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Trading Order Out of Chaos

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Trading Approach

You can buy-and-hold Foreign Exchange just like any other asset class! Indeed investment banks have been trying to ram this notion down investors’ throats for at least a decade, and I myself have been involved in creating Foreign Exchange Benchmark Indices, and even trading them at hedge-funds.

You’ll now ask: how is this possible. How can you even think of FX as a tangible thing that partakes in long-term growth? The usual counter-argument to Foreign Exchange as an Asset Class relies on the relative exchange exchange of two cash notionals, without any underlying tangible. “Zero Sum Game” is the usual phrase that even investment professionals start to use when confronted with Foreign Exchange, and most have only seen an FX transaction when travelling oversees. You’d be surprised how confused people get when they get confronted with expressions such as “long EURUSD.” Long what? EUR or USD?

So first off, let’s actually take a look at what I mean by and FX Benchmark. This one is quoted in USD (and you can create various others, which are quoted in whatever currency is convenient for you):

FX Benchmark
FX Benchmark

Ever since the collapse of the Bretton Woods regime in 1974, the G10 currencies have been freely floating against each other. Their value is set by market forces (supply and demand driven by speculators and hedgers). So how does this growth come about? Well, the FX Benchmark is constructed by taking three factors into account which drives the relative value of currencies:

  1. Carry: the interest rate differential between the various countries.
  2. Value: the Law of One Price
  3. Momentum: short term price dynamics

All three factors are well documented in the academic literature, and many have made fortunes exploiting the them. The whole point, however, is the continued persistence of these factors over the last 30 years.

So what’s a possible cause for what drives these factors and the relative value of currencies against each other? A simple long-run economic growth model, such as the Solow model, would tell us that the current G10 economies are closely aligned, with the developing economies still having to catch-up by a long distance. However, these G10 economies are not so perfectly aligned: one economy can show signs of growth while the other stagnates, viz. the current situation between the US and the Euro Area. These fluctuations aren’t as wild as you find them in Emerging Markets (just look at the movement in ZAR on the back of the replacement of the South African Financial Minister!). These relative cycles between the G10, allow for the purchase of the undervalued and sell of the overvalued. This is analogous to two sine wave out of sync:

Economies out of sync
Economies out of sync

The FX Benchmark, comprised of these three factors, does exactly that: it determines when an economy, and hence its currency is starting to get out of favor compared to the others. These oscillations are fairly stable and exploitable, and presumably will end exactly then, when all economies converge to one, which is unlikely, given the political / fiscal / monetary difference between all of them.

So how does this compare to any other benchmark for other assets? If you compare the usual stats to that of the S&P 500, it performs twice as well:

  • Sharpe Ratio: 1.23
  • Sortino Ratio: 2.58
  • Annual Return vs Maximum Draw Down: 0.7

So how do you trade and create such a portfolio, and can you even outperform it?  Sign-up to my newsletter, for updates and more information on how to exploit these strategies.

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Testimonials

In previous articles I’ve written about the idea of Kelly betting or using leverage to really boost the growth of your returns.  I’ve also shown how different fundamental components work together to create an FX Benchmark index. This article is slightly different.  I want to keep it KISS: “Keep It Simple Stupid.”  I will show you how to combine several instruments (three in actuality), which will create a Hedge Fund Benchmark.  And then we apply leverage to this index, and see wha… Read more
Money Growth: Trade it Like a Hedge Fund
“Greed is good”, but one shouldn’t always assume that the counterparty won’t notice. Last Wednesday, 27th January 2016, was FOMC day, news event day, and the markets went ape. Following on from the previous articles the idea was to continue to exploit the observed quote outages and extract value. Turns out that (presumably as expected), brokers aren’t that slow on their feet. I was moved from B-book status (i.e. rookie / loser status) to A-book status. Let’s just say that exces… Read more
FOMC Day: How the Golden Goose got cooked – Getting my A-book status
Taking control of your trading numbers is very important.  Here is an example of how straight forward it can be to run backtests in Excel. If you want to follow along in the article series, follow the link: Taking Control of Your Trading Numbers
SPY 12 Month Momentum Filtered Backtest in Excel
In this article I’ll follow up from Part I, on using the UK Services PMI to trade the GBP. The questions we’ll answer are:
  1. What economic indicators for GBP are out there and which can we use?
  2. How do you set up a macro system?
  3. What does it mean to trade a basket of currencies against GBP, or is there a preferred pair to trade?
Let’s cover the main themes that affect the Foreign Exchange Rate:
  1. Inflation: influences Central Bank behaviour, but also tells us about price increas… Read more
4 Economic Indicators to help your Fundamental Trading of GBP– Part II
EURUSD tick data for the period 10th April 2016 to 15th April 2016. Zip file contains CSV files for each day. The format of the CSV files are: Local Time, Server Time, Server Time Milliseconds, Bid, Ask. The time resolution is in seconds. This means that there can be multiple quotes per second.
Tick Data EURUSD, 20160410 - 20160415, Broker 1
Investing in Bonds
Of all things on this planet?!  Aren’t they boring?  Not explosive enough?  Isn’t this stuff what old people invest in?  Also, aren’t they supposed to start to sell-off?  And how do you get your hands on these over the counter instruments. In the first article of this series on Creating Profitable Trading Strategies  we started with the premise that you need to look at assets and their underlying biases. We covered equities.  They’re exciting.  Buffett makes 19.1% a year on them.  An… Read more
Why Would You Want to Invest in Bonds?
It’s only been the fourth trading day of 2016, but there is no shortage of surprises, volatility, and all round mayhem. Today the AUDUSD had two announcements which can be considered relevant. The first was at 00:30GMT, the Building Approvals number, and shortly after 01:15GMT the PBOC rate fixing for the CNY. The first announcement was followed by a slow 10 pip grind to the downside, followed by a retracement to 0.7084. The PBOC announcement was issued at 01:16GMT, on the back of which … Read more
More on Market Dynamics: AUDUSD and the PBOC
I’ve written several articles on what happens during news announcements, and associated quick trading strategies.  But from a regular trader’s perspective, surely there must be another way to approach these things. In this article I’ll given an overview as to how to trade these news announcements in a slightly more leisurely way, and see if there is anything to be had out of trading against market hysteria.  The instrument of choice will be the EURUSD, though you can pick any other inst… Read more
Trading News Announcements Systematically: EURUSD and Non-Farm Payrolls

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