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Trading Tips

Picking the best forex pair(s) to trade

currencies

Chris as Winner’s Edge Trading did a post a couple months back with suggestions for how to go about picking the best pair or pairs for your forex trading. Essentially, his list came down to a handful of key considerations:

1) Your strategy or analytic methodology

2) Currency correlations and diversification

3) Liquidity

The list actually has eight factors in it, but I consider several of them to be essentially the same type of consideration. Thus my list of just three.

Let me expand on them.

Strategy considerations
In terms of #1, you are best off looking at currency pairs which are well suited to the approach you’ll be taking in your trading. Generally speaking, that will either be trend oriented or range-trading oriented. Thus, if you are a trend following trader you are going to be best off working in pairs which have strong trending characteristics in your chosen time frame. Likewise, if you favor a more mean reversion oriented approach, you’ll want pairs that tend toward ranging and/or sharp counter-trend moves.

Note that one currency pair can fall into both categories depending on time frame and market phase. If there are strong underlying factors at work, then in the higher time frames the pair will tend to trend, but maybe in the shorter time frames it may go through ranging periods. These things can and will change over time. As such, it makes sense for you to have a way to identify current market conditions.

Correlation/Diversification
If you’re trading primarily the major currency pairs it is very hard to truly have an uncorrelated portfolio of positions. You can only go 3-4 deep with majors and major crosses before you have one currency in multiple pairs, which automatically introduces correlation. And even then, certain currencies will tend to naturally be correlated based on the current economic environment. For example, the CHF and EUR will often be positively correlated because both are impacted by the fundamentals of the European economy.

You can certainly trade multiple pairs which share the same currency (e.g. USD/JPY, GBP/USD, AUD/USD). If so, however, you need to account for that in your risk management strategy. It is highly likely that all the pairs you trade sharing that common currency will move together based on the same factors. That’s great when the market goes in your direction as it will multiply your gains, but the same thing happens with your losses when the market goes the other way.

Liquidity
For the most part, liquidity isn’t a major concern for retail forex traders as your orders will usually get filled at or very close to your order price. Yes, during major news events there can be slippage when trading outside the major pairs and crosses – and even in the majors on occasion. If you’re operating in a higher time frame, though, that’s likely not a major concern.

The bigger consideration here is the cost of trading. The more liquid pairs have narrower bid/ask spreads. That can significantly impact your returns if you’re an active short-term trader, but maybe not so much if you playing the longer-term market moves.

How many?
One additional consideration I would add into the mix is how many pairs you should trade. This is a question which comes up a lot in trading forum discussions. To my mind, this all depends on your time frame. If you’re a day trader you’re likely going to want to keep your focus fairly narrow – especially if you’re in and out frequently (e.g. scalping). As you go out the time frames, though, you probably need to be tracking more pairs. It’s simply a function of providing yourself with enough trading opportunities.

In Chris’s post he also mentions personal preference, which I suppose can be an additional factor. If you want to truly be a good trader, though, you should be able to trade whatever market makes the most sense at the time.

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Trading Tips

Some more forex trading tips

risk management

Mike over at The Financial Blogger recently offered up his seven tips for staying safe while trading forex. They go something like this:

– Stick with what you understand, from both a positive and negative perspective.

– Know your risk tolerance and how you emotionally handle your exposure in the markets.

– Have a clear strategy and stick to your trading plan

– Never add to a losing position

– Keep things simple

– The trend is your friend

– Control your emotions and minimize their effect on your decision-making

I can see folks taking some umbrage at the trend one. There are many who consider themselves mean reversion traders. Certainly, those types of strategies can work. The aren’t so good in trending markets, though, just as trend systems get hurt in ranging markets. That’s why having a multi-phase approach can be very beneficial.

The controlling your emotions advice is something you often here. The trouble is, it’s harder to say than do. Further, emotion is an important part of our decision-making process, whether we realize it or not. In fact, I’ve seen research which suggests we actually make decisions emotionally much more quickly than we can consciously, and as a result what we end up doing in what we think is the decision-making process is just rationalizing the decision. Something to think about.

Beyond that, Mike’s got some fairly good, if not particularly new, advice or traders – forex or otherwise.

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Trader Resources Trading Tips

Is social trading all it’s cracked up to be?

social trading

The other day I came across an article at Finance Magnates which encourages brokers to add social trading to their product offering. It offers up ten reasons:

  1. Social trading brings a new age of transparency.
  2. Social trading improves customer relations by creating a more confident trader that is happy trading with your brokerage.
  3. Social trading can be an essential marketing tool that seeks to blast through the acquisition barriers to entry, while at the same time bolstering client retention.
  4. Social trading entices users to convert themselves into traders simply by following and copying already established traders in a broker’s social community.
  5. Social trading helps a broker boost their acquisition and deposits by giving a novice trader who is nervous about losing his money, the notion of being able to copy from already established traders with a proven track record, thus quelling his fear of a first deposit.
  6. Social trading helps brokers lower their attrition rates and in turn boost retention by giving traders an FX community they can feel a part of. Once a trader finds his place in a network and begins following and copying a master, he would prefer to stay with your brokerage and not forfeit what he has already accomplished.
  7. Social trading helps a broker increase their trading activity. When a master trader opens a position in a social trading community, all those traders copying him will open the exact same position at virtually the exact same time.
  8. Social trading networks that are seamlessly integrated into a broker’s trading platform tend to increase the amount of time a trader spends inside the platform, thus increasing trading activity and retention.
  9. Social trading gives traders the ability to trade even when they are asleep. A broker may see his traders being active even during their downtime if they are following a master who may be trading in a different time zone, and is therefore active.
  10. Social trading makes newbie traders more comfortable because the experience is more social and less intimidating.

Obviously, this piece was targeted at the business side of retail forex. Many of the points made relate to gaining and keeping brokerage customers. In fact, at the end of the article the following justification is made:

When implemented correctly, social trading can boost the lifetime of the average trader by 14% or nearly a full month, increase trading activity by more than 50%, increase net deposits by 32% and a broker’s P&L by 40%, thus raising the value of each trader significantly.

I don’t know where those numbers come from as there aren’t any citations included.

I’d actually like to look at things from the trader’s point of view, though. I did a fair amount of work with Currensee, which was the first forex trader social network and one of the early social (copy) trading platforms (they were eventually bought by OANDA, then later shut down). As a result, I got to learn about some of the downsides of social trading. I also recently completed a PhD focusing on trader performance, so I have an idea of the sorts of issues that can arise in this kind of structure.

That’s why I have some problems with #1. Transparency isn’t necessarily all that great. There are signs that sharing one’s trading with others can actually result in worse returns. In fact, at Currensee one of the original Trade Leaders (as they were called) totally blew up once they brought him in to the program. Basically, he couldn’t handle it psychologically. Once they dropped him, though, he went right back to being profitable.

And related to #10, one of the things I heard from the Currensee folks is that traders were messing around with the social trades being done in their accounts. Specifically, they were closing them early, to their detriment.

On top of all this, there is a lot of research into the poor track record of investors moving in and out of mutual funds. This is essentially the same idea as being able to change which traders one accepts social trades from, so that’s another pitfall.

Oh, and as to #9, many traders already have that sort of access. They do so by using Expert Advisers (EAs) and the like to trade automatically.

I’m not saying social trading can’t be beneficial. I’m just saying it needs to be given a lot of thought and consideration.

 

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Trading Tips

Is forex more predictable than other markets?

prices

In a recent post at Zero Hedge, the following assertion was made:

“But the currency markets are easier to trade from a predictability standpoint compared to many other markets once one learns the relationships.”

The whole piece is essentially one long sales pitch in favor of trading forex over other markets, so it is perhaps no surprise to see a comment of this sort. I’m not here to agree or disagree with that general sentiment. The bottom line is that each trader should pick the market or markets which best suit them and their particular situation.

What I will challenge, however, is the above quote.

I don’t know if anyone has done any tests of market predictability, but if I were to hazard a guess as to which one tops the list I’d have to say stocks. Just look at any major index and the trend it’s had going back multiple decades. Just to be clear, I’m not talking individual stocks here, but rather the market as a whole.

Now, one might say something like, “But who trades in that kind of time frame?”

It’s true. Thinking in terms of decades is the realm of the investors, not traders. That brings me to the main point I want to make with respect to predictability.

The author of the statement above makes a valid point about central banks, etc. signaling their intentions. What they fails to consider, however, is the time frame variation involved.

The vast majority of retail (individual) forex traders operate in the hours to days range. They are day or swing traders, for the most part. The central bank signaling is something which works over significantly longer periods.

While it may be true that the BOJ wanting the JPY to be weaker results in a general down trend in the yen exchange rates, that path is anything but straight and smooth when considering normal trader time frames. Along the way toward yen devaluation there are any number of market influences at work in the shorter time scales.

To my mind, in the shorter term where traders tend to operate, no market really has a long-term predictability advantage.

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Trading Tips

Which currencies are most/least profitable?

One of the things I plan on doing in the book I’m looking to develop about real trader performance is to see if there is any difference in returns based on the currencies people trade. Consider this blog post a bit of a teaser of what’s to come in that regard.

I’ve got just shy of 4 million trades done by a group of traders from all over the world through a number of different brokers between July 2008 and May 2013. After trimming out the most extreme 0.5% of them as being potentially erroneous, when I tabulate things I find that on average they lose 0.00487% per trade. This is looking only at the change in the exchange rate, so it doesn’t factor position size in at all. For you stat geeks out there, the T-test on a hypothesized mean of 0 produces a t-value of -24.3664, so clearly statistically significant.

Here’s a look at the distribution of those returns. The green line indicates a normal distribution. These trades follow the fairly classic pattern in the markets of being highly clustered around zero with long tails.

Trade Returns Distribution

To put thing in terms which some may find easier to understand, a -0.00487% return would equal about 0.6 pips in EUR/USD if it was trading at 1.2, and about 0.5 pips in USD/JPY if that rate was at 100. In other words, we’re talking a very slight thing here.

In fact, that average loss is less than what you would expect given the usual spreads. I also looked at returns if you exclude an estimated bid/ask spread. My estimates were taken during the London/NY overlap, so in a high liquidity period. That means they should have been at about their lowest. Unfortunately, there was no way for me to actually figure out what the real spread would have been for each trade. I think my estimates at least are reasonable, though. When I add the spread loss back into the trades they average a gain of 0.0098%. The spread obviously makes a big difference.

Now, lets have a look at how the collective group of traders did trading the various major currencies using the same kind of comparison. The table below provides the figures. Not surprisingly, the majority of trades in the sample involved the dollar, with the euro not too far behind.

Currency Number of Trades Avg. Return Avg. Return ex-Spread
USD                    2,954,855 -0.0064% 0.0051%
EUR                    2,008,303 -0.0041% 0.0059%
GBP                        854,186 0.0012% 0.0180%
JPY                        683,804 -0.0101% 0.0105%
AUD                        507,894 -0.0074% 0.0150%
CHF                        277,874 -0.0061% 0.0152%
CAD                        238,255 0.0085% 0.0296%

What’s quite interesting here is that even before I account for the spread cost, the average returns for trades in the pound and the Canadian dollar are positive. That means trades in those currencies are actually beating the spread. (Again for the stats minded, the p-values for all the above are 0.00 with the exception of average return for GBP where it comes in at 0.0032).

These are really rough numbers, though. They shouldn’t be taken as a strong suggesting that you focus your trading on the CAD and the GBP, and perhaps avoid the JPY. We need to account for things like variation in individual trader skill, time of year, and things like that to really get a proper understanding. That’s all stuff I’ll be doing for the book.

I’ll try not to bore you with too much econometric analysis! 🙂

P.S. I do find it interesting that the two most active currencies, USD and EUR, have by far the lowest average return ex-spread. That would seem to say something about the efficiency level of those markets.

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Trading Tips

A forex trading interview

I’m finally on YouTube!

Well, at least my voice and a somewhat dated picture of me have made it there. I did an interview about forex trading yesterday with Jason Decks which he recorded and has posted. Being immersed in my PhD work, I hadn’t done an interview like this in a while, but I think it went pretty well.

The interview was mainly aimed at new and developing traders, but it does cover some broader ground, including some discussion of forex trader performance and what I’ve found in my research.

Have a listen and let me know what you think.

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Trading News Trading Tips

And the brokers go BOOM!

The dust seems to be settling now, but once more we’ve seen how one event can create market mayhem with massive fallout. I am, of course, talking about the Swiss National Bank (SNB) removing the 1.20 floor below the EUR/CHF exchange rate. This was something largely unexpected in the market, so it caused considerable market volatility, as you can see from the charts of EUR/CHF, USD/CHF, and CHF/JPY respectively below.

SNB-Move-Reaction

Now normally when we talk above moves like this there are companion stories about traders and investors being wiped out. For sure, many traders got slammed by this action. Retail forex being a zero sum market, though, at least in that arena there were winners to match the losers.

The big retail forex brokers weren’t so lucky, though. Because they have a policy of not letting customer accounts go negative, they were exposed to the market move in a way that was rather like being an option writer. Forex Magnates suggested the losses to the industry could have been $1bln or more. A couple of the bigger names (FXCM and Alpari) were put under severe pressure as a result. Just goes to show that market risk is not something to be taken lightly, no matter the form.

Not surprisingly, the volatility in the Swiss franc, which cascaded into other currencies, triggered an increase in margin requirements. Individual brokers increased them unilaterally and in the US the NFA increased them for everyone later.

On a more personal basis, I now have to add a little something to my PhD thesis due to these events.