FUNDAMENTAL TRADING STRATEGIES

FUNDAMENTAL TRADING STRATEGY:
RISK REVERSALS




Risk reversals are a useful fundamentals-based tool to add to your mix of indicators for trading. One of the weaknesses of currency trading is the lack of volume data and accurate indicators for gauging sentiment. The only publicly available report on positioning is the “Commitments of Traders” report published by the Commodity Futures Trading Commission, and even that is released with a three-day delay. A useful alternative is to use risk reversals, which are provided on a real-time basis on the Forex Capital Markets (FXCM) news plug-in, under Options. A risk reversal consists of a pair of options for the same currency (a call and a put). Based on put/call parity, far outof-the-money options (25 delta) with the same expiration and strike price should also have the same implied volatility. However, in reality this is not true. Sentiment is embedded in volatilities, which makes risk reversals a good tool to gauge market sentiment. A number strongly in favor of calls over puts indicates that there is more demand for calls than puts. The opposite is also true: a number strongly in favor of puts over calls indicates that there is a premium built in put options as a result of the higher demand. If risk reversals are near zero, this indicates that there is indecision among bulls and bears and that there is no strong bias in the markets.

What Does a Risk Reversal Table Look Like?

We showed a risk reversal table before, but want to describe it again to make sure that it is well understood. Each of the abbreviations for the currency options are listed, and, as indicated, most risk reversals are near zero, which indicates no significant bias. For USD/JPY, though, the longer-term risk reversals indicate that the market is strongly favoring yen calls (JC) and dollar puts.

How Can You Use This Information?

For easier graphing and tracking purposes, we use positive and negative integers for call and put premiums, respectively. Therefore a positive number indicates that calls are preferred over puts and that the market as a whole is expecting an upward movement in the underlying currency. Likewise, a negative number indicates that puts are preferred over calls and that the market is expecting a downward move in the underlying currency. Used prudently, risk reversals can be a valuable tool in judging market positioning.

FIGURE  EUR/USD and Risk Reversal Chart

While the signals generated by a risk reversal system will not be completely accurate, they can specify when the market is bullish or bearish. Risk reversals become quite important when the values are at extreme levels. We identify extreme levels as one standard deviation plus or minus the average risk reversal. When risk reversals are at these levels, they give off contrarian signals, indicating that a currency pair is overbought or oversold based on sentiment. The indicator is perceived as a contrarian signal because when the entire market is positioned for a rise in a given currency, it makes it that much harder for the currency to rally, and that much easier for it to fall on negative news or events. As a result, a strongly negative number implies oversold conditions, whereas a strongly positive number would imply overbought conditions. Although the buy or sell signals produced by risk reversals are not perfect, they can convey additional information used to make trading decisions.

Examples

Our first example of the EUR/USD. Visually you can see that 25-delta risk reversals have been a leading indicator for EUR/USD price action. When risk reversals plunged to –1.39 on September 30, it was a signal that the market had a strong bearish bias. This proved to be a reliable contrarian indicator of what eventually became a 300-pip rebound in the EUR/USD over the course of nine days. When prices spiked once again almost immediately to 0.67 in favor of a continuation of the up move, the EUR/USD proved bulls wrong by engaging in an even deeper selloff. Although there were many instances of risk reversals signaling contratrend moves on a smaller scale, the next major spike came a year later. On August 16, risk reversals were at 1.43, which meant that bullish sentiment hit a very high level. This preceded a 260-pip drop in the EUR/USD over the course of three weeks. When risk reversals spiked once again a month later to 1.90, we saw another top in the EUR/USD, which later became a much deeper descent.

The next example is the GBP/USD. Risk reversals do a very good job of identifying extreme overbought and oversold conditions. Buy and sell levels are added to the GBP/USD chart for further clarification of how risk reversals can also be used to time market turns. With the lack of price and volume data to give us a sense of where the market is positioned, risk reversals can be helpful in gauging general market sentiment. 

USING OPTION VOLATILITIES TO TIME MARKET MOVEMENTS
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Using option volatilities to time foreign exchange spot movements is a topic that we touched upon briefly. Since this is a very useful strategy that is a favorite among professional hedge funds, it certainly warrants a more detailed explanation. Implied volatility can be defined as a measure of a currency’s expected fluctuation over a given time period based on past price fluctuations. This is typically calculated by taking the historic annual standard deviation of daily price changes. Future prices help to determine implied volatility, which is used to calculate option premiums. Although this sounds fairly complicated, its application is not. Basically, option volatilities measure the rate and magnitude of a currency’s price over a given period of time based on historical fluctuations. Therefore, if the average daily trading range of the EUR/USD contracted from 100 pips to 60 pips and stayed there for two weeks, in all likelihood short-term volatility also contracted significantly compared to longer-term volatility during the same time period.

FIGURE  GBP/USD Risk Reversal Chart

Rules

As a guideline, there are two simple rules to follow. The first one is that if short-term option volatilities are significantly lower than long-term volatilities, one should expect a breakout, though the direction of the breakout is not defined by this rule. Second, if short-term option volatilities are significantly higher than long-term volatilities, one should expect a reversion to trading range.

Why Do These Rules Work?

During a ranging period, implied option volatilities are either low or on the decline. The inspiration for these rules is that in periods of range trading, there tends to be little movement. We care most about when option volatilities drop sharply, which could be a sign that a profitable breakout is under way. When short-term volatility is above long-term volatility, it means that near-term price action is more volatile than the long-term average price action. This suggests that the ranges will eventually contract back toward average levels. The trend is most noticeable in empirical data. Here are a few examples of when this rule accurately predicted trends or breaks.

Before analyzing the charts, it is important to note that we use onemonth volatilities as our short-term volatilities and three-month volatilities as our longer-term volatilities.

In the AUD/CAD volatility chart for the most part shorter-term volatility is fairly close to the longer-term volatility. However, the first arrow shows an instance where short-term volatility spiked well below long-term volatility, which, as indicated by our rule, suggests an upcoming breakout scenario in the currency pair. AUD/CAD did eventually break upward significantly into a strong uptrend.

FIGURE  AUD/CAD Volatility Chart

The same trend is visible in the USD/JPY volatility chart. The leftmost arrow shows an instance where one-month implied volatility spiked significantly higher than three-month volatility; as expected, the spot price continued to range. The next downward arrow points to an area where short-term volatility fell below long-term volatility, leading to a breakout that sent spot prices up.

FIGURE  USD/JPY Volatility Chart

Who Can Benefit from These Rules?

This strategy is not only useful for breakout traders, but range traders can also utilize this information to predict a potential breakout scenario. If volatility contracts fall significantly or become very low, the likelihood of continued range trading decreases. After eyeing a historical range, traders should look at volatilities to estimate the likelihood that the spot will remain within this range. Should the trader decide to go long or short this range, he or she should continue to monitor volatility as long as he or she has an open position in the pair to assist them in determining when to close out that position. If short-term volatilities fall well below long-term volatilities, the trader should consider closing the position if the suspected breakout is not in the trader’s favor. The potential break is likely to work in the favor of the trader if the current spot is close to the limit and far from the stop. In this hypothetical situation, it may be profitable to move limit prices away from current spot prices to increase profits from the potential break. If the spot price is close to the stop price and far from the limit price, the break is likely to work against the trader, and the trader should close the position immediately.

Breakout traders can monitor volatilities to verify a breakout. If a trader suspects a breakout, he or she can verify this breakout through implied volatilities. Should implied volatility be constant or rising, there is a higher probability that the currency will continue to trade in range than if volatility is low or falling. In other words, breakout traders should look for short-term volatilities to be significantly lower than long-term volatilities before making a breakout trade.

Aside from being a key component for pricing, option volatilities can also be a useful tool for forecasting market activities. Option volatilities measure the rate and magnitude of the changes in a currency’s prices. Implied option volatilities, on the other hand, measure the expected fluctuation of a currency’s price over a given period of time based on historical fluctuations.

Tracking Volatilities on Your Own

Volatility tracking typically involves taking the historic annual standard deviation of daily price changes. Volatilities can be obtained from the FXCM news plug-in available at www.fxcm.com/forex-news-softwareexchange.jsp. Generally speaking, we use three-month volatilities for longterm volatilities numbers and one-month volatilities for the short term.  The next step is to start compiling a list of data for date, currency pair price, implied one-month volatility, and implied three-month volatility for the currency pairs you care about. The best way to generate this list is through a spreadsheet program such as Microsoft Excel, which makes graphing trends much easier. It might also be beneficial to find the difference between the one-month and three-month volatilities to look for large differentials or to calculate one-month volatility as a percentage of threemonth volatility.

FIGURE  IFR Volatility Data

Once a sufficient amount of data is compiled, one can graph the data as a visual aid. The graph should use two y-axes with spot prices on one, and short- and long-term volatilities on the other. If desired, the differences in short- and long-term volatilities can be graphed as well in a separate, single y-axis graph.

FUNDAMENTAL TRADING STRATEGY: INTERVENTION
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Intervention by central banks is one of the most important short-term and long-term fundamentally based market movers in the currency market. For short-term traders, intervention can lead to sharp intraday movements on the scale of 150 to 250 pips in a matter of minutes. For longer-term traders, intervention can signal a significant change in trend because it suggests that the central bank is shifting or solidifying its stance and sending a message to the market that it is putting its backing behind a certain directional move in its currency. There are basically two types of intervention, sterilized and unsterilized. Sterilized intervention requires offsetting intervention with the buying or selling of government bonds, while unsterilized intervention involves no changes to the monetary base to offset intervention. Many argue that unsterilized intervention has a more lasting effect on the currency than sterilized intervention.

Taking a look at some of the following case studies, it is apparent that interventions in general are important to watch and can have large impacts on a currency pair’s price action. Although the actual timing of intervention tends to be a surprise, quite often the market will begin talking about the need for intervention days or weeks before the actual intervention occurs. The direction of intervention is generally always known in advance because the central bank will typically come across the newswires complaining about too much strength or weakness in its currency. These warnings give traders a window of opportunity to participate in what could be significant profit potentials or to stay out of the markets. The only thing to watch out for, which you will see in a case study, is that the sharp interventionbased rallies or sell-offs can quickly be reversed as speculators come into the market to fade the central bank. Whether or not the market fades the central bank depends on the frequency of central bank intervention, the success rate, the magnitude of the intervention, the timing of the intervention, and whether fundamentals support intervention. Overall, though, intervention is much more prevalent in emerging market currencies than in the G-7 currencies since countries such as Thailand, Malaysia, and South Korea need to prevent their local currencies from appreciating too significantly such that the appreciation would hinder economic recovery and reduce the competitiveness of the country’s exports. The rarity of G-7 intervention makes the instances even more significant. 

Japan

The biggest culprit of intervention in the G-7 markets over the past few years has been the Bank of Japan (BOJ). In 2003, the Japanese government spent a record Y20.1 trillion on intervention. This compares to the previous record of Y7.64 trillion that was spent in 1999. In the month of December 2003 (between November 27 and December 26) alone, the Japanese government sold Y2.25 trillion. The amount it spent on intervention that year represented 84 percent of the country’s trade surplus. As an export-based economy, excess strength in the Japanese yen poses a significant risk to the country’s manufacturers. The frequency and strength of BOJ intervention over the past few years created an invisible floor under USD/JPY. Although this floor has gradually descended from 115 to 100 between 2002 and 2005, the market still has an ingrained fear of seeing the hand of the BOJ and the Japanese Ministry of Finance once again. This fear is well justified because in the event of BOJ intervention, the average 100-pip daily range can easily triple. Additionally, at the exact time of intervention, USD/JPY has easily skyrocketed 100 pips in a matter of minutes.

In the first case study the Japanese government came into the market and bought U.S. dollars and sold 1.04 trillion yen (approximately US$9 billion) on May 19, 2003. The intervention happened around 7:00 a.m. EST. Prior to the intervention, USD/JPY was trading around 115.20. When intervention occurred at 7:00 a.m., prices jumped 30 pips in one minute. By 7:30, USD/JPY was a full 100 pips higher. At 2:30 p.m. EST, USD/JPY was 220 pips higher. Intervention generally results in anywhere between 100- and 200-pip movements. Trading on the side of intervention can be very profitable (though risky) even if prices end up reversing.

The second USD/JPY example shows how a trader could still be on the side of intervention and profit even though prices reversed later in the day. On January 9, 2004, the Japanese government came into the market to buy dollars and sell 1.664 trillion yen (approximately US$15 billion). Prior to the intervention, USD/JPY was trading at approximately 106.60. When the BOJ came into the market at 12:22 a.m. EST, prices jumped 35 pips. Three minutes later, USD/JPY was 100 pips higher. Five minutes later, USD/JPY peaked 150 pips above the preintervention level. A half hour afterward, USD/JPY was still 100 pips above the 12:22 a.m. price of USD/JPY. Although prices eventually traded back down to 106.60, for those watching the markets, going in the same direction at the time of intervention still would have been profitable.

The key is not to be greedy, because USD/JPY could very well reverse if the market believes that fundamentals really warrant a stronger yen and weaker dollar in this case and that the Japanese government is simply slowing an inevitable decline or fighting a losing battle. Committing to take a solid 100-pip profit (of a 150- to 200-pip move) or using a very short-term intraday trailing stop of 15 to 20 pips, for example, can help lock in profits.

FIGURE  USD/JPY May 19, 2003 

FIGURE  USD/JPY January 9, 2004

The last example of Japanese intervention is from November 19, 2003 when the Bank of Japan sold dollars and bought 948 billion yen (approximately US$8 billion). Before intervention, USD/JPY was trading around 107.90 and had dipped down to 107.65. When the BOJ came into the markets at 4:45 a.m. EST, USD/JPY jumped 40 pips in under a minute. Ten minutes later, USD/JPY was trading at 100 pips higher at 108.65. Twenty minutes following intervention, USD/JPY was trading 150 pips higher than preintervention levels.

FIGURE  USD/JPY November 19, 2003

Eurozone

Japan is not the only major country to have intervened in its currency in recent years. The central bank of the Eurozone also came into the market to buy euros in 2000, when the single currency depreciated from 90 cents to 84 cents. In January 1999, when the euro was first launched, it was valued at 1.17 against the U.S. dollar. Due to the sharp slide, the European Central Bank (ECB) convinced the United States, Japan, the United Kingdom, and Canada to join it in coordinated intervention to prop up the euro for the first time ever. The Eurozone felt concerned that the market was lacking confidence in its new currency but also feared that the slide in the currency was increasing the cost of the region’s oil imports. With energy prices hitting 10-year highs at the time, Europe’s heavy dependence on oil imports necessitated a stronger currency. The United States agreed to intervention because buying euros and selling dollars would help to boost the value of European imports and aid in the funding of an already growing U.S. trade deficit. Tokyo joined in the intervention because it was becoming concerned that the weaker euro was posing a threat to Japan’s own exports. Although the ECB did not release details on the magnitude of its intervention, the Federal Reserve reported having purchased 1.5 billion euros against the dollar on behalf of the ECB. Even though the actual intervention itself caught the market by surprise, the ECB gave good warning to the market with numerous bouts of verbal support from the ECB and European Union officials. For trading purposes, this would have given traders an opportunity to buy euros in anticipation of intervention or to avoid shorting the EUR/USD.

Shows the price action of the EUR/USD on the day of intervention. Unfortunately, there is no minute data available dating back to September 2000, but from the daily chart we can see that on the day that the ECB intervened in the euro (September 22, 2000) with the help of its trade partners, the EUR/USD had a high-low range of more than 400 pips.

Even though intervention does not happen often, it is a very important fundamental trading strategy because each time it occurs, price movements are substantial.

FIGURE  EUR/USD September 2000

For traders, intervention has three major implications for trading:

  1. Play intervention. Use concerted warnings from central bank officials as a signal for possible intervention—the invisible floor created by the Japanese government has given USD/JPY bulls plenty of opportunity to pick short-term bottoms.
  2. Avoid trades that would fade intervention. There will always be contrarians among us, but fading intervention, though sometimes profitable, entails a significant amount of risk. One bout of intervention by a central bank could easily trigger a sharp 100- to 150-pip move (or more) in the currency pair, taking out stop orders and exacerbating the move.
  3. Use stops when intervention is a risk. With the 24-hour nature of the market, intervention can occur at any time of the day. Although stops should always be entered into the trading platform immediately after the entry order is triggered, having stops in place is even more important when intervention is a major risk.

USING EQUITIES TO TRADE FX
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There has been a growing correlation between the equity market and the currency market over the past few years. Part of this correlation stems from the excesses of the Greenspan era, when traders and investors bought everything in sight. As a result, equities and carry trades became a measure of risk, with both rallying in environments of strong risk appetite and falling in environments of risk aversion. However, using equities to trade currencies is more complex than simply selling the USD/JPY as stocks are falling or buying the USD/JPY if they are rising.

Like the story of the chicken and the egg, it is difficult to figure which market is actually leading the other. Just as often as I have seen a movement in equities trigger a move in currencies, the reverse has happened as well.

There are three primary correlations that create the foundation for our trading strategies.

Correlation between the Nikkei and the Dow

The strong correlation between the Japanese stock index (the Nikkei 225) and the Dow Jones Industrial Average. Since 2000, the price patterns of these two indexes have mirrored each other, and a closer look at the chart shows that the moves in the Nikkei can sometimes be far more exaggerated than the moves in the Dow (please bear in mind that these two indexes have not been normalized in the chart). More important, it should be clear there are times when the Nikkei rises or falls before the Dow and times when the Dow leads a move in the Nikkei. Correlations between global stock market indexes are nothing new and not unique to just the United States and Japan.

FIGURE  The Nikkei 225 and the Dow Jones Industrial Average 

Correlation between the Nikkei and the USD/JPY

Figure 10.28 illustrates the correlation between the Nikkei and USD/JPY. Although it is not as strong as the correlation, it is still significant. The axis for the Nikkei in this chart has been flipped, which means that USD/JPY falls when the Nikkei rallies and vice versa. When the Japanese stock market is doing well, it reflects on the health of the economy and the market’s optimism, which is why it tends to be positive for the yen as well. When the Japanese stock market starts to tank, however, domestic and foreign investors alike become nervous and pile out of not only Japanese equities but also the Japanese yen.

Correlation between the USD/JPY and the Dow

This leads us to the correlation between the USD/JPY and the Dow. Since the Nikkei and the Dow are correlated like the Nikkei and USD/JPY, one would automatically assume that the Dow and USD/JPY are correlated as well. Although this is true, the correlation is weaker than the two correlations that we have already seen, which illustrates why it is particularly important to not base your trade ideas primarily on the correlations. It is nice to see that on a day-to-day basis, the asset classes may move in lockstep, but that should be only a component of your trading decision and not the primary basis for the strategy. With this in mind, there are two different ways that I like to use equities to trade currencies, and both incorporate either fundamental or technical analysis.

FIGURE  The Nikkei 225 and the USD/JPY

TRADING THE CORRELATION WITH FUNDAMENTALS
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My favorite strategy is to use the correlation with fundamentals. Here is an example of an actual trade that I recommended to subscribers of BKTraderFX .

On May 7, 2008, we recommended going short the New Zealand dollar against the U.S. dollar for two reasons. The first was that the Dow had plummeted over 200 points and we believed that carry trade selling would continue into the Asian trading session. With an interest rate spread of 625 basis points at the time (New Zealand’s rate was 8.25 percent and the U.S. rate was 2.00 percent), the NZD/USD was one of the few carry trades left in the market. However, that was not the only reason we took the trade. The primary reason was the upcoming New Zealand employment report, which we expected to be weak. The market was looking for employment to drop by only 0.1 percent in the first quarter, but given the big drop in the Manpower Index and the employment component of the Purchasing Managers Index, we were looking for an even bigger decline. The combination of a bearish carry trade environment and the possibility of weak New Zealand data gave us the confidence to short the New Zealand dollar at 0.7812. As indicated by the progression of our trade, we managed to bank 107 pips.

FIGURE  Sample Trade, BKForex Advisor

Shows how the NZD/USD was trading. Trading was heavy all day due to the weakness in the Dow and then broke down following the New Zealand employment numbers.

TRADING THE CORRELATION WITH TECHNICALS
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Another way to trade the correlation between equities and currencies is with technicals. Here is a simple example. On May 1, 2008, the Dow Jones Industrial Average opened strongly and rallied over 100 points in a matter of three hours. USD/JPY, interestingly enough, did not follow higher. One of the reasons for this lack of follow-through may have been the strong resistance provided by the 100-day simple moving average. Given the strength of the equity market, a possible strategy would have been to buy on the break of the moving average in the expectation that stocks would take USD/JPY higher in the U.S. session and the move would continue into the Asian trading session. The entry point would have to be above the attempted break four hours before at 104.21. As indicated in figure, such a strong move in the Dow should lead to a similar rally in the Nikkei when the markets opened for trading. The Dow proceeded to rise another 100 points by the time the market closed, and even though USD/JPY did not race higher immediately, it did quietly grind higher throughout the Asian and European trading sessions. The key to using technicals with equities is to have flow on your side.

FIGURE  NZD/USD Hourly Chart

FIGURE  USD/JPY Hourly Chart


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