Wednesday, June 27, 2012

Why I believe trend-following strategies are less effective in forex markets

One thing that took awhile to notice is how range-bound the forex market is, relative to other markets like stocks or commodities. Range-bound markets tend to be dangerous for trend-following systems, since these systems only work by generating a few giant rewards in exchange for many small losses. Such rewards can only be found in long-term, sustained trends in the market. A choppy, horizontal market will wipe out trend-following traders.

I've tried backtesting a few trend-following strategies, such as using an ATR (Average True Range) trailing stop. A few quick backtests using various multiples of ATR yielded unremarkable results.

Luckily, gold and silver are unoffically considered "currency" and most forex brokers allow you to trade both precious metals. However, gold and silver are also commodities with real-world applications, and can be considered as part of the commodities market as well.

Let us compare gold with the USDCHF and the AUDUSD. The CHF is the Swiss franc and is 20% backed by gold (courtesy of the Swiss central bank). The AUD is a commodity currency, with Australia being a major exporter of gold. Thus you would expect some correlation between the two currency pairs and gold.

Gold chart from mid-2006 to mid-2012:

Mid-2006, gold's low was around $545/oz. It peaked at $1920/oz in 2011. This is a multiple of 3.5. For the most part, there is a clean, crisp trend.

USDCHF chart from mid-2006 to mid-2012:

As you'd expect, there was an (inverse) correlation between the USDCHF and gold. The USDCHF's high was 1.2768 in late 2006, before hitting a low of 0.7061 in 2011. This is a multiple of 0.55. Since we want to compare this multiple to gold, we find the inverse, which is 1.81.

AUDUSD chart from mid-2006 to mid-2012:

And here is the chart for the Aussie dollar. Look at all that chop! The Australian dollar hit its low during late 2008 at 0.6009, before peaking to 1.1079 in mid-2011. This is a multiple of 1.85.

What it all means

Forex markets are more range-bound than other markets, as demonstrated by the lower multiples of 1.81 and 1.85 versus gold's 3.5, even when there is correlation. Lets examine why.

1) Currencies measure the strength of national economies. Barring some catastrophe like war or instability, economies only move a few percentage points per year, GDP-wise. This is unlike commodities, which are more subject to "micro-economic" factors like bad weather, labor disruptions or technology.

Stocks are much more nuanced and volatile, with garage start-ups capable of experiencing explosive growth as they expand or create new market share (e.g. Facebook, Google), or suffering catastrophic collapse (e.g. Enron). Can an entire national economy see the same kind of growth as Facebook did? Nope. Likewise, you won't see an overnight collapse (barring some catastrophe).

2) The forex market is the largest and most liquid on Earth. Informed, liquid markets tend to find equilibrium faster than less-informed markets like penny stocks.

3) Governments and central banks have an interest in maintaining price stability. A central bank or government isn't going to care if Facebook stocks are overvalued. But if their currency becomes overvalued and starts harming local exporters, these two institutions are more likely to manipulate their currency, or even peg it.

4) Currencies are less influenced by inflation than stocks or commodities. Lets assume we have a currency pair, with both currencies experiencing 3%pa inflation. Over time, inflation should not influence the price of the currency pair as both currencies are being devalued at the same rate. On the otherhand, stocks and commodities will be rising 3%pa on inflation alone.

5) Currencies are less likely to be influenced by emotion like fear or greed, especially the latter. Greed or wishful thinking may create bubbles in certain stocks like the dot com bubble. However, no-one is ever going to bet their house on the value of the New Zealand dollar flying to the moon.
That's all I can think of at the moment. Thoughts appreciated.

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