000$480 641
$30 000$500 000$600 797
Profit/loss %Annualized % gain/lossTotal number of tradesWinning tradesLosing tradesPercent profitableGross profitGross lossAvg. winning tradeAvg. losing tradeAvg. win/avg. lossProfitability coefficientProfit factor
−3.0 %−0.4 %110100 %−$15 074$0$0(€15 074)
37.9 %4.5 %65183 %$194 634−$5100€38 927−$5100
76 %8.1 %50371374.0 %$420 908−$40 267$11 376−$30973.675.2610.45
120 %11 %139835659.7 %$594 362−$98 565$7161−$17604.074.006.03
Max. drawdownDate of max drawdownMax. % drawdownMax. losing tradeMax. consecutive lossesStd deviation of equityRisk-adjusted returnSharpe ratioAvg. trade length – daysTrades/year
−$246 05810-11-02−49.2 %−€15074
−$42 06607-24-02−8.4 %−€5100
4.46 %−0.1 %−1.02649.00.1
3.93 %1.2 %0.12649.00.8
−$22 8015-5-03−4.6 %−$741951.78 %4.6 %2.34957.0
−$42 91612-5-02−8.6 %−$726082.58 %4.5 %2.921819.2
Securities on testIntermarket security
Figure 16.1 Security profit distribution of the first relative strength test on futures. The mostprofitable trades involved the Mexico IPC Index and copper futures which soared 325 % and150 % respectively. The worst trade involved cattle futures which lost 17 %.
Figure 16.2 Composite chart of gold (cash prices) in bold and the S&P 500 from May 2000until November 2007. The 150-day relative strength with its 120-day moving average (dottedline) is plotted in the top window. Buy and sell signals are superimposed on the chart. The lasttrade was never closed.
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Figure 16.3 Closed equity (%). The worst drawdown of –4.6 % of equity occurred on 5 May2003 and was mainly due to losses from the Australian All Ordinaries Index and Aluminumfutures.
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Figure 16.4 Monthly profit distribution of the relative strength ETF system (Test II).Thesystem did not start making any money until the end of 2003, mainly because it was tooheavily weighted in stock sector ETF. The worst drawdown of –8.6 % of equity occurred on5 December 2002 and was mainly due to losses from the energy sector ETF (IYE), the healthcare sector ETF (XLV) and the Templeton Dragon Fund (TDF). The best performing ETF wasthe iShares Latin America 40 (ILF).
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Figure 16.4. You can also see in Figure 16.2 typical buy and sell signals generatedby the system, in this particular case for the Gold futures contract. For comparisonpurposes, the buy and hold method returns for both a 100 % US equity and a staticdiversified portfolio are also included in the second and third columns. The returnsusing the dynamic as compared to the buy and hold or static approach are impressive.The futures portfolio made over $480 000 compared to a $15 000 loss suffered by theinvestor who bought and held the S&P ETF during the 7-year test duration.Furthermore, the dynamic asset allocation model added value over the static diversified portfolio with a reasonable turnover of six to seven trades per year. Overthe 7-year period, examined within the confines of this test, the dynamic strategy increased the average diversified static portfolio yearly annualized return by 660 basispoints, from 4.5 % to 11 % per year, and increased the Sharpe ratio by 2.80 points.None of the systems made any money during the 2000–2002 bear market but, unlikethe S&P, they managed to get through with minimal losses. The futures portfolio(Test I) which had the least exposure to equities, suffered the lowest drawdown andhad the highest risk-adjusted return. The best performing commodities were copperfutures (HG) and No. 11 sugar futures (SB) and the best performing equity indiceswere the Mexico IPC Index (MXX), the Hang Seng (HSI) and the Russian MoscowTimes Index (MTMS). The worst performers were live cattle (LC), aluminum futures(AL) and the Nikkei 225 Index. These are depicted graphically in Figure 16.1.The ETF portfolio, on the other hand, had heavy exposure to equities and as aconsequence suffered a rather heavy drawdown during the 2001–2002 bear market.The maximum drawdown of $42 000 or 8.6 % of equity occurred in December 2002.This was, however, small change compared to the devastating $246 000 (or 50 % ofequity) drawdown suffered by the investor who bought and held an S&P index fund.The best performing ETFs were the iShares S&P Latin America 40 Index fund(ILF), the iShares MSCI Singapore Index Fund (EWS) and the Goldman SachsNatural Resources Fund (IGE). The worst performing ETFs were the Asia PacificFund, the iShares MSCI Switzerland Index Fund (EWL) and the SPDRs Select SectorHealth Care Fund (XLV).By looking at the buy and sell signals on the chart and examining some of theworst losers a common pattern emerged:• The majority of the losing trades occurred in 2002, during the last phase of thebear market.• Some of the worst performing ETFs involved defensive sectors like health orenergy which outperformed the S&P 500 during the initial bear market phase butfailed to follow through and reversed during the last and final part of the bearmarket.In an effort to alleviate some of the losses, I tried adding a stop-loss condition butdecided to abandon it as it stopped out too many profitable trades as well, reducingconsiderably the overall system profitability.
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CONCLUSION
The current system may not enter or exit a trade at the exact bottom or top but it willsystematically keep your assets moving into the right instrument in approximatelythe right time frame. Investment survival depends on an investor’s ability to adapt tothe market and this can only be achieved by a dynamic asset allocation model.In the current system, because of the limitations of the programming language, onlybinary asset selection has been employed but nonetheless results were impressive.A selection process which would combine several assets at once would of coursebe preferable. This could be implemented by starting out with a diversified portfoliosimilar to the one described in Table 16.3, and revising the portfolio compositionmonthly, replacing the weaker assets or sectors with the stronger ones.One of the most significant disadvantages of using the relative strength methodin trading is probably the fact that the indicator always produces signals, even indeclining markets. In other words, in a bear market, the danger exists that in aselection decision based on relative strength alone, preference will be given to thedefensive assets that decline less, but end up losing money none the less. This presentsa challenge to the reader for possible improvements which could be implemented bycombining the current system with a classic technical system; the relative strengthindicator adding value by filtering out trades involving weaker asset classes.
17Forex Trading UsingIntermarket Analysis
Human decisions affecting the future, whether personal, or political or economic, cannot depend on strict mathematical expectation, since the basis formaking such calculations does not exist.–John Maynard Keynes
17.1
THE FOREX MARKET
The foreign exchange market, commonly referred to as the “forex” or “FX” market, isthe largest and most liquid market in the world as the 3.3 trillion USD daily turnoverdwarfs the combined turnover of all the world’s stock and bond markets. Banks,import/export companies and multinationals, as well as hedge funds and other largeinstitutions trade trillions of dollars on the forex market every day. Because of theirsuperior liquidity, forex markets are less prone to manipulation by even the largestplayers, although the central banks intervene from time to time to affect the pricemovements of their respective currencies. Such interventions, however, can onlyinfluence currency values for short periods as market trends tend to move currenciesagainst the central bank. One example is the Bank of Japan intervening in order topush down the value of the yen in order to promote exports.Some countries, such as China, manage the exchange rates of their currency. Inthis chapter I will focus on countries with floating exchange rates.Forex is an exchange where one country’s currency is exchanged for another’sthrough a “floating” exchange rate system. A trade is executed with the simultaneousbuying of one currency while selling the other.Although the FX market is not centralized on an exchange, two electronic brokers –EBS and Reuters – dominate the interbank market. The Electronic Broking Service
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(EBS) partnership was set up in 1990 to challenge the monopoly that the Reuters’electronic system enjoyed. It is owned by a consortium of 16 banks including Citibank,Chase Manhattan, Credit Suisse First Boston, JP Morgan and UBS. The systemconnects all member banks to each other so they can buy or sell currency. This wasone of the first electronic exchanges and that is why the FX market has been slow,compared with equity markets, to develop internet-based trading. A new generationof web-based products using internet technology is trying to give electronic access toa wider range of participants, including corporate treasury departments, hedge funds,and even independent forex traders. Among these new systems are Irish e-commercefirm Cognotec, Seattle-based Financial Market Solutions (FMS), and New York’sMatchbookFX. In addition, some banks already have or are developing web-basedsystems of their own to trade with clients. But most bankers concede that the nextstage will be a system that connects not only clients and banks, but banks and otherbanks. The system that achieves enough critical mass to become indispensable couldquickly turn into the industry standard, sidelining other competing systems.The forex market is open 24 hours a day, every working day. It begins tradingon Sunday at 5pm US EST in Wellington, New Zealand and follows the sun toSydney, Tokyo, Seoul, Hong Kong, Singapore, Bombay, Dubai, Moscow, Athens,Frankfurt, Geneva, Paris, London, New York, Chicago, Los Angeles and Honolulubefore starting again. Markets stay open 24 hours during that period and therefore gapsare never seen on daily charts, because the close of previous day is the open of the next.While it is possible to trade a variety of international currencies, seven are by far themost popular, providing six currency pairs with the US dollar acting as the benchmarkin each. The currencies are the euro, the US dollar, the yen, the British pound, theSwiss franc, the Canadian dollar and the Australian dollar and their market share is:• The euro (EUR/USD)• The yen (USD/JPY)• The British pound (GBP/USD)• The Australian dollar (AUD/USD)• The Swiss franc (USD/CHF)• The Canadian dollar (USD/CAD)
28 %7%14 %5%4%4%
Pairings with the US dollar are known as “majors” and non-US dollar pairingsare known as “crosses”. For example, a popular cross is the GBP/EUR or theEUR/JPY. Cross pairs can be derived from the majors; for example, the EUR/JPYis the EUR/USD divided by the USD/JPY. Exchange rates must be consistent acrossall currencies, or else it will be possible to make riskless profits by arbitrage tradingcross against major pairs.The main trading systems used in forex are those that follow trends (a popularmaxim in the market is “the trend is your friend”), or systems that buy or sell onbreakouts. This is because economic indicators often cause large price movementsthat tend to last for prolonged periods of time.
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Advantages in Forex TradingApart from the superior market liquidity, which helps ensure price stability, forextrading has the following advantages over equity trading:• No commissions: There are no commissions in forex trading, only the point spread.The spread is not fixed but can vary according to the broker, the currency pair,liquidity and volatility and it is usually 1–4 points or pips (see also about hiddencommissions below).• Increased leverage: The margin required by most forex brokers is only 1–2 %,compared to a 50 % margin required for equity markets and 5–15 % for futures.• Leveraged carry interest: When you’re long a currency pair, your account iscredited with the interest of the first currency and debited with the interest of thesecond currency. For example, if you’re long the USD/JPY, you earn $9.17 interestper day on each contract of 100 000 units, even if you’ve only put in $2000 as your2 % margin.• Continuous trading makes it possible to respond to breaking news immediately,day or night.• Liquidity and 24-hour trading contributes to less slippage and more efficient execution of stop loss or limit orders.• There is less random noise (that is, volatility) in the forex markets, and trends aregenerally of a long-term nature.• You can diversify your portfolio with foreign currencies. This is particularly effective in declining stock markets, just where it is needed most.• Currencies tend to follow fairly strict rules, and are therefore more predictableusing technical indicators than equity markets.Of course nothing is perfect, especially in the financial markets, and forex tradingcan have some major problems:• Commissions: When choosing a broker, it is essential to do your homework. Mostbrokers advertise “commission free” but is it really? How do brokers make moneyto cover their platform costs? In practice, brokers conceal points to the price spreadin lieu of commissions. The interbank spreads are usually 1–2 pips but brokersusually widen them by 1 or more pips. For example, assuming that the interbank orreal quote in the yen (USD/JPY) is 104.89/104.90 (bid/ask), the broker’s platformwill show 104.87/104.92. If a trader buys $1 000 000 at 104.92, the broker willdebit his client’s account with 104 920 000 yen whereas he would have to pay only104 900 000 to his bank in order to cover the trade. The 20 000 yen ($190) is thehidden commission that the trader has to pay twice (once for opening and once forclosing his position).• Leverage, as long as it is used properly, is a great tool. There are many brokerstoday that offer 100 to 1 (1 % margin) and even 200 to 1 leverage. That means
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that you could open an account with $10 000 and control $2 000 000. This can bedisastrous, especially when the market moves against you. For example, if you arelong the USD/JPY and the yen goes up by more than 0.5 % then your entire equitywill be wiped out. This is not something that happens only rarely, as there is a20 % chance that the yen will go up by more than half a percent in a day and a 6 %chance that it will go up by more than one percent based on 15 years of historicaldata.• Data: Developing a mechanical trading system to trade forex requires back-testing.And back-testing requires high quality historical price data. There are serious problems with the consistency and accuracy of data obtained from different providerswhich is surprising considering the size and liquidity of the foreign exchange market. In the forex market, unlike the future and stock markets, there is no centralexchange to speak of and consequently no “official” historical data exist as such.Various forex data vendors combine data collected from a number of banks. Someof them filter the data in order to remove outliers and low volume trades. As aresult historical data can vary according to the number of banks being used tocompile the data and the filtering method used. Another issue affecting mainly theconsistency of the opening and closing prices is the time zone in which the dataprovider is located, as every source reports the open or close at different times,which of course would give different prices. Yet another issue causing disparitiesin the daily extreme prices is the way that banks determine the high and low. Abank will call a high or low depending on how much volume went through at thatrate. For example, let’s suppose that the USD/JPY fell to a 103.55 intraday lowbut only $2 million went through at that rate. Some banks will call that the officiallow whereas other banks will ignore it and report a higher low of 103.60 that wastraded on higher volume. This is not a problem if large amounts are traded, but canbe confusing to small traders who can sometimes find that their trade went throughat a price below the official low or above the official high of the day. Dependingupon the time frame and trading frequency, this disparity can be highly significantand can create serious problems in back-testing mechanical systems if the tradingmodel is developed and tested on a different data set from the one upon which itwill actually be traded. For a realistic mechanical system you will need to use thesame data provider as your broker, otherwise you may find that your actual tradingperformance differs considerably from the system’s predicted results.• Carry trades are popular in the FX market as they guarantee traders extra returnon their medium or longer term positions. If you are a long-term trader, however,it is essential to choose the right broker, because you may find you are payinginstead of receiving the carry interest as some FX brokers pay less than marketrates on long balances and charge considerably more on short cash balances. Inaddition, they apply a tier method when calculating interest to long cash balances(similar to the insurance deductibles). Let’s consider the following example whichsimulates a real trade using a popular broker. You entered a long position to buy$100 000 and sell 10 400 000 yen on 23 May 2008 intending to take advantage
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of the near zero interest rates in the yen. This particular broker credits long USdollar balances over $10 000 with the Fed Funds overnight rate less 0.5 % (whichcomes to 2.05 − 0.50 = 1.55 %) and debits short yen balances with JPY Liborminus 1.5 % (which is 0.56 − 1.5 = −2.06 %). Supposing that you reversed thetrade in a year and assuming, for the sake of simplicity, that the USD/JPY rate hasnot changed then your carry trade interest would consist of the interest received onthe long USD position (which would be ($100 000 − $10 000)* 1.55 % = $1395)minus the interest that your broker would have charged you on the short yenposition (10 400 000* 2.06 %/104 = $2060). When you close the trade you wouldbe surprised to find out that instead of receiving the interest spread of $1490(100 000* 1.49 %) you had to pay $665. Your broker pocketed the whole amountof the carry interest from his bank plus $665 from you which comes to a total of$2155 without even taking any currency risks at all! This is on top of the pointspread that he made on each trade.
17.2
FOREX FUNDAMENTALS
When it comes to trading, like anything else, you have to have a very good handlenot only on technicals but also fundamentals. Luckily, unlike with stocks, in forexthere are only few economies to look at.Currency prices are affected by a variety of economic and political conditions,the most important of which are interest rates and, to a lesser degree, inflation andpolitical stability.One of the main driving forces behind foreign exchange trends is the interest ratespread between the currencies in the pair to be traded. Although such interest ratedifferentials may not appear very large, they are of great significance in a highlyleveraged position. Generally, economic strength and political stability during thebusiness cycle can lead to higher interest rates and thus a higher currency.However, it is by no means a certainty that the currency with the higher interestrate will be stronger. If the reason for the high interest rate is runaway inflation orexcessive government budget deficits, it may undermine confidence in the currencyand override the benefits perceived from the high interest rate. Moreover, high interestrates can be a disadvantage to a nation in the long term, because they make it moredifficult to compete with countries enjoying lower rates.On the other hand economic weakness can lead to lower interest rates as centralbanks attempt to improve conditions. Because this process often involves increasingthe money supply, a country’s currency usually falls in value as a response.In addition, the following economic reports, statistics or news can also affectcurrency exchange rates:• Trade balance: This is a measure of the difference between imports and exports oftangible goods and services. Typically, a nation that runs a substantial trade deficit
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has a weak currency due to the continued commercial selling of the currency.However, this can be offset by financial investment flows for extended periods oftime. The United States has been running a substantial trade deficit in recent yearsand changes in this figure can affect the US dollar significantly. US trade figuresare released monthly.• FOMC meetings: The Federal Open Market Committee holds eight regularlyscheduled meetings per year. At these meetings, the Committee reviews economic and financial conditions and determines the appropriate stance of monetarypolicy by adjusting the overnight discount rate (which is the interest rate charged toborrow directly from the Federal Reserve Bank to meet regulator reserve requirements). The Fed may also attempt to change the federal funds rate (the interestrate that banks charge other banks to lend their surplus balances at the FederalReserve) through the use of open market operations like purchasing and sellinggovernment securities. With this mechanism, the FOMC attempts to affect pricelevels in order to keep inflation within the target range while maintaining stableeconomic growth and employment. Changes in rates affect interest rates for consumer loans, mortgages, bonds, and the exchange rate of the US dollar. Increases inrates or even expectations of increases tend to cause the dollar to appreciate, whilerate decreases cause the currency to depreciate. Almost as important as what theFed does with interest rates is the statement that they release which can sometimesreveal what they might do in the future.• ECB rate announcements: The European Central Bank rate announcements areusually well anticipated and the actual decision does not tend to impact the marketa lot. The ECB President’s press conference, however, is more important becauseit can provide a clue on the likelihood of further rate changes. Often, the languageused in the press conference holds important signals on how the ECB feels aboutinflation and the economy.• BOE rate decision: The main task of the Bank of England’s Monetary PolicyCommittee is to set the monetary stance by fixing the overnight borrowing rate,which is crucial in determining short-term rates. The Bank of England MonetaryPolicy Committee also issues a statement with every rate decision. When it comesto interest rates, the future direction of rates is generally far more important thanits current rate and because the decision itself is normally highly anticipated, thewording of the BOE statement is usually even more important than the actualinterest rate level.• Consumer Price Index (CPI): This is a measure of the average level of prices of afixed basket of goods and services purchased by consumers. The monthly reportedchanges in CPI are widely followed as an inflation indicator. Rising consumerprice inflation is normally associated with the expectation of higher short-terminterest rates and may therefore be supportive for a currency, although significantinflationary pressure will often lead to an undermining of the long-term confidencein the currency involved.• Producer Price Index (PPI): This is a measure of the average level of prices ofa fixed basket of goods received in primary markets by producers. The monthly
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PPI figures exclude food and energy and can therefore obscure the more importantconsumer inflation trend.• Quarterly GDP figures: This is the broadest measure of aggregate economic activityavailable. A high GDP figure is often associated with the expectations of higherinterest rates, which is frequently positive, at least in the short term, for the currencyinvolved.• Housing starts: High construction activity is usually associated with increased economic activity and can therefore be supportive of the involved currency. Housingstarts are one of the earliest indicators of the housing market, only trailing buildingpermits in timeliness.• Building permits: This figure is used as the earliest indicator for developments inthe housing market as issuing a building permit is the first step in the constructionprocess. An increase in building permits implies an increase in investment andgeneral optimism about the economy.• US non-farm payrolls: Monthly changes in payroll employment reflect the netnumber of new jobs created or lost during the month. Large increases in payrollemployment are seen as signs of strong economic activity that could eventually leadto higher interest rates that are supportive of the currency, at least in the short term.This report is released on the first Friday of each month and tends to move markets.• Durable goods orders: This is a measure of the new orders placed with domesticmanufacturers for immediate and future delivery of factory hard goods. Monthlypercent changes reflect the rate of change of such orders. Durable goods ordersare measured in nominal terms and can therefore be misleading as they includethe effects of inflation. The PPI growth rate must be subtracted in order to obtainthe inflation-adjusted durable goods orders. Rising durable goods orders are againassociated with stronger economic activity.• Michigan sentiment figures in the US, the German business climate or IFO index,and the Tankan quarterly survey in Japan: The University of Michigan ConfidenceSurvey is considered one of the foremost indicators of US consumer sentiment. Itassesses consumer confidence regarding personal finances, business conditions andpurchasing power based on hundreds of telephone surveys. This number is releasedmonthly and tends to move markets as it is a leading indicator of an economicdownturn. The IFO index is equally important as Germany is responsible forapproximately a quarter of the total Euro-zone GDP and it is therefore viewedas a significant economic health indicator for the Euro-zone as a whole. TheTankan Survey is released quarterly by Japan’s central bank, and measures businessconfidence in Japan. The report is based on a survey sent out to corporations andit covers business conditions, supply and demand conditions, sales and profits,capital expenditure, employment, etc. The results can provide some insight intoupcoming monetary policy and interest rates and are used to formulate monetarypolicy.• Political events such as G7 meetings.• News: National elections and the war in Iraq are examples of events that haveaffected currency values.
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In simple terminology, news drives the market; whether that news is economic orpolitical makes no difference. However, you should keep in mind that it is easy toblame an obvious news event because the market tends to build up a vulnerabilityand then wait for any reasonably appropriate event as a catalyst to extenuate the builtup tension.
17.3
THE CARRY TRADE
Few people can resist the lure of free money and hence the popularity of crosscurrency carry trades. In a currency carry trade, the speculator borrows money ina low-interest rate currency and buys higher-yielding assets in a different currency.Today, the low-rate currency is usually the Japanese yen; higher yielding assets arebonds, currencies like the Australian dollar, the New Zealand dollar or the Britishpound but sometimes more volatile assets such as emerging market equities. Thebiggest risk is generally that the exchange rate moves against you – the higherinterest rate currency rapidly devalues, reducing the value of your assets relative toyour borrowing. Also, these transactions are generally done with a lot of leverage,so a small movement in exchange rates can result in huge losses unless hedgedappropriately. A popular hedging method is buying a three-month forward option onthe yen at the Chicago Mercantile Exchange.While the yen-carry trade can be profitable, there’s no such thing as a free lunch.Playing the wide spread between the cost of money in Japan and other higher-interestrate markets in the end may turn out to be a fool’s game.The following is an example of a scenario for disaster: As we head into theeconomic slowdown, speculators who borrow in yen to invest in risky cyclical assetswill cut their losses, bail out and buy yen to repay debt. A rising yen would putinterest rate carry trades positions under water, causing them to sell off and head backinto the yen, and so on in a vicious circle.
17.4
TRADING THE JAPANESE YEN
The yen is the third most widely traded currency in the world, after the US dollar andthe euro, and is traded worldwide by banks, corporations, institutions, hedge funds,speculators and commercial hedgers. Because of the big interest rate differential withthe other currencies, the yen is also very popular among the “big boys” because ofthe “leveraged carry interest” mentioned above.The yen is traded 24 hours a day in the forex interbank markets but yen futurescan also be traded on the Chicago Mercantile Exchange (CME), the New York Boardof Trade (NYBOT) or the CME GLOBEX system electronically. Yen futures tradeon the CME from 9:30 to 14:00 under the symbol JY, and from 8:30 to 16:00 onthe GLOBEX under the symbol 6J. The lowest increment (pip) is 0.000001 and
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the contract size is 12 500 000. For the benefit of small traders, the GLOBEX hasrecently introduced the e-mini (symbol J7) which is half (6 250 000) the full-sizedcontract. On the NYBOT the symbols are YY and SN for the full sized and e-minicontracts respectively.Since 1999 (except for a brief weakness in 2002) the yen has been moving in asideways range, between 102 and 125, with the natural equilibrium at around 115.However, it broke out in March with the dollar sinking to as low as 96 yen to thedollar as liquidity was withdrawn by carry traders, despite interventions by the Bankof Japan.The Japanese government would love a weak yen, perhaps as low as 125 yen to thedollar, to help promote exports, making them more competitive with cheaper exportsfrom China. On the other hand, if the US deficit continues to expand, the dollar/yenwill get weaker, not because the Japanese economy is doing better but because theUS deficit is getting fatter.Speculators and commercial hedgers who trade currency futures often use technicalanalysis to determine trading signals