Back in the Market After Some Forward Testing, a Bad Carry Trade, and a Bit of Boredom

Hello again, and apologies for this blog's recent suspended animation. For various reasons hinted at above I decided to give forex a rest for a while - but I'm now back and have just made my first foray into live trading the EUR/USD again.

The principal reasons I took a break were:

I was frankly a little bored and disappointed with the progress of my EUR/USD trading system. Out of impatience with its performance, I'd convinced myself it didn't actually work with real trades, it just looked good in backtesting. In fact, I ended up questioning the entire idea of backtesting since it offers absolutely no guarantee your trading rules will work into the future. So I decided to give it a break, and maybe come back in a few months, plug in the new data, and see if my system would've actually made decent trades in that time.

Around the same time, largely because I was disillusioned with my own trading system, I convinced myself carry trading was by far the best way to trade. So I devised what I thought was a very clever hedging system using the USD/CAD to balance the volatility of the carry trader's beloved GBP/JPY pair. But unfortunately I decided this just before the GBP/JPY carry trade experienced a giant melt-down that demonstrated how little I know about carry trading or hedging. So I got burned. Thanks to my stop-losses I didn't get wiped out, but I did get scorched pretty badly. (Did I mention I also broke my own trading rules by taking on way too much risk? Well, I did. And it was dumb.) In case you're wondering what a carry trade meltdown looks like, here's a picture. Congratulations to all the GPB/JPY shorts out there, it must've been a fun couple of months:


But there is some good news after this tale of burnout and reckless trading. As I mentioned, I've been letting my trading system sit idle for the past few months while new EUR/USD price data piled up. This new data was the raw material I needed to effectively forward test my system and see if it actually produced real, profitable trades, not just pretty pictures of historical backtests. When I plugged in the new data earlier this week, I was very pleasantly surprised: my system had racked up a very steady, consistent, profitable trading record while I was ignoring it. Which is why I'm back trading (and posting) again.

One of the trading risks I've described before is the desire to fiddle compulsively with your system, even when it's doing just fine as it is - the "If it ain't broke, don't fix it" problem. Since I'm a bit of a compulsive fiddler, my challenge now is to find something else I can fiddle with to keep me from breaking what isn't broke. One thing I've been wanting to learn for a long time is how to program Metatrader to trade my system automatically using their MQL programming language. I suspect it'll be quite a challenge transitioning all my trading rules from Excel to Metatrader - but if I can get them automated it'll save a huge amount of time over the long term. So if there are any experienced Metatrader programmers out there, any advice on getting started with MQL would be much appreciated!

British Pound Hits 26 Year High Vs. US Dollar

While I'm not currently trading the GBP, I thought this was an interesting bit of news - on Wednesday, April 18 the British pound hit its highest level versus the dollar since 1981, breaking $2.010 for the first time in 26 years. And here I am looking at daily, weekly and monthly highs and lows - sorta puts your own little trading timeframe in perspective.

The big rise against the dollar followed data out of the Bank of England showing inflation in the UK at 3.1%, which is way above the bank's goal of holding inflation at 2%. Traders are now guessing that the bank will raise interest rates to try and bring the inflation rate down - and with those higher interest rates will come more profitable carry trade opportunities for those buying the GBP. (The pound has long been a key component of most forex carry trading strategies.)

Hence this dramatic spike upward. Hope you GPB/USD traders out there made some pips off it!

Forex may be chaotic...but some things are still predictable

I was just reading this post over at Trader Rich's Forex Project about a study at MIT that concluded that "treasury bonds are random, the stock market is correlated, and forex is chaotic." Firstly, let me say I haven't actually read the study in question, and probably never will. What I have read is Rich's summary of the study author's summary of his findings in Currency Trader Magazine. Also I've never studied chaos theory, higher math or physics. So obviously I'm extremely well-qualified to comment on this research in a thoughtful, informed, and in-depth manner. So here goes...

While I agree that a lot of forex market activity appears chaotic, and as soon as you come up with a predictive rule the market breaks it, there are still a few things you can predict with some accuracy amid all the chaos. And these are the things that keep me trading forex. Off the top of my head, they are:

Trading range: I can say with reasonable confidence that the trading range of the EUR/USD tomorrow will be somewhere between 30 and 150 pips. Occasionally it may be more, occasionally less. But it will almost certainly not be 500 pips. Or 1000 pips. Nor will it flatline and refuse to move at all. Now a currency whose range varied from 10 to 1000 pips a day on a fairly unpredictable basis...that would be chaotic.

Reaction to certain news events: some events will move the market. Period. What direction, and how many pips, can be hard to prediect. But I can predict with a high degree of confidence that there will continue to be news events that shake things up periodically.

Periodic emergence of trends: very real, very tradeable trends will emerge from the chaos every so often, and in all likelihood will continue to do so. Just looking at a price chart without a single fancy indicator on it can tell you this.

If you place trades long enough you'll eventually get one right. This is the principle behind the Martingale strategy. I'm not saying it's a good strategy to use, but it's based on a statistically valid and predictable observation. Chaos or no chaos, the odds will eventually swing in your favor.

Buying some currency pairs pays you interest. Holding others costs you interest. This is what carry trading is all about.

Someone who routinely takes on too much risk when trading in chaotic conditions probably won't last as long as someone who knows exactly how much risk they can afford to take.

Someone with a clear head can combine observations like these into a trading strategy with decent odds of paying off in the long run. Someone whose outlook is clouded by wishful thinking, impatience, inconsistency, lack of discipline or impulse control, and any other problems of the compulsive gambler doesn't have a chance in the world.

Forex can be boring for long periods. Whether that's chaotic or not I can't really say. But it's certainly predictable.

I'm sure the chaos theorists wouldn't disagree with any of this, and would point out why chaos theory allows for all of these possibilities. But I'm not writing for them - I'm writing for the traders out there like me who see a statement like "forex is chaotic" and think they must be crazy to keep chasing the market if the MIT scientists say it's a giant chaotic whirlpool ready to suck your accounts dry. So if I've made any of you feel a little better, I've done my job. Enjoy the chaos!

How undervalued is the yen?

I just read an excellent article in the most recent Economist discussing the undervaluation of the Japanese yen, which their editors assert is putting the global economy at serious risk. This story ties in closely with an earlier article about the carry trade, of which the yen forms an integral part because of low Japanese interest rates.

The Economist's take on the situation is that speculation by carry traders combined with complacency by world governments is holding the yen's value down at an artificially low level. How low? The article claims it could be undervalued by as much as 40% vs the Euro. That's a lot. And when the yen finally does begin to adjust upward (not if, but when), there are as many as $1 trillion in carry trade positions that will start unraveling with every pip it rises.

Say you've bought the GBP/JPY pair with a highly leveraged forex account and are making a nice profit off the dramatic interest differentials between these two pairs. Suddenly the yen appreciates by 1%. Then 2%. Then 5%. It's not a pretty picture. There's a reason this strategy has been called "Picking up nickels in front of a steamroller." So if you've been pursuing a carry trade system with the yen, this article is a compelling argument against complacency in your positions.

One of the most informative parts of the article for me was its discussion of how hundreds of billions of dollars in yen carry trades aren't closely tracked by official statistics. The reason for this is that unlike spot currency traders who will sell the yen to buy a higher yielding currency, hedge funds will instead use financial instruments called currency forward swaps to place their carry trades. How can you measure how much these off-balance-sheet transactions add up to? According to the article, "A better clue comes from record net 'short' positions in yen futures on the Chicago Mercantile Exchange. Estimates of the total size of the carry trade range as high as $1 trillion."

In short, it's well worth reading, whether you're a carry trader or just trade the yen on a regular basis. And even if you don't go near the yen in your trading, keep in mind that any major movement in this currency will have significant spill-over effects into others.

Here's the article: Carry on living dangerously

The Thanksgiving Carry Trade...Or, How I've Been Short the EUR/USD All Week and I'm Too Lazy to Stop Now

[Well, Murphy's Law kicked in and it's up over 1.2900 today, taking my stops with it...so no Thanksgiving carry trade after all. This trade turned out to be quite a turkey.]

For the past week or thereabouts I've been sitting on a short EUR/USD position that has been possibly the most boring trade I've ever had the displeasure to make. A week ago the pair was hovering around 1.2820 and aside from a 30 pip run up in the last couple hours it's been doing the same thing this week. Tomorrow I won't be surprised if it's back somewhere between 1.2820 and 1.2830. Since I'm not expecting a lot of volatility over the Thanksgiving holiday and weekend - especially considering the tedious and annoying lack of volatility lately - I think I'll end up just holding this interest-positive position until next week and make a few dollars from the holiday carry trade. Unless of course I wake up tomorrow and suddenly the EUR/USD is above 1.2900 and heading higher, in which case please disregard everything I just wrote. (By the way, I'm not recommending the EUR/USD for carry trades, it's just what I happen to be trading these days - there are far more lucrative pairs out there, like the GBP/JPY.)

Speaking of holidays, I'm curious if the November-December holiday corridor is an especially good time for carry trades because of its relatively lower volatility. Something I'll have to do more research on.

Happy Thanksgiving fellow traders - hope your current trade's not a turkey!

Related topics:
Learning about carry trades
The Economist covers carry trading

The Economist Covers Carry Trading

Not long ago the Economist ran a good article on the risks and rewards of carry trading. Here are a few of the highlights:

"In the foreign-exchange version of the carry trade, an investor receives an income by borrowing a low interest rate currency and owning a higher-yielding one. This produces a positive return most months, but the risk is that the high-rate currency will devalue, resulting in a heavy loss."

"Cynics have described these bets as 'picking up nickels in front of steamrollers'. [Great quote, huh?] A long series of small gains is punctuated by the occasional wipe-out. However, from the point of view of a hedge-fund manager, it is a perfectly rational approach."

The article also makes the point that trading against the interest-positive direction (or "anti-carry trading," as it could be called) will usually be a losing strategy, unless the market is clearly trending that way.

However, it concludes rather ominously by stating that: "Low volatility and the carry trade sow the seeds of their own destruction."

You can read the whole article at Economist.com:
"Instant returns: why investors have become addicted to the carry trade." Definitely worth a look, whether you're currently carry trading, are considering it, or just want to learn more about how it works.

Related topic:
Learning about carry trades

Learning about carry trades

One of the areas I've been pretty ignorant about in the world of forex is carry trading, which relies on interest rate differentials between currencies to profit from interest rather than fluctuations in the actual currency prices (though those can certainly contribute nicely to any interest gains if they trend in the right direction).

As usual, the Oanda forums proved to be a trove of information on the subject: currently I'm in the midst of this thread, and am finding the posts by Interest-Hawk and the excellently named HAPHAZARD_TRADING particularly interesting.

Interest-Hawk describes the steady profits he's been making with a long position in the GPB/JPY pair, which will pay out just over $22 a day per lot in interest. As he describes his strategy, "I trade using FXCM (a topic for another thread) and they require a 2% margin to earn interest. For me, that comes down to every 100k lot costs me $2000. 2k per lot, simple as that. Each of those lots then pays me exactly $22.70 per day, every day of the year in rollover interest. That breaks down to doubling my initial investment (In interest ONLY) every 88 days."

That got my attention pretty quickly, as did HAPHAZARD_TRADER's list of the currency pairs in his interest-positive basket:

"GBP/CHF, LONG
GBP/JPY, LONG
AUD/JPY, LONG
USD/JPY, LONG
USD/CHF, LONG
EUR/HUF, SHORT, for those who like 100 pip spreads

Not all at once and all the time, but I'll keep trading them so long the INTEREST keeps rollin in."

Carry trading is probably not a great strategy for those who are impatient, short-term in outlook, or addicted to the thrill of freqent trading. That said, I do see an opportunity for a hybrid strategy that combines trading and carrying, with the potential to benefit from both. Here's how I would go about designing it:

Identify a pair like GPB/JPY with a high interest differential

Create a rule-based trading strategy for it as I would for any other pair, but with the exception that...

This strategy would focus only on interest-positive trades: in the case of the GBP/JPY, long trades.

Once I had a working trading strategy that I felt comfortable with, regardless of interest, I'd then start placing long trades with it. If all went well, I'd be gaining interest while hopefully profiting from uptrends in the GBP price as well.

In this type of hybrid system, any losses in trading would be offset by gains in interest, and in the best case, interest and trading gains would coincide to generate significant profits...especially when daily compounding enters the picture.

Another strategy is to open inversely correlated positions that are both interest-positive. This way, any losses in one currency's price would be (roughly) offset by gains in the other, while both earned interest. This is the idea behind a balanced basket of interest-earning currencies.

But I'm still very new the whole carry trade concept, so there's a still a lot to learn. If I've made any amateurish errors here, any carry traders in the audience are welcome to correct them in the comments below.

Related topics:
Carry Trading Strategies
The Economist Covers Carry Trading
Forex Interest Calculator

Online Forex Interest Calculator

Every so often I get curious about how much interest I'm earning or losing by holding certain currency positions. For instance, I recently discovered I've shelled out a lot more than I've made in interest this year because I've been making a lot more long EUR/USD trades than short ones. Knowing that I can make a few extra bucks may also affect my decision to hold a position through the weekend or not. So I decided it would be helpful to have a handy calculator on hand that would tell me exactly how much I could expect to earn or pay out in interest.

Fortunately there's no shortage of these calculators online, and Oanda offers this easy to use one as part of its FXMath suite of currency trading tools. Curious how exactly interest is calculated, or perhaps you'd enjoy nothing more than calculating it yourself? Here's a detailed explanation of how it's done.

Related topics:
Forex Calculators & Converters
Learning about carry trades