ForexSpirit

There seems to have been a recent resurgence in the usage and discussions of correlations between forex pairs. Two currently high profile forex trading systems that seem to be primarily based on using correlations are FreedomRocks and ForexForSmarties. Tom Yeomans also seems to be on a correlations trip at the moment, although he uses them in a completely different which I will also be touching on.

This article was originally written to explain the way that FreedomRocks uses correlations as part of their trading strategy. From both feedback I have received and a bit of a reality check on my part (see previous post) I’ve changed things to make my explanations hopefully more balanced. I’m trying to not sound like a FreedomRocks fanboy, which I think was slightly the case with the original article due to a slight lack of critical thinking on my part.

Hedging and correlation are bandied about as if they are in effect the same thing. This is not the case, and it is unwise to equate one with the other, especially in the forex world. I’ll be examing both to show where most people mis-step.

Hedging
Hedging is a strategy designed to minimize exposure to an unwanted financial risk, while still allowing the assets involved to profit from their investment activity.

Both FreedomRocks and ForexForSmarties use the strong correlation between some currency pairs as their ‘hedging’ strategy. This hedge aims to minimize the risk from moves with the currency pairs used, thus allowing profits to be accrued from the daily interest payments received from holding the currencies.

While the FreedomRocks and ForexForSmarties trading methodologies use the principle of hedging to limit the risk of movement in the markets and thus stabilise the overall value of trades you hold, it is does not hedge perfectly.

Correlation pairs
Let us say that you are using just two currency pairs: EUR-USD and USD-CHF. These two currency pairs are made up of three individual currencies: the euro, the US dollar and the Swiss franc.

By using these two currency pairs we can perfectly hedge against any movement in the one currency that is common to both pairs. In this case it would be the US dollar. We can sell the same amount of US dollars in EUR-USD as we buy in USD-CHF. We have thus shielded ourselves from all movements that directly affect the US dollar.

That leaves two currencies remaining: the euro and the Swiss franc. These currencies have been chosen because of their close ties and similarities. They generally respond in the same way to factors that affect their sphere of influence. Switzerland is obviously based in continental Europe, which means that events in the European Union (which uses the euro currency) affect the financial markets in Switzerland due to the close ties that Switzerland has to the countries that make up the EU. Conversely, events that take place in Switzerland will impact the financial markets of the EU, again due to the close ties that are in place due to business and financial matters.

What history shows us is that the euro and Swiss franc will closely mirror each other. If the euro gets stronger than the Swiss franc will get stronger by about the same amount. If the euro gets weaker then the Swiss franc will weaken also. The amount to which these two currencies mirror each other’s movements can be determined by calculating the correlation between them.

In probability theory and statistics, correlation, also called correlation coefficient, indicates the strength and direction of a linear relationship between two random variables. In our case, the two variables are the euro and Swiss franc currencies.

History shows that the correlation between the euro and Swiss franc is generally 0.95 or higher. A value of 1 indicates a perfect correlation. A value of 0.95 tells us that the currencies mirror each other very closely, but not perfectly.

Resources
There are several web resources that you can use to keep up to date with the current correlation between these and other currencies.

My first recommendation is to use the FXCorrelations tool that is part of Oanda’s FXLabs.

I prefer to use the table view, which lists actual correlation numbers, rather than the default heatmap view. Oanda updates the correlation values daily.

Another interesting resource is a monthly commentary on forex correlations that can be found on the dailyfx.com website. For example, the article on December 2006’s correlations can be found here. You can read articles from previous months by clicking on the ‘Previous articles’ link found at the top of the current article.

To get forex correlations over the past 5, 20 or 100 days, you can analyse the data provided by Swiss broker RealtimeForex here.

The imperfect hedge
After digesting the above information you are probably wondering how much risk does the lack of perfect correlation between the euro and Swiss franc place us in. Asking such a question has its basis in the certainty that the underlying pairs, no matter how well correlated, will eventually move against you.

As I stated previously, the use of two currency pairs does not result in a perfect hedge. Therefore it is important to heed this possibility and protect ourselves against it.

No matter what trading system you use it is imperative that you protect your trading capital at all costs.

More specifically, with either of the FreedomRocks or ForexForSmarties trading systems you do not want to ever have to put yourself in the position where you might experience a margin call. You must not over gear yourself so that an unexpectedly large deterioration in the correlation between the currency pairs puts your capital in jeopardy.

Thus, while there is no perfec hedge when using currency pairs, it is possible to use sensible planning and position allocation to limit our risk if such an event were to unfold. Plan for the worst.

Just as there are currency pairs that include the US dollar and the euro (EUR-USD) and the US dollar and Swiss franc (USD-CHF) there is also a currency pair made up of the euro and Swiss franc (EUR-CHF). The price change in the EUR-CHF pair reflects the imperfect correlation between these two currencies. The correlation between the two currencies ebbs and flows each and every day. Just as economic, political and other world events impact on the EUR-USD exchange rate, so will events impact on the EUR-CHF exchange rate.

Two currency pairs (such as our original EUR-USD and USD-CHF pairs), no matter how well correlated, will tend to trend to some extent. This trend is reflected in the EUR-CHF rate.

Historically the trend between the two will favour the currency with the stronger fundamentals (which includes macro economic factors such as higher interest rate, current account surplus, and so forth). At the moment, there is a higher interest rate available from holding euros compared to holding Swiss francs which is one of the main factors behind the euro’s steady rise against the Swiss franc over the recent past.

If we hold a currency that has stronger fundamentals than one we have sold then we adding to our edge in that the trend will, in the long run, generally be in our favour. This means that the imperfect hedge we are holding will generally act in our favour, rather than against us. Any moves that do go against should be short term corrections taking place against the backdrop of a long term trend that is going to help us.

Market conditions can obviously change (Switzerland or the European Central Bank can update their interest rates) which will have an effect on the underlying strength of the trend of one currency against the other. Thus our edge can be altered. It is important to have a least an understanding of this and to make sure that our edge in this regard does not turn against us.

The basis of the FreedomRocks and ForexForSmarties systems is therefore pretty solid. As long as you are receiving interest, using reasonable margin and following the system the odds are strongly in your favour.

Do your homework
No trading system is without risk and that includes FreedomRocks and ForexForSmarties. Make sure that the risk level you are taking on is within your comfort zone.

Keep abreast of the correlations in the currencies that you are trading in, on a monthly if not weekly basis.

Know when the various central banks of the currencies you are trading meet to discuss and potentially change their interest rates.

Be aware of the underlying trend in the cross rate of the currencies you are trading. If you are trading EUR-USD and USD-CHF in FreedomRocks then your cross rate is EUR-CHF. If you have added sterling into the mix then you also need to look at GBP-CHF.

Trading naked
One question that is frequently asked when it comes to trading highly correlated pairs is:

Why not just trade the resulting cross rate naked?

What this question is asking is instead of trading both EUR-USD and USD-CHF why not just trade EUR-CHF directly?

If you look up the interest rate gains to be made by buying some euros against the Swiss franc you’ll find that you would make daily gains. I would even suspect that those daily gains would be close to what you would make in daily interest from holding the hedging pairs of EUR-USD and USD-CHF.

The biggest difference (barring any minor short term discrepancies between the various pairs) is that you only have to pay the spread once if you stick to EUR-CHF.

If all you are doing is just entering a trade on EUR-USD and hedging your US dollar exposure on USD-CHF then you would be better off just trading EUR-CHF. You will not have to pay spread costs on two orders, but just once. You’ll get just about the same daily interest, depending on your broker’s premium rates, and the movement of holding the two trades versus the single one in EUR-CHF will be almost exact. I’m sure there are plenty of arbitrage systems out there that make sure the cross rates match the main currency pairs.

Your exposure from holding a naked trade is going to always just about equal when you hold two hedged positions.

A second area of difference that gets slightly more difficult to really quantify comes from the secondary part of the trading strategy that a program like FreedomRocks offers.

The FreedomRocks system also involves placing additional small trades on the correlated pairs. These additional trades are generally only about 2% the size of your main trade, and look to make profit from the large daily movement of the main pairs. Since the two correlated pairs will move in varying ways throughout the day it is guaranteed that these trades will be hit in a random order resulting in skewed balancing between the correlated trades. Since the placement of these trades is part of the ‘black box’ component of the system it is very hard to tell if their aim is to keep the correlation stable, or to skew it slightly depending on how the markets move.

I would surmise that it would make perfect sense to just trade the EUR-CHF pair as your main trade (and save yourself some spread costs) and then place the small trades in EUR-USD and USD-CHF as an alternate way to trade the FreedomRocks system.

There might be some way to translate the small trades to just on the EUR-CHF but since I’m not privy to exactly how the trade orders are precisely calculated (the main black box area again of FreedomRocks) it’s impossible for me to know the feasibility of that.

The EUR-CHF pair will not move as much on any given day as compared to its correlated pairs (EUR-USD and USD-CHF). While EUR-USD seems to average moves of 70-80 pips a day, the EUR-CHF pair seems to average 30-40 pips. There are obviously days when both pairs will move much less, and other days when they will move double or triple their average.

One of the reasons why the EUR-USD and USD-CHF pairs will move much more is that they are tied to the US dollar, which is still the reserve currency of the world. These are some of the most highly liquid and heavily traded currency pairs in the world. This is why it is not uncommon for these pairs to move a 100 pips or more in a 24 hour period.

What’s up with those small trades?
If you use the FreedomRocks system you will be following its Portfolio Manager which instructs you to buy small lots of the currencies you hold as price moves up and down. If prices in these currency pairs trend (i.e. move in one direction consistently) then you will find yourself consistently buying lots in one pair and selling lots in the other pair.

Why are you doing this?

While I don’t know the real in-depth reason for this, my guess is that it is to take advantage of the times when the currencies reverse direction as well as when they enter range bound areas. You then end up selling the positions you have previously bought (and likewise buying the positions you had previously sold). You are therefore making profitable trades that capitalize on the large movements that these forex pairs make.

As well as the daily interest gains that result from holding large positions, you also end up profiting from the large daily moves that happen.

If the market never returns to close out the small lot positions that you had initiated at the start of a large trending move, all is not as bad as it seems. Since you would have bought and sold an equivalent amount in your two hedged currencies your hedged position is still in place. I am of course assuming here that the Portfolio Manager aims to keep your hedge in place; this might not be really the case, as it might instead aim to shift the balance depending on how the markets move.

All you need to make sure of is that you are still comfortable with the amount of margin that is being used up by the total number of lots that you now currently hold. If you feel uncomfortable in having so much margin used up you would be well advised to close out all your positions and reallocate your portfolio back to using a level of margin that you are happy with.

No matter what way you look at it the EUR-CHF trend is vitally important to profiting from the FreedomRocks or ForexForSmarties strategies. If the trend holds then peole will make money. If the trend reverses and stays in reverse then bad things will start to happen to people’s accounts if they’re not aware of the situation and manage their trade allocations accordingly.

Given my regular short/medium term way of trading using a median grid in EUR-USD I’m wondering if it makes sense to investigate using the same sort of approach in EUR-CHF. There is a clear trend and holding trades through retracements would at least result in interest payments. The fact that I have to pay interest on positions I hold in EUR-USD is one thing I don’t really like about trading that pair.

Correlations as a predictor
The final point of interest relating to correlations is the way that Tom Yeomans takes advantages of the correlations between currencies.

He uses the movements in highly correlated pairs to determine where price movements will go in the very short term.

I’ll use EUR-USD and GBP-USD as a simple example of how he does this. EUR-USD and GBP-USD generally have a high correlation. What Tom does is to look at the tick movements in both these currencies to try and determine which currency is the leader and which one is the follower.

On any given day, price movement might tend to occur first in sterling and then be followed by a similar movement in the euro. If you watch the tick movements of the pairs for an hour or two you might be able to pick up which one is the leader that day.

You can then use this knowledge when you are looking to enter or monitor trades. You would only look to enter trades in the lagging currency pair. You look for confirmation of future movement in the leading pair which allows you to make decisions about what to do in the lagging pair.