Trading ETF shadow prices
Between the ETFs for the Australian dollar (FXA) and the Japanese yen (FXY), the yen ETF is the more volatile and is the shadow of the Australian dollar (see “Shadowing currencies” below). As competing currencies of the Pacific rim, the ability to trade with the lowest price currency can be an important reason for the yen not to remain high with respect to the Australian dollar. A potential spread trade would be indicated by a return to the 10% to 15% difference in cumulative percentage price changes.
The “FXE and FXF” chart shows the comparative price changes in ETFs for the euro and Swiss franc, respectively. With one brief departure from a policy by the Swiss National Bank to hold the franc no higher than 1.2 euro, the two currencies and their ETFs have formed a continuously strong bond in price movements. The day on which the Swiss announced what is now known to be a very temporary end to the restrictive price policy, the franc jumped up approximately 15%. Since that time, shown in the FXE and FXF chart, the Swiss franc has returned to its close association with the euro. There is obviously a vicious economic competition between the two currencies, producing almost no differences in price movements and as a result little chance for spread trades.
The large losses by some funds when the Swiss price policy was changed should be a warning for traders who depend on a shadow price that is managed and not freely traded on the market. There is a temptation to lever up these spread trades as you are trading two related markets, the SNB move illustrates that trading correlated markets can entail risk and proper risk management is still required. This is similar to the horizontal percentage price changes for the livestock ETN, LSTK that are the results of fund managers setting the price versus normal market pricing. COW focuses on front month livestock, which can allow for large divergences from the broader indexes around roll time.
Percentage price movements for the British pound and euro are reflected on “FXB and FXE” (second chart in “Shadowing Currencies”) by their ETFs. The prices are moving closely together until the Brexit vote in June 2016. Following Brexit the pound declined by 15% as a cumulative percentage price change to August 2016. The euro, in an attempt to match the pound’s decline, is currently at approximately a 5% decline since Brexit. The largest portion of the euro’s decline took place in October and November 2016 when the managers of central banks for the pound’s competing currencies were selling their own currencies and buying U.S. dollars causing a surge in the U.S. Dollar Index.
The increase in the U.S. Dollar Index is an outstanding example of the law of unintended consequences. The vote in favor of Brexit was a surprise, the British pound has a sudden drop and hypothetically all competing currencies try to catch the pound’s decline (a purely accidental beggar-thy-neighbor action resulting from a national vote) by selling their currencies for U.S. dollars.
Based on the charts presented, there are several potential spread trades: Sell SLV, buy iAU; sell corn, buy wheat; and sell FXE buy FXB. These spreads are not currently large as of March 24, 2017, but each one has the possibility of becoming smaller over the next several months. What is true for the ETFs carries over to the corresponding futures and options contracts.
The other three charts indicate things to watch out for. “LSTK and COW” predict that if COW declines sharply it is possible that the managers of LSTK may hold the price of their ETF constant for a period of weeks, providing the opportunity for profits on a temporary spread in prices. This hypothesis depends on the accuracy of prices shown by historical price quotes.
On “FXA and FXY” the normally volatile yen ETF is at least temporarily quiet. This suggests waiting until the yen makes a move either up or down with respect to the Australian dollar. In this case, patience is the key to success because in the past it has been the yen that makes the big moves in relative pricing. Wait for at least a 10% difference before deciding to trade the spread.
With FXE and FXF, the Swiss franc will stay close to the euro in its price changes because it seems that the restrictive price policy is back in force — a conclusion based on almost identical cumulative percentage price changes even through the rocky period surrounding Brexit. What if the Swiss make another announcement ending this new restrictive price policy? Because it has been artificially held back, the franc will have a fast gain over a day or less time. Be prepared for that opportunity to buy the franc, and in the meantime be very cautious about selling the franc short.
Finding shadow market relationships and their corresponding shadow ETFs can provide opportunities for profitable spread trades. They are inherently safer because you are trading related markets, but one- off events like Brexit can increase volatility. Still, when it comes to spreads, traders should let the shadow be your friend.