Ask the Experts

As much as I try to do my part to squash it, it seems there is always a group of retail forex traders who, for whatever reason, think “hedging” is a good idea. You’ll notice I put the term in quotes there because the way these folks use it varies from the way most people in the markets do. Hedging, in common usage, is the practice of putting on a position in a different market or security which attempts to minimize the risk of a position in some way. For example, someone holding a long position in the stock market could short the S&P 500 index as a way to protect against a general market decline. This is classic hedging.

But not in retail parlance
In retail forex “hedging” has come to mean putting on a position exactly opposite the one you already have. For example, a hedge of this kind could be putting on a 1 lot short in EUR/USD when you have a 1 lot long already in place. The idea most often cited by those who do this kind of thing is that it neutralizes the risk in a position that’s going against them, giving them a chance to wait it out until the market turns. This, of course, is exactly the same thing as just closing the trade.

There are variations on this hedging idea which actually involve putting on both the long and the short at the same time. It’s a kind of straddle play. Sometimes it’s done in what’s call a grid strategy where trades are layered at different levels. The underlying structure of these trades is actually one based on mean reversion or counter-trend action. They look for the market to reverse its recent move.

Using the simultaneous long/short example, the idea is to have a target for each side. The expectation is that the market will move to one target, then turn around and move to the other. That would make both legs profitable. In the meantime, though, going long and short at the same time just locks in a spread loss and one never actually has a directional exposure until one of the legs is closed.

A sample system
An example of a “grid” system I recently heard about (though there are many variations) is from a player who starts with simultaneous long and short positions. He used a 100 pip target. If the market moved to that target the profitable leg of his original pair is closed and another matched long/short pair of trades is put on. This goes on every time the market moves to a 100 pip target level.

Let’s think about what this would look like if the market were to rally 100 pips. First of all, by putting on the original matching long/short the trader has lost the spread because he went long at the offer and short at the bid. When the market rallies those 100 pips the long is +100, but the short is -100, so no net gain or loss. The long is closed, so a realized gain is achieved, but an open loss remains in the remaining open short. Now a new long/short combo is added (again, immediately costing the spread). This means 1 unit of long and 2 units of short, so a 1 unit net short position.

From here, if the market turns down then everything is good because the gain on the 2 shorts will exceed the loss on the 1 long. Should the market keep rallying, though, the loss in the 2 shorts exceed the gain on the 1 long, so the trader is losing money. What you have here is a counter-trend or mean-reversion system, as a result.

Confused traders losing money
All strategies like the one mentioned above can be replicated in a non-hedging fashion. In this case, the trader could have just waited until the market rallied 100 pips and put on a 1 unit short. It would have the same net market exposure and would not have cost the spread twice. That’s the thing a lot of these folks don’t realize. This tells me they don’t fully understand just what they’re doing. They think the risk is lower, but it isn’t.

The reason I wanted to bring this up is because I’ve heard tell of people employing these types of strategies who are followed by social traders. This worries me considerably. This “hedging” is nothing more than a method of accounting (and not allowable in the US, though one can get around it by using multiple accounts). As such, it can create a very distorted view of performance. One could, for example, end up with a high win %, which may be attractive to potential investors, but that hides the major blow up risk underlying the approach being used.

So when you’re looking at traders to follow – either from a social perspective or just from a learning angle – avoid those who employ these types of “hedging” strategies. It demonstrates a lack of understanding of trading mechanics and potentially means they don’t realize the sort of risk they are taking.

Flag is a technical pattern indicating a resumption of the trend rather than a trend reversal. Flag is created when there is a large movement in a certain direction, up or down (that's the flag "pole") followed by sideways activity (three or more candles) in the top of the flag pole for long (or the bottom of the flag pole for short), which do not cover most of the stick and are almost the same length.

It is important to understand that like any pattern, the first and second flag have greater chances to succeed than the sixth flag when it comes in a row, without a decent correction.

When entering this pattern it is better to look in other indicators to strengthen the entry. There are two methods for an entry. One technique is taking a trade from the bottom of the flag for going long or the upper line of the flag for going short to minimize the stop loss. The second strategy, which is my favorite, is to wait for a candle that closes significantly (the amount of pips depends on the time frame of the flag) above/below the flag's resistance/support.

Flag is a pattern that works in any time frame. To mark the take profit for the trade you will need to measure the flag pole (perhaps deduct several pips out of the measured amount as a divergence is possible) and add this amount to the candlestick that broke outside the flag.

If the market continues to trade higher/lower following a trading gap and then trades sideways it can be viewed as a potential for a flag as we see in USD/JPY, although it is more complex as gaps tend to be filled by the market. Therefore, the first profit should be measured using the flag pole but without the trading gap.

The second objective may be larger and can include the trading gap within the flag pole, depending on the market.

Last week I took at a look at the current state of the euro. This week I think I’ll have a look at the yen and see how things are shaping up with that currency.

If we start with a look at USD/JPY we can see a market in the process of consolidating the powerful rally which dominated the first part of this year. Notice the falling Bollinger Band width indication in the bottom sub-chart.

Likewise, we see a similar sort of thing going on in EUR/JPY. Here, though, we can observe that the consolidation has progressed further. This is indicated by the Band width being much closer to the lows of the last several years.

More consolidation can be seen in GBP/JPY. In this case the indication is more akin to what we see in USD/JPY in that the Bands have been narrowing, but remain well above their most narrow.

Things are a bit different with AUD/JPY. Thanks to the weakening of the Aussie through the middle part of the year there was a turn back up in the Band width, indicative of a rise in volatility rather than the decline seen in the other pairs.

What I think is significant with AUD/JPY is the way the cross has developed support near the highs of the 2010-2012 range area. This is a place we’d expect support to form after the range break, and if it holds there’s every chance the market will turn back up. If that happens, though, the Bands will start narrowing once more.

I mention this because it ties in with what I’m thinking is likely to happen with the yen over the next few weeks or months. EUR/JPY looks like it wants to break out of its consolidation, which fits in with my expectation that the euro is getting ready to move. GBP/JPY and USD/JPY, however, still look consolidative to me. It may be a bit longer before those two pairs are ready to move again (though GBP/JPY is a bit closer). As a result, I expect the yen pairs to mainly continue to work through consolidation for a little while yet, but with a bias toward JPY weakening.

Currensee is pleased to welcome guest author Mario Singh for today's post.

One of the most popular technical indicators among forex traders is Bollinger Bands®. This technical analysis tool has proven to be quite reliable in determining overbought and oversold levels – and the visual cues are quite simple. If the price touches the upper Bollinger Band® then that’s a signal to sell, and when it touches the lower Bollinger Band® then you need to buy.

Bollinger Bands® have proven to be quite effective when applied to markets that are range-bound since prices will usually travel between the two bands – think of a ball that’s bouncing between opposing walls. But this tool is not always effective in giving accurate signals on when to buy or sell. To increase accuracy, many employ more specific bands within the Bollinger Bands®.

John Bollinger, the man who formulated the Bollinger Bands®, does acknowledge the limitations of his creation. He said that “tags” are just tags – they are not signals. Tagging the upper Bollinger Band® does not necessarily mean it is a sell signal. The same thing with a tag of the lower Bollinger Band® – it doesn’t necessarily mean it’s a buy signal. Price has a way of just walking the band – and this does happen. Traders who stubbornly sell  at the top tag and buy at the bottom tag are not trading wisely. What can happen is that they may just be faced with a series of stop-outs, or even worse, a deepening floating loss that they may not be able to recover from.

There is a sentiment that a better way to use Bollinger Bands® for forex trading is by using it to evaluate trends.

It is a commonly recognized observation that prices often range about 80 percent of the time since the forex market (or any other investment market, for that matter) usually consolidates as bullish and bearish movements battle each other for dominance. Trends in the market are not common, which is why it is so hard to use it as a trading indicator. If we look at price from this perspective then we can consider “trend” as a deviation from what is normal (which is the range).

At its very heart, Bollinger Bands® measure deviations. It is this quality of Bollinger Bands® that make it perfect for looking at trends. Making two sets of Bollinger Bands® – one earmarked for “1 standard deviation (SD)” and the other for the more common setting of “2 standard deviation” we can observe price in a totally different way.

By plotting a chart using this setting, we can see that when the price channels between the +1 SD and +2 SD away from mean of the upper Bollinger Bands® then the trend is up and that channel can be classified as a buy zone. On the other hand, when the price channels between the -1 SD and -2 SD of the Bollinger Bands®, then that channel is a sell zone.  If the price stays within the +1SD and -1SD bands then it is considered neutral.

Bollinger Bands® can adapt to the expansion and contraction of price as volatility waxes and wanes, which is one of its best features.  This means the bands will compensate and would widen or contract alongside the movement of currency value. This creates what many consider as a precise trending pocket.

It is now up to the trader how to precisely employ Bollinger Bands® in their trading analysis and strategy. Some traders may use its most obvious properties – buying when the long position is hit and selling when the short position is reached. Other traders may use Bollinger Bands® to take advantage of trend exhaustion by picking when the price turns. It should be noted, however, that counter-trend trading will demand a far larger margin of error because trends have a tendency to attempt continuation of the present movement before they relent.

Bollinger Bands® are popular among traders as one of the most effective technical analysis tools but by extending its usage to plot trends it acquires more value and gives traders more reasons to try and master it.

About The Author

Mario Singh talks about various technical analysis tools and forex news trading at his website Askmariosingh.com.

A while back, motivated by persistent misinformation being presented in the media, I did a quick study of volatility in various markets. It was something I repeated here last year using weekly rather than daily data. Markets have had lots of different things happening recently, so I decided to re-run the daily data study, this time using 5 years of data rather than just the 1 year I went with the first time around. Also, rather than showing the figures in tabular format, I’ve decided to make things more visual and put the results in a pair of charts.

Here is the first one which compares four exchange rates, four major US stock indices, eight big cap common stocks, four major commodities, and four key US interest rate instruments (using futures for the latter two groups). It looks at volatility from the perspective of the standard deviation of daily % returns. This basically gives us an idea of how much of a change we see in each market on a given day.

The results are consistent which my prior analysis. The interest rate and exchange rate markets are noticeably lower in volatility than commodities, stocks, and stock indices. The major forex pairs move roughly about the same amount as longer maturity fixed income instruments like T-Bonds (using a price basis rather than an interest rate basis).

The second chart uses average daily ranges as the comparison point. The ranges are calculated as (High – Low)/Prior Day’s Close. This allows us to look at percentages for all markets so we’re comparing apples to apples.

There’s a bit of shuffling around in the order in which the markets rank when looking at ranges rather than returns, but generally the pattern is the same. Interest rate and exchange rate markets fall on the low end of the scale while individual stocks and commodities are on the high end.

The first reason for showing these images to you is so the next time someone tells you how risky the forex market is you can show them the comparison and ask them if they want to reconsider.

The other reason I bring this subject up is to provide a better understanding of volatility across markets , which factors into things like bid/ask spreads, margin requirements, and the like. This should help in your investment asset allocation process – or at least to have some insight into how different markets move if you’re just focusing on only one or two. Of course once you start applying leverage you can create a situation where any market can result in a very volatile account equity line.

Equity prices have vaulted to within touching distance of all-time highs, and the upturn in investors’ fortunes has pushed valuation ratios to levels that have preceded protracted periods of poor stock market performance in the past.  The widespread belief that stock market returns mean revert over long horizons means that it could well be possible to use the information contained in high valuation ratios to time the market, and capture the favorable combination of lower risk and higher returns.

An interesting paper authored by Elroy Dimson, Paul Marsh, and Mike Staunton of the London Business School, and recently published in the ‘Credit Suisse Global Investment Returns Yearbook,’ casts doubt on this view.  The academics assess the predictive ability of a cyclically-adjusted price-dividend ratio – the ratio of the current real index level to the average of the preceding ten years’ real dividends – across a variety of world stock markets, and conclude that, “we learn far less from valuation ratios about how to make profits in the future than about how we might have profited in the past.”

The choice of valuation metric appears reasonable, since dividend payments, unlike earnings, cannot be manipulated, and often reflect a company’s own view of its long-term earnings power.  However, there is no theoretical reason as to why a cyclically-adjusted dividend-price ratio should mean-revert, since the higher multiple might simply reflect substantive changes in the percentage of earnings that companies decide to pay to shareholders.

It is important to appreciate that stock market value is made up of both current dividends and expectations for future growth.  The pace at which dividends grow in the future depends on the percentage of earnings that a company distributes to its owners, and the rate at which retained earnings are reinvested in the business.  In other words, a low dividend yield might simply reflect a lower payout ratio, and higher expectations of future growth.

Historical data for the US demonstrates that the corporate sector’s payout ratio has been in secular decline for decades.  The ten-year average payout ratio dropped from a peak of almost ninety per cent in 1940, when expectations for future growth were virtually non-existent, to below forty per cent in 2007, when expectations for uninterrupted growth for the indefinite future held sway.  Long-term differences in payout policy means that it is impossible to identify a mean around which the cyclically-adjusted dividend-price ratio might oscillate.

Financial theory suggests that we should be able to observe a negative relationship between corporations’ payout ratios and subsequent growth rates in earnings and dividends.  In other words, higher growth rates would be expected to follow lower payout ratios and vice versa, but if this expectation is frustrated, then the dividend-price ratio might retain some predictive ability, as disappointing growth outcomes are reflected in lower share values.

The historical evidence in both the UK and the US reveals that low payout ratios have typically been followed by surprisingly low real growth rates over subsequent ten-year periods, and not the high rates of expansion that might have been expected at the outset.  This surprising outcome suggests that the corporate sector is either over-investing, or that  competitive markets quickly erode excess returns, or that low payout ratios reflect management’s intention to signal lower future growth to shareholders.

In light of the above, the dividend-price ratio does retain some predictive ability regarding future real returns, but it is still not possible to say what level is indicative of fair value.  As a result, it would be wise to replace the cyclically-adjusted dividend-price multiple with a valuation metric that rests on sounder theoretical footing.

In this regard, the Q-ratio, developed by the late Nobel laureate James Tobin in 1969, is a natural choice.  This metric measures the market value of equity relative to its replacement cost, and a fundamental relationship should exist between the market value and replacement cost; corporations should be valued at their cost of creation in the long-run, and as a result, the multiple should hover around unity given rational expectations.

The “law of one price” or “build-or-buy” arbitrage should ensure that the relationship holds over long horizons.  A ratio above unity implies that it is cheaper to invest in new capital rather than buy existing capital, while a figure below unity suggests the opposite.  The historical data confirms that the Q-ratio does indeed demonstrate mean-reverting properties, and importantly, the analysis reveals that the adjustment takes place through a change in real share prices rather than changes in the capital stock.  In other words, Tobin’s Q can be used to predict long-term real returns.

Unfortunately for equity investors, the current value of Tobin’s Q is almost forty per cent above its long-term mean – a level that has rarely been exceeded in the past.  The ratio’s elevated level, in tandem with its mean-reverting properties, does not mean a catastrophic decline is imminent, but it does suggest that disappointing real returns are virtually assured over long horizons.

www.charliefell.com

Be sure to read the full risk disclosure before trading Forex. Please note that Forex trading involves significant risk of loss. It is not suitable for all investors and you should make sure you understand the risks involved before trading. Performance, strategies and charts shown are not necessarily predictive of any particular result. And, as always, past performance is no indication of future results. Investor returns may vary from Trade Leader returns based on slippage, fees, broker spreads, volatility or other market conditions.

1 Comment

Last week the big headline grabbing market development was the plunge in silver prices on the heels of a hike in the margin requirement for the futures contracts. There were loads of news stories about how that increase in margin drove prices lower.

Hope you didn't actually believe that.

Here's the deal. The only people forced to close out positions like those in silver when there's a hike in the margin requirements are folks who are highly leveraged. Guess who that is? Hint, it ain't the big traders and institutions. Who does that leave? You got it, the little guy who's trading positions too big for his account in the first place. These folks don't represent a significant portion of the market.

Want proof? Take a look at the open interest (OI) in the front-month silver contract. If there was a massive liquidation we'd see OI plunge. As the chart below shows (red line), though, front-month OI has only drifted lower, which is what it normally does when the contracts roll as they did the week before last.

So why did silver fall so far so fast? Because it went up too far too fast and the margin hike gave folks an excuse to sell. Take a look at the green Average True Range (ATR) line. Even before the market tanked, ATR was already well higher than it's been in years. That tells us of a market getting very frothy, that's subject to a reversal.

There's a lot of talk these days about inflation and the impact of Fed policy on the dollar and the extension through the weaker dollar into higher commodity prices. Those looking to flame the Fed for its quantitative easing (QE) and generally loose monetary policy point to the falling dollar as the cause for oil going up above $100 and gold crossing $1500. While it's certainly true that the greenback is lower (the USD Index has been as much as about 12% off it's January peak), is the weak dollar really to blame for things like the rising cost of gasoline at the pump? Let's take a look at what the charts have to say about it all.

First is a comparative chart of oil prices in dollars and oil priced in euros. The chart below covers the last year's trading. The red line is the dollar value of a barrel of oil, referencing the left scale. The black line is the euro price of a barrel off oil (using front month futures), with that price on the right scale. Both scales are logarithmic so they express similar percentage moves between noted levels.

Now, the chart above doesn't show relative % gains for oil in the two currencies. Those are +31.3% in USD terms and +22.6% in EUR terms. This is about what we'd expected given the relative performance of EUR/USD over that time. The point of the chart is that aside from wiggles where oil has done better in one currency than the other for a period of time, the pattern of the two lines is consistent. Oil has been moving higher in roughly the same pattern, regardless of what currency we're talking about.

Now let's take a look at gold (again front month futures). Once more, the red line is in dollar terms and references the left scale, and the black line is euro terms referencing the right scale.

In this case, gold is up 29.6% against the USD and 19.4% in EUR terms. Again, that difference can be explained by the change in EUR/USD over the last year, which is as it should be. Here, though, we see a lot more variation in performance. In dollar terms gold has been in a fairly steady uptrend with only two relatively minor retracements. In euro terms, however, the ride has been much more dramatic. Those periods when the EUR line diverges considerably from the USD line are periods when EUR/USD was selling off.

The chart below highlights the variation between how gold and oil trade relative to the dollar. It shows EUR/USD on the top with the correlation between EUR/USD and gold plotted in red and the one with oil plotted in green.

Notice how much choppier the green line is than the red. That means the correlation between oil and EUR/USD is much more fickle than the one between EUR/USD and gold. That said, however, oil has spent more time with a positive correlation (meaning rising oil with rising EUR/USD and falling oil with falling EUR/USD). The gold correlation has been much more balanced. In particular, the gold correlation has been more negative when EUR/USD is falling.

Now, correlation does not mean causality. It just shows how similar the movement patterns are without looking at why that might be. The way I would tend to read the above, however, is to say that rising gold is more a factor of what's happening in the currency arena than rising oil prices. If you think about the implications of increasing money supply (which is what loose monetary policy is), then it makes sense. Gold is something with what could essentially be called a near fixed supply (very slowly increasing), so the more dollars there are the higher the value of gold per dollar (or any other currency). Oil has a different dynamic which is must more closely tied to economic considerations and geopolitics.

On the Currensee Facebook page yesterday a link was provided to a Fidelity article about how the stock market is climbing a wall of worry. In light of that, I thought it would be worth taking a look at the last time the stock market was seen to be climbing a wall of worry back in 2003/04 as it recovered from the tech bubble bursting and the impact of 9/11.

Here's a weekly chart of the S&P 500 index going back to 2002. The two lower plots are the Normalized Average True Range (N-ATR) and the Bollinger Band Width Indicator (BWI). The former is a measure of range volatility (find articles I’ve written about N-ATR at Trade2Win and TASC) while the latter looks at the volatility of closing prices by measuring the width of the Bollinger Bands relative to their center point (the 20-period moving average).

The thing I'd like to focus on is how N-ATR has followed a similar course recently as it did during the recovery in 2003 in that it has fallen pretty steadily as the market has rallied. It's not back to about the top of the range it was in for most of 2004-2007, during which time the market was working steadily higher. Similarly, BWI has also fallen back down into the area where it was during last decade's major bull market. This doesn't mean we're sure to get a repeat of the that kind of rally, but it certainly makes a good case to expect something like that, especially given the underlying general investment psychology in the economy. Bear markets are often indicated by rising volatility, not falling volatility.

We can take a comparable look at the Dollar Index.

Here we obviously have a bit of a different pattern. Volatility in the USD Index as indicated by N-ATR (remember, that's period range volatility) has fallen, but is nowhere near where it was in 2007 before the financial crisis began. I'd argue that you don't want to give those lows too much thought as any long-time market pro will tell you that was an unusually quite market, despite the persistent down trend. I would say that the index has basically normalized, with both N-ATR and BWI at about the midpoint of where their readings have been over the last decade.

What this indicates to me is that in the currency market we are no longer in crisis mode trading. The risk-on/risk-off swings that were so common are no longer to be seen as a major driving force barring some kind of major new event. Instead, we're back to trading more on the big macroeconomic drivers like interest rate differentials, and trade and capital flows.

In honor of the Masters, and inspired by a recent Currensee tweet, let me draw some parallels between golf and trading. I’m not a golfer. The extent of my playing has been a whopping total of 9 holes. I do watch the game, though, especially the majors. I mean come on! Who doesn’t enjoy watching Tiger Woods pull amazing shots out of seemingly nothing and just dominate the field when he's on his game?

Anyway, it’s risk control that comes to mind when watching even the best players in the world play. Good golfers understand that things can go bad very, very quickly. It’s much harder to get birdies than to get bogeys. Moreover, the best possible score you can get on a given hole is a 1 if you get a hole-in-one. There’s no limit to how bad a score you could make, though. Methinks I see some commonalities with trading there.

Experienced golfers have a very similar mindset to experienced traders. Sure, they take their chances and go after opportunities when presented. No risk means no opportunity for gain, after all. They do not (mostly) take stupid, needless risks, though. You will often hear them talk about making sure they don’t make six by doing something foolish when the situation strongly suggests that a five is going to be a good score.

That sounds to me an awful lot like cutting your losses short. Good golfers know that sometimes they just have to accept their lumps and not let things get any worse. Similarly, good traders know that staying in a trade that’s gone against them in hopes that it comes back is a good way to end up with an even bigger loss.

Good golfers know how to grind out the results. Good traders do exactly the same thing. Both develop a plan of action and execute it. Sometimes things go well and you get that really good shot – that really good trade. Sometimes they go against you. Sometimes you do something stupid and it works out well. Most of the time doing something foolish means bad news.

How often do you see a golfer make one bad mistake, then completely lose it? They go from having a good scoring run to suddenly getting a series of bogies and double bogies. It’s not that they’ve changed anything mechanically in the matter of a couple of holes. They just lost it mentally. Their confidence went completely away. Sound familiar? Think Rory McIlroy on Sunday.

There are two things that really make good golfers and good traders stand out. The have a plan and stick to it, and they quickly shift their focus to the next shot, the next trade. The past doesn’t exist. What you did on the last shot or trade doesn’t matter. It’s only about how you execute the next one.

You might be thinking that someone like Tiger is all about skill. While it’s hard to argue that he’s a better shot maker than most, it’s also true that Tiger practices and seeks to improve his game relentlessly, not just in terms of swing execution, but also in round management and decision-making. Good traders, ones seeking trading mastery, do exactly the same thing.

So the next time you’re on the course or watching a round on TV, think about the parallels to trading. It’s another way to learn and find ways to get better.