and not thinking that this is a zero risk arbitrage trade.

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Some of the worst market analysis ever!

I came across an article the other day which got my blood boiling a bit. It basically talks about trading the “spread” between the S&P 500 and EUR/JPY forex cross rate. The author was quite happy with himself for calling the spread being exceedingly wide and recommending a spread narrowing trade. He went so far as to say “Selling ES and going long EURJPY is now pretty much risk free.” I don’t know what anyone else’s definition of “risk free” is, but this trade certainly isn’t mine.

I don’t have any problem with the general idea underlying the trade that stocks and the EUR/JPY rate tend to trade in tandem. It’s been the case for quite a while now that when the market’s are feeling good and buying stocks EUR/JPY (and really all the JPY pairs) will rally, but when the markets are nervous and shifting into a risk aversion mode both the exchange rate and the stock market falls.

My issue with this analysis is this. The author is using a dual-axis plot of the S&P and EUR/JPY (meaning two price plots with different y-axis) to determine the “spread”. When there’s a gap between the lines there’s a spread. When there isn’t, the spread is zero. That would all be just fine if the S&P 500 and EUR/JPY were even close in price, which they aren’t.  At this writing the mini S&P contract is at about 1066 while EUR/JPY is right around 110. Notice how they are not anywhere close to zero?

This has got to be some of the worst analysis I’ve ever seen. Please, please, please don’t every employ this methodology – if you can even call it that.

And calling or implying this trade is some kind of arbitrage is even worse. There is absolutely no mathematical or other direct linkage between the S&P and EUR/JPY. That means no arbitrage, just a coincident relationship. It just so happens that in this market cycle they are trading based on the same main drivers. That could change at any time. That means you most definitely have risk.

Again, I’m not necessarily arguing against the idea of the trade (stocks and cross get back in line). I’m just saying the analysis used to get there is severely flawed and dangerous.

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Forex Seasonals Coming Up Big So Far

Do you know the seasonal patterns which tend to play out in the forex markets? If so, then you were well positioned to take advantage of what we saw out of the likes of the dollar and the euro over the last couple of months. Both moved in accord with their historical tendencies during January and February.

Take a look at as this chart of how EUR/USD tends to perform throughout the course of the calendar year.

EUR/USD seasonal performance through the year

What the chart is telling you is that if you sell EUR/USD during the first 8 weeks or so of the calendar year, and hold that position for a month, you will generally make month. The chart includes data for 1997 to 2008 (pre-1999 data is from the old ECU to which the EUR was pegged at its launch). It doesn’t include 2009 and 2010, which would make things even more negative as the chart below shows

EUR/USD Chart showing Jan 2009, 2010 performance

And here all the market commentators were talking about what was happening with Greece as the main driver of the decline in EUR/GBP the last couple months. While that certainly was contributory, there’s no denying that January and February have a seasonal tendency to move lower anyway. The current news and psychology in the market has been riding along the seasonal pattern.

So where to from here?

Well, the dollar tends to stay on the positive side through about the first quarter of the year, though the latter part of that span is not quite to strong as what is seen in the first two months. As we progress toward the middle part of the year the dollar takes on a comparably negative bias as the positive one seen at the outset of the year.

Look at what’s forthcoming in USD/JPY.

USD/JPY seasonal performance through the year

Week 23, which falls in June, is about the start of 2-3 month stretch over which USD/JPY tends to perform badly. That wouldn’t be a time one generally is going to want to be long.

A little more immediate is the strong tendency for GBP/CHF to rally in the month of April. Between 1982 and 2008 the cross was up 70% of the time at an average rate of 1.73%. Overall, the cross has averaged a gain of 0.78% during the month. And those figures don’t include a 3.3% gain GBP/CHF experienced in 2009.

There are loads more seasonal patterns in the majors and major crosses, from monthly down to daily. Don’t ask me to tell you why they persist. I can only hazard a guess about what the drivers may be, but really I’m just reporting what the numbers say. And you definitely should be aware of these patterns. You’re not going to base your trading decisions on them alone, but they may help you improve your trading odds by biasing you in the right direction.

The data above comes from the research report Opportunities in Forex Calendar Trading Patterns, which I put together after I started noticing these patterns while I was doing my own trading. I have definitely used them profitably since.

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Biases In Market Analysis

A headline on the Business Insider blog caught my attention this morning: Once Again, Moody’s Is Behind The Curve, As The Debt Market Has Already “Downgraded” The US From AAA. The title of the story obviously served its purpose drawing me in, but after that it all fell apart as the author clearly demonstrated his personal bias in interpretting the information. The evidence provided to suggest the market has “downgraded” Treasury debt is that recently yields on Berkshire Hathaway, Proctor & Gamble, and Lowes debt have all traded lower than yields on comparable Treasury maturity paper recently. All three firms are top level corporate credits – AAA ratings.

If you’re thinking the author has it right, that Treasury yields being higher than those of AAA corporates means the market has effectively rated the creditworthiness of the US government below that of some companies, consider this. The US government has WAY more debt outstanding than any corporation – more than all the AAAs combined, and more coming all the time thanks to the big budget deficits. That’s the supply part of the supply/demand equation. More supply is going to tend to mean lower prices, and conversely higher yields.

Granted, if the market thinks a debtor is less creditworthy it will see lower prices (higher yields) because of reduced demand. The markets have been paying a lot of attention to that side of the equation, parsing the results of every auction and holdings report to look for any indication of slackening demand (and not finding much so far). It is important to realize, though, that both supply and demand have to be taken into consideration.

The author of the Business Insider blog post has demonstrated his bearish bias where US Treasury debt is concerned. That caused him to ignore or overlook part of the analytical equation.

It’s also worth mentioning crowding out theory. One part of that theory suggests that the more the goverment borrows the greater the impact it will have on general interest rate levels – driving them higher because investors will put more of their funds into government debt and less into the debt of other borrowers. While higher supply of government debt certainly can have a negative impact on the prices of that debt (they crowd themselves out), government borrowing is done to level off the government inflow/outflow balance out. That means government borrowing comes about because of government spending – money getting put into the economy. That spending improves the financial condition of the private sector (it has more money and/or less debt). The private sector doesn’t need to borrow as much and/or has more money to invest in government debt, so there’s no crowding out.

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Looking for Meaning in Big Open Interest Drop in S&P 500 Futures

Here’s something I noticed today that I found REALLY interesting.

First of all, take a look at this Commitment of Traders data chart for the last year. The green line is Open Interest. Notice the pattern of steadily lower troughs, as highlighted by the red trend line. The troughs come at each quarterly contract rollover period.

S&P 500 Futures Commitments of Traders Data through December 22, 2009

The reason this grabbed my attention was that Open Interest, meaning the number of active futures contracts outstanding, has been steadily declining through the year, even as the stock market has been rising. In other words, stocks have been going up in the face of increasingly less participation by the major institutions (those being the main players in the S&P futures).

Now look at how this year’s Open Interest compares to where it’s been over the last few years.

Monthly S&P 500 Futures with Open Interest

My initial reaction is to be concerned about the fact that the participation of the big players during this rally has been so light. Of course, on the flip side, it suggests there might be a lot of buying potential still on the sidelines.

I’m still mulling it all over, though. What do you think it means?