From the April 01, 2008 issue of Futures Magazine • Subscribe!

Take the money and run

Foreign exchange is the most liquid market sector and is therefore the anchor of many diversified trend following programs. In recent years, higher volatility in currency markets has made trading forex difficult for long-term trend followers, yet short-term traders have thrived.

Given the performance of the U.S. dollar in 2007, it would have been easy to assume that the long-term trend following programs fattened up in the currency sector, but that was not the case. John W. Henry & Company’s International FX program dropped 31.07% in 2007, the program’s fourth consecutive down year. Its financial and metals program, which has a significant (38%) allocation to currencies, also was down, as were programs of stalwart trend followers Campbell and Company and Dunn Capital Management (all of these programs are up double digits in the first two months of 2008). While there were solid trends in the currency market, short-term spikes caused by the increasing volatility shook a lot of managers out of winning trades and others may have found it difficult shorting the dollar against specific currencies at record levels.

Bob Kozak, currency futures analyst for Alaron Trading, says, “Currencies probably are one of the strongest trending markets of all the sectors.” But Kozak has noticed a change of late. “These markets have been very volatile. When you are a trend follower you take large risks. From the standpoint of the short-term trader, they can pick and choose.”

And they have. Alex Moisseev, principal of Dighton World Wide Investments, trades forex from a short, medium and long-term perspective in his diversified program. His program has a substantial portion of its return in forex, but only with his short-term model.

Joe Gelet, president and head trader of Elite E Services, sees this as a more substantial shift. Gelet, whose FX V1 program earned 67.97% in 2007 and had profitably traded his short-term strategy since 2002, says the “old school” long-term trend followers have failed to keep up with the changes in the forex markets. “A lot of these old school guys are trading the same strategies they were before there was a euro. Currencies would trend for months at a time and they would trade five times a year and do well. A lot of old models stopped working.”

Darren Merwitz, vice president of system trading for the FXCM Sentiment Fund, says, “Longer-term systems are more focused on trending and carry strategies. They are also more likely to let positions go fairly substantially against them because they are focused on the bigger picture and not as concerned with shorter-term noise.”

But when that short-term noise becomes deafening, long-term traders get hurt. “Shorter term volatility traders are able to take advantage of the volatility being experienced on a day to day basis, whereas the shorter term ranging traders, on the other hand, would likely be suffering,” Merwitz adds.

Added volatility

The subprime debacle, the credit crunch, massive infusions of money from central banks, rising geopolitical concerns, the Fed taking an aggressive easing stance, all time record prices in equity indexes, $100 crude oil, record prices across the commodity sector, a couple of the worst single day drops in equity indexes, investment banks with multi-billion dollar write downs; the list goes on. It is not exhaustive, but suffice it to say volatility was on the rise and with markets based on money, the one market that is money is going to experience quite a bit of that volatility. All the managers we spoke with attributed strong performance in their short-term programs to a massive increase in volatility.

“Greater volatility is what is creating this,” Kozak says, “I see a lot of central banks flip flop positions within 30 days.”

Michel Landert, principal of Zurich- based Harmony Investment Managers’ Pro Fund FX program, expects the trend of strong performance in short-term currency programs to continue. His program earned 31.44% in 2007 trading forex markets from one to four days. “It will be a longer-term trend because of the increase in volatility. A lot of long-term guys are getting stopped out of the market. If volatility stays high, short-term traders will perform quite well,” Landert says.

The greatest spike in volatility was due to the subprime crisis and resulting liquidity crunch. “They have to bring in liquidity and they have to close out positions,” Landert says.

Markets can move for either fundamental or technical reasons, but the credit crunch caused greater volatility because many participants in forex needed cash due to a downgrade in a credit position. They needed to find liquidity fast and exit the currency markets. They were not reacting to any technical or fundamental analysis in the euro or yen or Swiss franc but to a sudden need for cash. “Subprime woes have a lot to do with the volatility. It is the major pairs that have the liquidity they need,” Kozak says.

Carry me away

The carry trade has long been used by professional forex traders as a way to add value to a portfolio. Basically you are buying the currency of a country offering higher interest rates and selling a currency from a country with lower interest rates.

Futures’ 2007 Top Trader Gregory Cotter (see March 2007) attributed much of his success in 2007 to taking the other side of an overheated carry trades in the EUR/JPY and GBP/JPY (see “Carried away,” above). Cotter noticed that any time he visited a currency related Web site, it was always discussing the carry trade. What was once an obscure insider trade had become mainstream and extremely oversubscribed.

Dighton took advantage of the overextension in the carry trade. “When you see imbalances in the carry trade three times what they normally are — then we take the other side, when the lenders are over stretched,” Moisseev says.

Kozak says that normally when the equity markets weaken, the carry trade falls. “When equity markets move higher they take more risk, same with carry traders.”

The large reversals in the carry trade corresponded with corrections in equity indexes in February and August.

“They got whacked in the carry trade,” says longtime forex trader Osman Ghandour. Ghandour has avoided the volatility of forex in playing his short-dollar position by simply being long gold. “I am still long gold and am comfortable staying long over $1,000.”

Landert says it is harder from a psychological standpoint for a long-term trader to buy a new high, which brings another factor in increased volatility. Many traders expect the dollar to have a strong rebound and this has caused spikes any time the dollar shows signs of life, as no one wants to be caught on the wrong side of a major move. This has meant some dramatic short-term spikes that stop programs out. Having the agility to move in and out of markets taking quick gains is an advantage in this environment.

An example is the March 4 tightening in Australian interest rates. Australia raised its short-term interest rates to 7.25% but indicated that this could be the last increase, causing a buy the rumor sell the fact sell-off. The Aussie dollar dropped more than 100 ticks based on speculation that this could be the last increase even though the U.S. Fed was likely to lower rates 50 to 75 basis points in two weeks, increasing the interest rate differential between the USD/AUD to a whopping 4.75%. The technicals indicated a bullish Aussie dollar and so did the fundamentals as even a neutral stance indicated a greater interest rate differential with the U.S. dollar in the future, yet many trend followers were stopped out.


Gelet says that his trading has improved because he has now completely automated his systems. “Before automated trading techniques you could trade only so many accounts and strategies,” he says.

His trades last from a few hours to a couple of weeks. Algorithms determine the signal and the stop loss and profit target. He says that his models are better because they are intelligent systems that constantly change with additional data. “What we have developed is something that works in real time,” Gelet says. This is important because he believes the current volatility is here to stay. “What if the Chinese float [their currency]? That will make currencies more volatile. It will throw off all the models,” he says.

Another factor in the success of short-term trading programs is the huge influx of small undercapitalized retail traders. Kozak points out that the influx of small retail traders as a result of the explosion of numerous forex trading platforms increases volatility and provides low-hanging fruit for short-term professional forex traders. “There are guys opening accounts for $300, $500, $1,000 using 100-1 leverage. Is it a level playing field?”

The answer is probably no, as short-term volatility knocks these traders out, but so far there has been a steady stream of people to replace them. And there has been a steady stream of short-term forex trading programs to pick off this low hanging fruit (see “Currency only”).

Will volatility remain?

“Volatility will be here for some time,” Merwitz says. “Risk aversion can jump into the market very quickly as a result of any number of causes, but even when the underlying cause has passed, which I don’t think it has, it takes some time for things to return to normal as traders’ jitters calm down.”

And forex may see the bulk of it. “The current volatility being experienced is by no means restricted to forex. It has been seen across almost all markets. Forex, however, has two characteristics that few other markets offer, and that is the ability to leverage high cheaply, which obviously increases the risk and reward, and the ability to sell short as easily as going long,” he adds.

Any trading program will perform better or worse in different market environments and there is no guarantee that a market will move in the future the same way that it is moving today. However the sheer number of factors contributing to the increase in volatility in forex markets would indicate that an elevated level of volatility in these markets will be around for a while.

“All these elements make the market more complex, adding to the volatility,” Kozak says. “They also give an edge to the shorter term trade. You have to be more nimble.”

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