1.Forex Market NeutralForex market neutral involves holding long (buy) and short (sell) positions in highly correlated currencies in similar and different investment products, in doing so reduce the exposure of the market. We may attain neutral either through buying and selling correlated currency pairs such as AUD/USD and NZD/USD or by selling AUD/USD on the spot and buying it in the options market. If we reduce the exposure of the market significantly, then a question arises, would it possible to earn sufficient return? It certainly yes, there is always part of the return is unrelated to the broad market movement which is called "residual return", which is the core concept behind the forex market neutral.
Before I explain neutral trading strategies, let's discuss the reason for being forex market neutral.
* No models, including fundamental and technical analysis, are capable of predicting the broad market movement precisely at a specified time frame. The currency prices can diverge from fundamentals for prolonged period of time.
* Forex market participants are diverged significantly and have different opinions and intentions. Hedgers such as the large corporations have a conflicting objective with the speculators like us while central banks would like to manage the currencies at target exchange rate. In addition, central banks have significant power to influence the exchange rate though interest rates and variety of other programs. Thus, it unlikely that market movements are directional.
* Neutral strategies can developed to capture profit in trending, sideways, low and high volatility markets and literally any instrument and any time frame.
* Returns are steady and less volatile compared to other strategies.
2.Overview of Divergence Strategy
2.1 Theory of relativityShort term movements in the forex market may be compared to the weather pattern. Both cannot be predicted by any known models in the short run precisely. Some analysts claim that it follows a random walk. The prediction process is made difficult by nature of the market as the exchange rate affected by many short term factors including market volatility, liquidity, market sentiment and etc. Let's see one factor, US dollar is one of the key determinants of the forex market representing 88% of one side trade [ 2016 Triennial Survey], the currencies may temporarily mirror/move opposite to the dollar. Often we may be misled by the false trend or break out. In addition, many technical indicators fail to predict the trend when there is a rigorous change in volatility. Then, how we filter the temporary movements, the answer is relative strength analysis. It is my view that when movement of price currency analyzed in terms of the portfolio of equally weighted liquid currencies, the trend can be identified relatively with great precision as it removes the common factors affecting these currencies. Let's take a look at the currency index.
2.2 Currency IndexWe can find the currency index in the market info section of Dukascopy website. The currency index measures the relative value or the strength of a currency to basket of equally weighted five most liquid currencies in the market. The widget also allow us selecting the start date, base date and no of days in the graph and tailored according to our requirement and strategies range from days to years.
2.3 Construction and re-balancingThe intuition behind the use of currency index is to buy the over performer and sell the under performer. This strategy looks straightforward. Is this even neutral? The over performer is purchased against the most liquid currencies and under performer is sold against the same. Long positions of basket of five currencies will offset with short positions. The most five liquid currencies are representatives the broad forex market and strategy take positions in relation to broad market. In other words, market exposure is limited.
We may require constant re balancing at regular interval as the convergence may occur. Based on the holding period of the currency, we may re balance daily, weekly or even monthly.
3. Return
3.1 Short term interval ( 1 July 2017 to 11 July 2017)
Graph 1
Red - USD, Blue - EUR, Green - GBP, Orange - CHF, Purple - JPY
The graph 1 shows the relative appreciation and depreciation relative to basket of five liquid currencies from 1 July 2017 to 11 July 2017. During the period, USD strengthened relative to other currencies but EUR gained momentum in the mid and settled slightly above USD at the end of the period. On the other hand, JPY weaken dramatically to its counterparts.
The table provides information about holding positions on a daily basis and the computation of profit or loss. Profitability graph shows cumulative profit or loss over the holding period and makes the tabular information more visible.
3.2 Medium term interval ( 1 January 2017 to 11 July 2017)
Graph 2
Red - USD, Blue - EUR, Green - GBP, Orange - CHF, Purple - JPY
The graph 2 illustrate the performance of currencies with a higher time frame than graph 1. The JPY outperformed the market in the first half followed by EUR in second part. The CHF and EUR seems highly correlated during the period. A higher level of convergence can be seen between CHF and GBP and remain very near to mean at the end. It is clearly visible that USD deteriorated right from beginning till the end.
As mentioned earlier, the currencies furthermost from the graph 2 are selected for the trading and the positions are adjusted or re balanced on a weekly basis as this is a higher time frame. Cumulative profit significantly dropped early of the March and end April as a result of the convergence of JPY. Overall profitability of the strategy looks lucrative this period though market corrections distort the profitability in the mid. I am always of the view that divergence tends to occur more often than the convergence in forex relative to traditional investments, However, the risk of convergence is the key limitation of the strategy. Continuous re-balancing reduces the risk to a great extent, however cannot be eliminated completely. Let's see the risk of the strategy.
4. Risk The risk of convergence, is it a risk or opportunity? Some hedge funds developed profitable trading strategies using the convergence of the highly correlated assets while some others sell at certain price ratios. However, In the long run, convergence to mean is highly likely to occur. This is called "mean reversion". If we take a closer look at the majors in the monthly time frame, the mean reversion is apparent. The strategy to exploit mean reversion named "statistical arbitrage". We will discuss this in a separate article.
Assume the risk of convergence is inherent part of strategy. In response to risk, no measures will be taken to avoid but some tactics employed to reduce. We may reduce the re-balancing interval to lower and use some technical indicators to gauge the reversals. Else, holding period can be increased, so positions will be hold until desired level of divergence.
5. ConclusionLong term Interval ( 1 January 2010 to 11 July 2017)
As discussed above, it is my view that divergence strategy rewards well relative to the risk. Currency index graph is an excellent tool for forex trading specially in screening the potential currency pairs for trading. Secondly, it also clearly shows the relative strength or weakness, trends and reversals of most liquid currencies on a specified time frame which can be tailored. Numerous strategies can be engaged with the widget and there is no single best approach. I encourage to use this tool as part of your strategy.
