De Econometrist

De Econometrist neemt een statistische kijk op de wereld.

Finance

Forex: Fortune or Forecastable?

With the cryptocurrency hype attracting so many new investors, let us shine a light on financial markets to show what else is out there. The Foreign Exchange Market (also known as Forex) is the global market for currency trading, which is, with a daily volume currently averaging about 5 trillion US Dollars, the largest financial market in the world. Not only does Forex average the highest volume of all financial markets, it is also opened 24 hours per day, five days per week. In The Netherlands (GMT+1) this is from 11 pm on Sunday until 23:00 on Friday; the first time complies with Sydney’s business week opening at 9am on Monday and the latter with the business week closing in New York at 5pm on Friday. Averaging several millions of transactions per day could make one wonder: who are trading these currencies so actively?

Basics of Forex

Market participants

There are many financial institutions that influence the foreign exchange market by buying or selling currencies, which are not necessarily trading to earn money, e.g. central banks often have targets for the exchange rate of their respective currencies and own large amounts of foreign currencies to stabilize this exchange rate. However, their primary objective is not to generate profit on this market, but to stabilize it. Most other participants are highly competitive and do have making money as their sole goal. These participants are mainly hedge funds, which are the most active traders on Forex by trading more than 70% of all volume on the market. Also, there are many banks, companies and individuals that trade on the foreign exchange market. Why are all these stakeholders attracted to trade on Forex?

Market characteristics

There are several characteristics that make Forex an extremely interesting financial market. Firstly, the trading costs on Forex are low compared to other financial markets, which increases potential revenues. These potential revenues can be enhanced further by the substantial possibilities to utilize leverages to enlarge margins with lower initial investments. Since there are so many competitive participants on the market, the foreign exchange market is seen as the one financial market that is closest to the hypothetical ideal of perfect competition.

Financial instruments in Forex

On the foreign exchange market, participants bet on a rate between two currencies, such as the value of one Euro in US Dollars, to either grow or drop. In this case we call the Euro the base currency and the US Dollar the variable. Comparable to other markets, there are several ways to trade in the foreign exchange market. First of all, you can go long on a position (buy), that is, you expect the Euro to become stronger with respect to the US dollar, or you can go short on a position (sell) for when you expect the opposite to happen. Both long and short positions can be acquired with large leverages until 50:1 on major currencies. This means that when you make an investment of €1,000,- you can acquire a position of (50*1,000=) €50,000,- due to financing from the bank with whom you are trading. When one buys a position, usually three numbers are chosen. One for the exchange rate at which you want to buy a position, which is called the entry order, and two more for when the position is already acquired: the limit order and the stop-loss. The limit order is the amount for which it is desired to take the achieved profit and sell the position again (the bank will then do this automatically). The stop-loss is the opposite; it is the amount for which losses are taken and the position is automatically sold. The first is to protect achieved profit for when the market fluctuates heavily and it becomes difficult to sell at the right time for the desired price. The latter is to protect the size of the loss taken, so when a rate decreases heavily when a long position is acquired, it sells the position at a certain amount of loss. Furthermore, buying and writing put- and call options are regular on Forex and many interesting constructions (such as collars and straddles) are possible with options; however, for clarity, these will not be discussed.

Algorithms

Since there are many technical instruments available to examine and predict exchange rates and their stability, many programmers and econometricians have written algorithms to predict fluctuations in the foreign exchange market. Many of these algorithms have shown to have significant predictive capabilities; however, very few have been able to generate profit and none have proven to sustain this. In the world’s most competitive market and because of the substantial effects of news (which is very difficult to quantify in an algorithm) on short term exchange rates, it is extremely challenging to create a neural network that does not require constant human input. This is because this news cannot be quantified by the algorithm, while the rest of the competitive market does react on this news extremely quickly. Although, there are several traits of these algorithms that may contribute to successfully trading on Forex. Primarily, they are capable of combining several of the technical instruments and draw conclusions from them more rapidly than any individual. Also, under normal conditions, so without any (groundbreaking) news concerning the base currency, the variable or the factors that influence them, these algorithms do manage to create revenues. However, one can never know with absolute certainty that the market will be stable without any news.

Luck

Now that we have discussed the influence of algorithms and their shortcomings, it would be easy to conclude that Forex trading does not require any luck, because it is about correctly reacting to news that becomes available through time. However, there are traders that continuously buy and sell positions within a minute with little acknowledgement to news, but because the rate increased some pips (a one pip change is a change from e.g. 1.0084 to 1.0085). Trading accordingly results in being comparable to the algorithms, but without the quick calculations. Nevertheless, there are people that make a living out of this: how do they outperform the market and what is the influence of luck?

There are several techniques that high frequency traders can use in their attempt to beat the market. One of the strategies that they undertake is to place long and short entry orders just below and above the market price respectively on several currencies. By doing so, they assure themselves that when the market price fluctuates a minor quantity of pips, they start to bet that the rate will flow back to its original state and assure themselves of a minimal percentage gain. However, when you trade with a large quantity of capital (or with a large enough leverage), it will still generate sufficient revenues. This is usually only done when there is little to no news concerning the exchange rate on which the orders are placed, because major shifts are disadvantageous for these traders. For news-traders, traders that analyse the current situation and speculate what certain news will do to exchange rates, the opposite of this strategy is regularly used. This means that they place long and short entry orders just above and below the market price respectively on the specific position they expect to react on the news. The idea is that a big shift is expected either upwards or downwards and either way money will be made. There are numerous similar and completely different strategies that high frequency traders apply, but it still does not clarify up to what degree it relies on luck.

Let me demonstrate the possible consequences of trading with these strategies with a recent example. On December 16th of 2015, the Federal Reserve (Fed) had a press conference concerning whether they were going to raise the benchmark interest rate for the first time in almost a decade (a.k.a. a rate hike, which is a more regularly used term in news items). If the Fed would hike, borrowing costs would increase, which would lead to lower asset prices, reduced risk-premium and a stronger greenback (popular term for the US Dollar). Now let us analyze the mentioned strategies to this event. This is clearly a position for news-traders, since big news is going to be presented. If the Fed would hike the rates, the US Dollar would become stronger compared to other currencies and if not, vice versa. Applying the second strategy would be a standard move.

This is the EUR/USD exchange rate from December 16th midday until December 17th at 3:00 pm. The red dot is December 16th at 8:00 pm (GMT+1), which is when the press conference of the Fed started. The grey line is the entry order for the long position and the red line for the short position for the news-trader strategy. For clarity, the grey line will be the stop-loss for the short position and the red line will be the stop-loss for the long position.

Finally, on the 16th of December, the Fed decided to increase the interest rate for the first time, so one would expect the EUR/USD to decrease so that the currencies are traded closer to 1:1. Eventually this does happen; however, before this happens, the rate fluctuates heavily up and down, which will trigger the entry orders just above and below the previous market price. Afterwards, the rate moves the other way, which means that many of the stop-losses of the newly acquired positions would be sold with a substantial loss. On the very short-term, the first strategy would have sufficed, because indeed the first two fluctuations of the currency were temporary, which would have triggered the entry orders. Once the exchange rate fluctuated back to, or even further than, its original state, the limit order will have been reached and the positions would be sold with profit. This rarely happens, because these kinds of trades are seldom done around big news items.

To conclude, there are actually traders that have been able to outperform the market on the long run, but these traders still have off-days where they lose substantial amounts of money. Even with many strategies and even more studies on how to outperform the market, it has proven to be extraordinarily strenuous to have a consistent and sustainable strategy to actually guarantee long term profits. The traders that make money claim it is due to skills; the traders that fail blame it on bad luck. Which one of the two it truly is, remains a mystery.


 This article is written by Wouter Nientker

 

 

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