It took some time within investment circles for currency to
be recognized as something where you can consistently add value. In currency markets,
because wherever there is a buyer there is a seller, many have said currency markets are a
zero-sum game. Also, as the currency market is the most liquid and largest financial
market in the world, it is a big ocean to feed in. This allows opportunities for our
system to extract value from inefficiencies in the currency markets and generate positive
returns.
Fx Quant 10, our quantitative currency
trading program, is based on
quantitative analysis - a statistical concept. It is 50% statistical
arbitrage and 50% position size management. Unlike most trading systems, which attempt
to predict market direction, our trading model reacts to price action and
makes trading decisions. Guessing market direction is impossible, or so say noble guys
with Nobel prizes. But good luck if you don't believe them.
Diversification. One of
the most important aspects of our trading program is diversification, the
ability to trade several different currencies. The strategy creates a
complex portfolio of 10 global currencies and adjusts its components daily.
The emphasis is on currencies of developed countries (G10 currencies), but current and
future portfolio construction is at Quant Trading's discretion. The mathematics of portfolio diversification
show that when you combine weakly correlated currency pairs together, a higher information
ratio (returns per unit of risk) is generated than with individual currencies. In other
words, diversification of currencies can lead to better risk-rewards for the combined
portfolio. As an example, in a portfolio comprised of three currency pairs, one position
can be unprofitable at the moment, but the other two can show profits to more than
compensate for the losses incurred with the losing one.
Our system works with all currency pairs. We also tested it with HUF and SGD and
obtained similar results. We decided to stay with the G10 currencies (EUR,
USD, GBP, CHF, JPY, CAD, NZD, AUD, SEK, NOK and DKK) for their excellent liquidity and tight bid/ask spreads. The system is
non-parametric, i.e. there are no parameters to optimize, except the leverage. Hence, the
system is very robust and does not depend on price patterns (which most trading systems
depend on).
Uniqueness of
the FX Quant 10 trading program.
Unlike
other trading systems, with uncorrelated monthly returns, losses generated by our system
(they can not be avoided!) are preparation for, or announcement of future gains. Our
numerical simulations show that in long run, and if reasonable leverage is used,
the profit factor of our system will always be greater than unity (the sum of gains will
always be greater than the sum of losses). The leverage is carefully determined in order
to avoid disastrous drawdowns.
Our standard risk parameters
employ an average combined leverage around 3:1 for the entire portfolio. The
maximum leverage is currently limited to 4:1. An important system feature is that leverage
reverts/oscillates around a long term average. The best time to start trading is when the
actual leverage is above the average (long term) leverage. We report the leverage and the
estimated risk in our monthly performance reports.
The system opens positions in opposite directions. It is
USD neutral (i.e. USD bought = USD sold), but there is a long/short exposure in other
currencies - see these position size graphs. As stated before, due to portfolio diversification, the risk is more limited
than if one was to trade just one currency alone.
Make sure you understand the level of risk involved in
the FX Quant 10 trading strategy and ensure that it is suitable to your personal investing goals,
time horizons, and risk tolerance. The leverage used is a double sided sword: it improves
returns, but it also increases the risk. As with any investment, the higher the
potential returns, the higher the risks you must assume.
Risk management. The risk is addressed by
diversification and position size management. The system rebalances portfolio by gradually
buying/selling fractional (odd sized) currency lots. Since the system does not open large
positions in any direction, directional risk is limited and controlled. As stated before,
the leverage oscillates around a long term average. Hence there is no need for protective
stops. When a drawdown occurs, portfolio is rebalanced and ready to recover from losses
and make a new equity peak.
Drawdowns typically occur during prolonged trending
periods (with no retracements, i.e. little price noise) in all currency pairs
simultaneously. These events, however, tend to be less frequent today, as the Forex market
is becoming more and more efficient - the "matured" G-7 currencies particularly.
As soon as the market retraces or enters the consolidation phase (actually, there is
always some noisy/random price action, even in a trending market), the system recovers
from losses and makes a new equity peak. This makes our system superior over most
rule-based, pattern recognition, Elliot Wave, W.D. Gann, many indicator-based trading
systems and other trading alchemy. No one knows when will the market change its behavior
and those systems will break up. Potential risk for our system comes from over-leveraged
trading, i.e. trading too large positions for the account size. In order to
avoid a potential disaster, please keep the recommended risk level of 25% (average
leverage of 3 and maximum leverage of 4:1) at all times.
Your account should be held with a Forex dealing
company which allows fractional lot size dealing (10
currency units or less per lot).
