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Automated Trading and Robots. Many hedge funds now use algorithmic tradingThe Final Frontiers This chapter is optional for the novice currency trader, although investors with some trading experience will find it informative. All traders should at least be aware of advanced FOREX techniques and ongoing market research. Rollovers A rollover is the process whereby the settlement of an open trade is rolled forward to another value date. The cost of this process is based on the interest rate differential of the two currencies. In the spot FOREX market, trades must be settled within two business days. For example, if a trader sells a certain number of currency units on Wednesday, he must deliver an equivalent number of units on Friday. Yet currency trading systems may allow for a rollover, with which open positions can be swapped forward to the next settlement date (giving an extension of two additional business days). The interest rate for such a swap is predetermined, and, in fact, these swaps are actually financial instruments that can also be traded on the currency market. In any spot rollover transaction, the difference between the interest rates of the base and counter currencies is reflected as an overnight loan. If the trader holds a long position in the currency with the higher interest rate, he would gain on the spot rollover. The amount of such a gain would fluctuate from day to day according to the precise interest-rate differential between the base and the counter currency. Such rollover rates are quoted in dollars and are shown in the interest column of the FOREX trading system. Rollovers, however, will not affect traders who never hold a position overnight, since the rollover is exclusively a day-to-day phenomenon. Some brokers will automatically roll over open trades while others may liquidate orders that exceed the two-day limitation. Also some dealers may append a rollover charge in addition to the interest differential. Rollover credits or debits are reflected in the unrealized profit-and-loss column of the open position. If you intend to maintain open positions longer than two days, carefully read your dealers policy agreement, or consult their customer service department. Also note that rollover costs may affect margin requirements. Hedging A hedge is a position or combination of positions in one security that reduces the risk of your primary position in the same security. An example of hedging in commodity futures is the Midwest farmer who grows #1 Soft Red Wheat and intends to take his harvest physically to market for September delivery. After tilling the soil and planting the seeds in late spring, the farmer initiates a short (sell) commodity futures contract for September Wheat at the Chicago Board of Trade at what he feels is a fair price. If the price of wheat declines dramatically in September, the farmer will suffer losses on his physical delivery but will make profits on his futures contract. If the price of wheat rises substantially in the fall, the farmer will make profits on his physical delivery but will suffer losses on his futures contract. Thus, hedging not only reduces risk but can also be used to lock in predetermined profits in some situations. Normally when you have an open position to buy or sell at your FOREX dealer, and you open a new position in the opposite direction, the two positions will close each other out. If you had a position for USD/CHF to buy and you opened a new position USD/CHF to sell, both positions would close, since you cannot be buying and selling currencies at the same time. The feature of hedging however, allows you to do exactly that if your FOREX dealer offers this trading feature. When you open a hedge position, both positions (the original and the newly hedged one) will remain open. You will have two positions, going in the opposite direction of each other in the same currency pair. This is basically used to lock your current loss or win, until you have a better understanding of where the market is moving. Theoretically, profit is to be gained by skillful timing of the liquidation orders. If liquidated at the same time, the trader will automatically lose the transaction cost. Brokers who offer hedging do not normally require additional margin for the second hedged position. Consult your broker for details before attempting to apply this rather esoteric trading strategy. You can hedge a speculative position, but it remains speculative and is not considered a legitimate hedge. Arbitrage In general, arbitrage is the purchase or sale of any financial instrument and simultaneous taking of an equal and opposite position in a related market in order to take advantage of small price differentials between markets. Essentially, arbitrage opportunities arise when currency prices go out of sync with each other. There are numerous forms of arbitrage involving multiple markets, future deliveries, options, and other complex derivatives. A less sophisticated example of a two-currency, two-location arbitrage transaction follows: Bank ABC offers 170 Japanese Yen for one US Dollar and Bank XYZ offers only 150 Yen for one Dollar. Go to Bank ABC and purchase 170 Yen. Next go to Bank XYZ and sell the Yen for $1.13. In a little more than the time it took to cross the street that separates the two banks, you earned a 13 percent return on your original investment. If the anomaly between the two banks exchange rates persists, repeat the transactions. After exchanging currencies at both banks six times, you will have more than doubled your investment. Within the FOREX market, triangular arbitrage is a specific trading strategy that involves three currencies, their correlation, and any discrepancy in their parity rates. Thus, there are no arbitrage opportunities when dealing with just two currencies in a single market. Their fluctuations are simply the trading range of their exchange rate. In the subsequent examples of currency pairs consisting of the five most frequently traded pairs (USD, EUR, JPY, GBP, and CHF) with recent bid/ask rates. We omitted the other two majors, CAD and AUD, for the sake of simplicity and not because of lack of arbitrage opportunities in these two majors. The fact that the USD is the base currency in two of the pairs (USD/CHF and USD/JPY) and is the quote currency in two other pairs (EUR/USD and GBP/USD) plays an important role in the arithmetic of arbitrage. We begin our investigation with just the bid prices. The criterion whether to multiply or divide the USD pairs in order to calculate the cross rate is simple: If the USD is the base currency in both pairs, then divide the USD pairs. If the USD is the quote currency in both pairs, then divide the USD pairs. Otherwise multiply the USD pairs. To determine the deviation from parity for each cross pair, subtract the exchange rate from the calculated rate and convert the floating point decimals to pip values. We can see that the EUR/JPY is out of parity by 4 pips. To determine if an arbitrage opportunity is profitable, we must first calculate the total transaction cost by adding the three bid/ask spreads of the corresponding pairs. An 8-pip transaction cost to earn a 4-pip profit is counterproductive (it amounts to a 4-pip loss). If the parity deviation (the number of pips by which the three currency pairs are out of alignment) were greater, say 30 pips, then a definite arbitrage opportunity exists. The trading mechanism to take advantage of this anomaly requires some consideration. First, determine what market actions are necessary to correct this anomaly. Assume that the EUR/JPY rate is currently trading at 133.51 and the calculated rate using the current EUR/USD and USD/JPY pairs is 133.81 (a 30-pip deviation). Parity between the three currencies will be restored if the following price action occurs: The EUR/JPY pair rises to 133.81, or The product of the EUR/USD and USD/JPY pairs drops to 133.51. Therefore the following trades are required to lock in the 30-pip profit: Buy one lot of the EUR/JPY pair Sell one lot of the EUR/USD pair Sell one lot of the USD/JPY pair Liquidate all three trades simultaneously when parity is re-established Warning: Executing only one, or even two, legs of the three trades required in an arbitrage package does not guarantee a profit and may be quite dangerous. All three trades must be executed simultaneously before the lockedin profit can be realized. EXAMPLE 2: Two USD pairs and one cross pair (divide) The above example uses the product of the two USD currencies to calcu late the cross rate. An example of the ratio of the two USD currencies follows. Assume the EUR/GBP cross pair is currently trading at 0.6992 and that the ratio between the EUR/USD and GBP/USD pairs is calculated as 0.6952, a 40-pip deviation. Parity will be restored when the following price actions occur: The EUR/GBP pair drops to 0.6952, or The ratio of the EUR/USD and GBP/USD pairs rises to 0.6992. In order for the second action to rise, either the EUR/USD pair must also rise or the GBP/USD pair must decline (this differs in the previous example). Therefore the following trades are required to realize a 40-pip profit: Sell one lot of the EUR/GBP pair Buy one lot of the EUR/USD pair Sell one lot of the GBP/USD pair Liquidate all three trades the moment parity is re-established EXAMPLE 3: Three non-USD cross pairs Technically the arbitrage strategy can be performed on three non-USD currency pairs also. In this example, we will examine a straddle between the three European majors (EUR, GBP, CHF) where we focus on the EUR/CHF pair in respect to the two GBP currency pairs (GBP/CHF and EUR/GBP). Assume the current rates of exchange are: EUR/CHF = 1.5676/78 EUR/GBP = 0.6915/17 GBP/CHF = 2.2604/12 and their relationship is: EUR/CHF = EUR/GBP GBP/CHF Thus the calculated value for the EUR/CHF rate is 0.6915 2.2604 or 1.5631. The deviation from parity is -.0045 (1.5631 - 1.5676) or 45 CHF pips since CHF is the pip currency in the EUR/CHF pair. The trading strategy is: Sell one lot of EUR/CHF Buy one lot of EUR/GBP Buy one lot of GBP/CHF Liquidate all three when parity is re-established If all three trades are executed successfully, a profit of 45 CHF pips is realized. Subtract the three bid/ask spreads for the transaction costs (2 + 2 + 8 = 12) to see a net profit of 33 CHF pips. Now convert CHF pips to dollars (33 divided by USD/CHF rate 1.2402) to obtain 27 USD pips. It should be noted in all the examples presented above that only three currencies are analyzed simultaneously. It is possible to add a fourth, or even a fifth, currency to the mix though this is normally left to the very serious arbitrage strategists. The methodology for examining four (or even five or six) currencies at one time is to calculate every possible 3-currency combination among the currencies selected. Rearrange them in magnitude of deviation from parity. Examine the deviations closely to see if there is a single anomaly or possibly even a double anomaly among the four currencies. This type of scrutiny will then determine if a 4-currency arbitrage opportunity exists. Specialized software is definitely required when dealing with four or more currencies in a single arbitrage package. Pros and Cons of Arbitrage Using triangular arbitrage strategies on the FOREX market has one very salient advantage: predetermined profits can be realized if the trades execute smoothly. Unfortunately, the disadvantages of this strategy are numerous: 1. Higher transactions costs. The trader must pay the bid/ask spreads on three separate trades. 2. Higher margin requirements. Roughly three times the margin is neces sary to execute the arbitrage strategy and odd-lot trading may be required for the small capital investor. 3. Precision timing is required. Arbitrage opportunities are usually short lived. 4. Multiple dimensions. The trader must thoroughly understand the arbitrage mechanism in order to determine which currency pairs to buy and which to sell. Each arbitrage package consists of two buys and one sell or one buy and two sells. Miscalculating any one of the three trades can cause disaster. 5. Advanced monitoring techniques are usually required. This means calculating the above analysis on several pairs simultaneously in real-time and will involve a software program that analyzes streaming quotes continually. It is possible to perform these tasks manually but the trader must have a high tolerance for tedium. I must also mention that in the examples above, I intentionally simplified calculations by using only the bid price throughout. When executing an actual arbitrage trade, the investor must supply both bid and ask rate where applicable. Artificial Intelligence Although it has lost some luster in this century, application of artificial intelligence methods have been seen in the FOREX arena. The three primary approaches are: expert systems, neural networks, and genetic algorithms. I developed an expert system-neural network hybrid in the early 1980s, Jonathans Wave, and used it successfully in the futures markets for a number of years. I moved on to exploring a cellular automata-based model, The Trend Machine. (See below.) But the possibility of revamping Jonathans Wave with modern techniques and computer firepower has rekindled my interest in artificial intelligence. The entire AI approach may have a second wind. Although there is intense disagreement on this subject, I feel these methods are still linear or conventional. Past market prices and data are manipulated to make forecasts, and curve-fitting remains the theoretical backbone involved. Complexity Theory Models The search for a Philosophers Stonea method that will consistently beat the markethas been afoot from the very inception of the markets themselves. In the mid-1900s many traders published (usually privately) small volumes with techniques to beat the markets. They typically looked good on paperbut failed when applied to real-time trading. Most were tested on simplistic market environments (trading markets, trending markets) and failed when the real-time market morphed into a different environment. (See Back-testing and Market Environments, Currency Codex, www.fxpraxis.com.) I am reminded of the secret system used by a trader I met in Hawaii in the 1980s. He believed the random spread of ink spots from the news printer was actually hidden buy and sell signals from the floor traders. To each his own. The advent of computer analysis in the 1970s and automated trading in the 1990s encouraged traders to use this new tool to find the trading method over the rainbow. Much of the effort has been directed to using vast batteries of conventional techniques with deep mathematical and statistical twists. It is clear, after 30 years of effort, no linear method is going to beat the market, at least not consistently in all markets. The Trend Machine There is however exciting and promising research using nonlinear methods and modeling techniques culled from the science of complexity. The underlying hypothesis is this: While the basic input datum of the marketsprimarily pricesmay be simple, the output can only be forecast with nonlinear methods derived from complexity theory. They do not use back-fit data or curvefitting as do all conventional technical analysis methods. These include chaos theory, catastrophe theory, and cellular automata. Whether it is possible to beat the markets with them remains to be seen. For an example, see Is the Market a Computer? discussing The Trend Machine, a cellular automata approach on www.fxpraxis. See a 5-hour noninterpreted forecast for the EUR/USD in 5-minute increments from The Trend Machine. (See Figure 20.1.) The top row is Up (1) or Down (0) from the previous 5-minute High. The bottom row is Up (1) or Down (0) from the previous 5-minute Low. The interpreted forecast generates an ordinal bar chart. Automated Trading and Robots Many hedge funds now use algorithmic trading (a term I coined in 1991), which is fully automated order entry based on a computer trading model. Individual traders are also now fishing in the same waters. I certainly do not recommend this approach for new traders, but the approach is very interesting. Ninjatrader, www.ninjatrader.com, is a software suite that includes robot or bot trading functionality. Many broker-dealers are also adding the feature to their platforms for advanced traders. FOREX traders may ponder this commentary from A Bust to the Markets by Michael D. Archer (Source: Currency Codex, April 1996). The investment markets will evolve into a war between several powerful computer programs, each seeking to develop new rules and information coding mechanisms and growing forecasts to keep up with the markets parallel behavior. But each computer will need to deal with another factor as well; a factor already noted in the markets. That is: What are the other players doing, or thinking of doing? What rules do they use to find the markets rules? Trading decisions will be made not on just what one concludes the market will do, but on what one concludes other systems on-line are likely to do. This becomes a problem for GAME THEORY, a field of study likely to be soon dominated by self-organizing and evolutionary computing techniques such as cellular automata and Agent computing. Computers in the market will make false moves to deflect the ability of other computers to know what it is planning to do and how it makes its decisions. (This will not sound at all futuristic to commodity floor traders who see the big interests routinely throw in false orders to deflect true intentions.) This multi-dimensional game theory scenario, with a single technique periodically busting a market will, I predict, be the hallmark of the investment arena not long into the 21st Century. This image of the market may not be to everyones liking; especially old-timers like this writer who fondly remembers customer boardrooms alive with the comforting din of ticker tapes and clacker boards. But the fact remains, the markets will continue to exist even when a single technique dominates the action from time to time. Trading will become even more difficult and undemocratic, but also much more profitable for the few. A Last Word Whether you trade with a two-moving average crossover calculated daily on a ten-dollar calculator or a bot executing a catastrophe model with an agent-driven genetic algorithm subroutine, I wish you success in the FOREX market. |
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