Momentum Trading Strategy: USD Pairs

I recently wrote an article explaining how it is possible for momentum traders to profitably implement a “best of” Forex momentum trading strategy, which included a back test conducted over a very recent 6 year period. There are a few loose ends in that article that are worth some more detail, so in this second part I want to make a stronger and more detailed case as to why standalone / time series momentum tends to be a better kind of momentum strategy overall, and clear up some concerns that might have arisen from my use of a 3 month look-back period in determining the best and worst performing currency pairs.


Why “Best of” Momentum Works

Academic studies have found that the most profitable trading strategy that can possibly be constructed based upon historical price data alone, is a time series momentum-based trading strategy. This can be implemented by momentum traders simply by selecting a diversified universe of tradable instruments and buying the ones going up and selling the ones going down. This is actually a method that tends to produce greater profits overall than adding a “best of” filter, but the draw-downs are larger and so it usually makes more sense to add a filter such as “best of” although there is no reason why fundamental analysis or other filters could not be used profitably instead.
There has been much academic speculation as to why momentum “works” and there is no consensus on this question. My own opinion is simply that for something to get from 100 to 200 in its price, it has to go up, and human nature is such that crowds tend to pile into moves at tipping points, making the momentum even stronger.
Now let’s turn to any concerns that might have been raised over my choice of 3 months as a look-back period for determining which pairs to trade.


Look-Back Period for Selecting Currency Pairs

I used a 3 month look-back period in my previous article simply because it produced the best overall result of all possible look-back periods. If you are a momentum trader concerned that the concept does not look very robust until some other look-back periods have been measured, you are absolutely right! In order to address this I am reproducing below the results for every look-back period at 2 weekly intervals from 2 weeks to 24 weeks (equating to 6 months), followed by another graph showing the average of all the samples.
Chart 1
Of the 12 samples, only 1 of them completes the test with a positive return, compared to 11 with a negative return. Therefore the 3 month look-back generation of a positive result might be a statistical fluke. You might say that since May 2012 the strategy overall has been slightly profitable, but not by much. Let’s look at the average performance of all of the 12 samples now:
Chart 2

The average performance is quite strongly negative, albeit marginally positive since May 2012.


Time Series Momentum

If these results make you feel nervous about using a “best of” Forex momentum strategy, you could instead consider using a simple time series momentum strategy. Here, momentum traders just select some Forex pairs, and for the purposes of our back test go long each week the price is higher than its own price of X time ago (X representing the look-back period), or short if the price is lower than its own price of X time ago.
The obvious question we run into first when trying to follow this kind of strategy is which Forex pairs to use? Do we want to be trading all the Forex pairs all time, without discriminating between them?
It makes sense to start by looking at the 4 major pairs: EUR/USD, GBP/USD, USD/CHF and USDJPY. Below are the results of a back test over a very long period of time – from January 2002 until early 2015, which represents more than 13 years. This test has some different parameters: the trades are taken only at the beginning of calendar months, trades are held for 1 month, and the look-back periods are previous calendar months. The look-back periods used were 1, 3, 6, and 12 months:
Chart 3
This is surprising, as all the look-back periods used were profitable. An average of all 4 strategies would have produced a return in excess of 100%, and currently it is only the 1 year period that is within a serious draw-down.


Trade USD and EURO Currency Pairs

The two biggest global currencies are the USD and the EUR. They are most prone to trending steadily and this is one of the reasons why time series momentum with the 4 major pairs has worked well: they are all USD currency pairs. Why should momentum traders be especially interested in these currencies?
Simply because they are the two largest currencies by volume and importance. It takes time to turn around a big ship.
Let’s conclude with some data showing how the USD and the EUR love to trend. Over a period of 6 years – from April 2009 to April 2015 – if you looked at the 28 most important currency pairs and went long or short of each every week depending upon its look-back periods of 13 or 26 weeks, the only currencies producing positive results were the EUR and the USD. Both currencies would have produced a return of 110% each based upon the 26 week look-back period (corresponding to 6 months). Using the look-back period of 13 weeks (corresponding to 3 months) produced a positive result of 161% for the USD and 82% for the EUR. Using this kind of momentum trading strategy could be a good way to turn $10,000 into $1 million.
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Using Fair Value in Fundamental Analysis

Fundamental Analysis is essentially the use of economic analysis to determine either the real value of an asset or whether a trend exists in the real value of an asset. The first method allows the derivation of the “fair value” or “real value” of an asset, allowing a trade to be placed if the current market price deviates significantly from that real value. The latter method allows a trader to have confidence in a trend if there is a trend of actual market price changes mirroring the fundamental trend.

Fundamental Analysis in Trading Stocks

For example, both of these methods of fundamental analysis are commonly used in trading stocks. Stock traders that are prepared to hold trades over the long-term may follow a macro rule of only being long in a bull market, and the use of fundamental analysis to detect improving global or local economic fundamentals is usually a part of making a call as to whether a bull market is in existence.
On a more micro level, fundamental analysis is also commonly used to derive a fair value for individual stocks, in order to determine which stocks are likely to be undervalued and therefore good bargains for relatively long-term buy and hold strategies. This is typically done through the use of price to earnings ratios (as earnings of a publicly quoted company may be easily and transparently discerned). Another method is to take recent dividend payments as discounted cash flow, with the “fair value” price of the stock being the discounted total value of the anticipated next twenty dividend payments.

Fundamental Analysis in Trading Commodities

Using fundamental analysis in trading commodities is usually considerably more difficult than it is trading stocks. This is because commodities are usually prone to sharp fluctuations based upon demand and supply issues and all manner of localized events which may be hard to foresee. Furthermore, different types of commodities behave differently and have strongly variant characteristics.
One example might be energies such as oil and natural gas. Fundamental factors affecting energy commodities typically include the economic health of large energy consumers (for example, Chinese industry’s appetite for oil consumption at any given time), as well as supply factors such as political instability affecting production areas. It is much harder to determine the “fair value” of a barrel of oil as changes in technology and other factors affecting the cost of extraction and/or production must be taken into account. What may have been the “fair value” of a barrel of oil ten years ago is quite different today due to big changes in extraction technology.

The Interesting Case of Gold

Gold is typically considered to be the quintessential store of value as mankind’s precious metal since the dawn of time: additionally, it has few dual uses to distract from its anointed role. It is seen as the ultimate “store of value” as unlike fiat currencies, as a store of value its “fair value” might be expected to remain constant. A study conducted a few years ago by financial academics Campbell R Harvey and Claude Erb found that in terms of gold, a Roman centurion during the reign of the Emperor Augustus
was paid about the same as a modern-day U.S. Army Captain, which would be their equivalent rank. Additionally, the price of a loaf of bread in 6th century B.C. Babylon was about $4 per loaf, which is not too far away from what a good-quality loaf might cost you in the modern-day U.S.A.
This study calculated that the “fair value” of an ounce of gold in 2012 was approximately $800, and that throughout history the price eventually reverts back to its “real price” after a significant deviation. This would have worked as a trading strategy in 2012 over the medium-term.

Fundamental Analysis in Trading Forex

Obviously straightforward methods of fundamental analysis can be applied to currencies by analyzing the economic data of nations. The use of “fair value” methods is even more attractive here, as it appears it can be easily derived by simply comparing retail prices of common goods in various countries, and then applying the differentials to the relevant current market exchange rates. For example if $10 worth of currency in country A buys more goods than $10 worth of currency in country B, it would be said that country A’s currency is overvalued and country B’s currency is undervalued. The undervalued currency would be bought and the overvalued currency sold in the hope that the exchange rate would move in that direction.
The problem with “fair value” in Forex is that it has not worked well at all over recent years. To test this theory, I looked at the value of the seven major global currencies (NZD, JPY, EUR, GBP, AUD, CAD, CHF) against the USD over a 9.66 year period, from January 2005 until April 2014.
The strategy used was fairly crude: at the beginning of each month, I hypothetically bought the three currencies that were the most undervalued against the USD according to the previous year’s OECD Purchasing Power Parities data, and sold the three currencies that were most overvalued. Each position was exited automatically after a month.
The results we present do not include the actual interest payment differentials that would have been earned or deducted. The results are simply based upon the changes in the exchange rates between the currencies and do not include transaction costs.
The results were as follows:
Fair Value 1

Fair Value 2

Conclusion

Using “fair value” is much more effective in long-term investing than it is over more short-term trading. Like most fundamental analysis, in my opinion it is likely to work best as an additional filter applied to conclusions derived from technical / price analysis.
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How Do Fed Rate Hikes Affect the U.S. and Global Economies?

The uncertainty of whether or not the Federal Reserve will raise interest rates has set global markets on edge for most of the past year. With a December hike looming—one that will move the current rate away from its current zero percent and will be the first increase since 2008--more and more central banks have put their own activity on hold in anticipation of a Fed decision.

What is the significance of an interest rate hike and why is the Fed move so pivotal at the moment?

The Federal Reserve Bank is the central bank of the United States. One of its major functions is to control monetary policy and it does this by increasing interest rates when the economy is growing too fast. This encourages people to save more and spend less, strengthening the dollar and reducing inflationary pressure. Conversely, when the economy is in a recession or growing too slowly, the Fed reduces interest rates to stimulate spending, which increases inflation.

WITH A DECEMBER HIKE LOOMING… MORE AND MORE CENTRAL BANKS HAVE PUT THEIR OWN ACTIVITY ON HOLD IN ANTICIPATION OF A FED DECISION.
Inflation Control

The Fed uses its control of monetary policy by setting a specific inflation rate which it believes will maintain stable consumer spending and the correct level of employment. When the economy is weak, inflation naturally falls; when the economy is strong, rising wages increase inflation. In 2011, the Fed officially adopted a 2% growth rate in order to help the economy grow at a healthy rate.

When the Fed introduced a near zero interest rate during the financial crisis in 2007, it expected inflation to increase steadily over the years. However, this failed to happen and now in 2015, inflation is still well below the 2% target, which is contrary to the normal effects of low interest rates. The reasons cited for low inflation in a low interest environment are falling oil prices and global economic crises.

A low interest rate helps businesses to expand, which in turn leads to more jobs and greater consumption. Under normal economic conditions, increases in the federal funds rate reduce inflation and increase the appreciation of the U.S. dollar. In addition, when the Fed increases interest rates, it attracts foreign funds to the U.S. which leads to a natural appreciation of the U.S. dollar, despite stagnant wages and low domestic consumption.

An interest rate hike now, with the 2015 economic environment as it is, will keep the growth of inflation close to the 2% benchmark while increasing the dollar’s appreciation.

How will an interest rate hike affect the American consumer? Higher interest rates work in two directions. On the one hand, higher rates will provide increased savings on bank accounts and long term treasury bonds. Certain other investment vehicles will also reflect this higher rate.

On the other hand, most consumers will feel the increase in their mortgages, bank fees, car loans and all other short term borrowing programs.

With lower gasoline prices at the pumps, however, consumers are already finding extra spending money in their pockets and together with a strong stock market and a job market that continues to improve, the overall mood among the public should continue to be positive even with a small rate increase.

Effect on Foreign Economies

Increasing interest rates go hand-in-hand with appreciating currencies. This affects economic facets domestically and around the world—particularly the credit market, commodities, stocks, and investment opportunities.

In many parts of the world, the US dollar is used as a benchmark of current and future economic growth. A strong dollar is seen in a positive light in developed countries where rising interest rates benefit from foreign trade by boosting US demand for products around the world, increasing corporate profits for both domestic and foreign companies. And because fluctuations in the stock market project views about whether industries will grow or contract, the resulting profit increases should lead to stock market rallies.

Emerging Markets

In emerging economies, reactions to an increased Fed interest look different.

A Fed rate will increase concerns in emerging markets which are already anxious over the effects of a surging dollar and capital outflows. The year has already been a tough one for many of the emerging economies with the continued slowdown in China and tanking commodity prices in countries that depend on them the most for their overall economies.

Higher interest rates strengthen the dollar against other global currencies and attract capital away from emerging markets, where $4.5 trillion in gross inflows was reported between 2009 and 2013. If imports slide, governments will find it difficult to fund their debts and business investment will decline.

The huge amount of credit denominated in dollars weighs heavily on government and corporate accounts the world over. Ultra-low interest rates have led borrowers to take trillions of dollars in debt tied to the dollar. If interest rates rise, many of those debts could become unsustainable.

Some analysts fear that a surplus in dollar-denominated credit brought on by a higher interest rate will spur a global debt crisis and credit market volatility has already reared its head.

In addition, since oil, gold, cotton and other global commodities are priced in US dollars, a strong currency following a rate increase would increase the price of commodities for non-dollar holders. This will have an immediate effect on economies that rely primarily on commodity production and an abundance of natural resources. As these products decline in value, their available credit streams will shrink.

Interest rates are fundamental indicators of an economy’s growth. In the US, the Federal Reserve’s move to increase interest rates is expected to spur growth and enthusiasm by investors, while moderating the economy itself. While the Fed’s main concern is the US economy, it will not be able to avoid watching closely how the effect of its rate increase will play out on foreign trade and on the world's credit and commodities markets.
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Islamic Accounts Add Interest to Forex Brokers

There are many Forex and Binary Option brokers today that provide their traders with the option of opening an Islamic Account. In order to understand how these accounts work, one must first understand the principles of sharia (Islamic law) and how it applies to compliant banking and finance.

Sharia laws prohibit acceptance of specific interest or fees for loans of money (known as riba, or usury), whether the payment is fixed or floating.

As of 2009, there were over 300 banks and 250 mutual funds around the world complying with Islamic principles. As of 2014, sharia compliant financial institutions represented approximately 1% of total world assets totaling close to $2 trillion in funds. Not all Muslims follow Sharia laws. According to accounting firm, Ernst & Young, Islamic Banking makes up only a fraction of the banking assets of Muslims, but it has been growing at an annual rate of 17.6% between 2009 and 2013, faster than banking assets as a whole and it is projected to grow by an average of 19.7% a year up until 2018.

Islamic banking is able to make money by keeping within Sharia frameworks. Unlike conventional banking, Islam forbids simply lending out money at interest, so specific Islamic rules have been created on transactions in order to prevent this from happening. The basic principle of Islamic banking is based on risk-sharing which is a component of trade rather than risk-transfer which is seen in conventional banking. As such Islamic banking employs concepts such as profit sharing, safekeeping , joint venture, cost plus and leasing.

Islamic Brokerage Accounts

Under normal trading conditions, trades in commodities and currencies are executed in the spot market for 24 hours. At 5:00 pm New York time, all open positions are rolled over for the next 24 hours and the daily interest is added to the company’s accounts every 24 hours. The brokerage company can then either pay the interest or charge the client’s account to cover what is considered rollover fees. For traders who hold positions overnight, rollovers can have a significant impact on an account’s bottom line.

In an Islamic account, things are different. Since there is no interest (Riba) in any form throughout the duration of the Islamic account contract, any open trades at the end of the trading day that are automatically rolled over pose a problem for those following Islamic law as this type of transaction is considered usury. So rollovers in a conventional form are simply not allowed.

SHARIA LAWS PROHIBIT ACCEPTANCE OF SPECIFIC INTEREST OR FEES FOR LOANS OF MONEY
Over the years, Islamic rules have been tweaked slightly so as to allow Muslims to participate in currency markets without violating sharia law. Most brokers now offer Non-Swap accounts which can be used under certain conditions that allow traders to either trade as much as their money permits, or take a loan from broker on the condition that the broker doesn’t receive any usurious interest on the loan. In most cases, there is no interest or commission taken on contracts lasting longer than 24 hours and zero rollover interest is a constant.

Revenues Come from Spreads

So how does a broker make any money on Islamic accounts?

A broker’s revenues come strictly from the trade spreads which is the difference between the Ask and the Bid prices of a currency pair. Many brokers that offer swap-free accounts will either raise the spreads on these accounts or require an additional commission or fee, so at the end of the day, it is like paying for interest incurred on overnight positions but often at a higher rate. Other brokers offer the Islamic account with no commission or additional fee and maintain the same spread as in its swap accounts.

There are also some brokers that offer additional perks for swap-free accounts in the form of Hibah. Hibah are gifts or donations awarded voluntarily, therefore the broker enables its Muslim clients to donate a share of their profit for charity.

With the Muslim trading community expanding, brokerage houses are doing their best to accommodate Islamic trading accounts. Not all brokers have jumped on the bandwagon just yet but if they wish to stay competitive they will have to add this feature to their offerings.
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Momentum Trading Strategy: USD Pairs Part 2

Earlier this month, I published the first part of this series, which explained how trading a “time series”momentum strategy restricted to USD and EUR currency pairs and crosses has historically performed far better that implementing a “best of” momentum strategy across a universe of currencies, at least over recent years.
In this second part, I will get into the details of the results of the back test I conducted, and show the differences in performance between the EUR pairs and the USD pairs, as well as examining how overall performance can differ with the application of certain filters.

USD vs EUR Currency Pairs & Crosses

I wrote in Part 1 that “Over a period of 6 years – from April 2009 to April 2015 – if you looked at the 28 most important currency pairs and went long or short of each every week depending upon its look-back periods of 13 or 26 weeks, the only currencies producing positive results were the EUR and the USD. Both currencies would have produced a return of 110% each based upon the 26 week look-back period (corresponding to 6 months). Using the look-back period of 13 weeks (corresponding to 3 months) produced a positive result of 161% for the USD and 82% for the EUR.”
Let’s take a closer look at these results, by conducting a 13 year back test on USD and EUR currency pairs and crosses (concluding in 2015), and working though the numbers.

4 Week Period

The first look back period was 4 weeks (corresponding to 1 month). The results are shown below:
USD
EUR1
The USD pairs achieved profitability, but would have been in a draw down for more than three years to date. The EUR pairs and crosses were quite consistently unprofitable. Overall, the combined result was very slightly positive over the period, by 19.46%. This period is really too short to use, although it seems capable of providing some profit over the long term.

13 Week Period

USD2

EUR2
The results for 13 weeks (corresponding to 3 months) look much better, although it has to be noted that both sets were under a draw down for more than one third of the period. The USD pairs performed better, at 328.44%. The combined return for both was 485.58%. This looks like a good time period to use as a look-back.

26 Week Period

USD3
EUR3

The results for 26 weeks (corresponding to 6 months) also look good, and possibly even better than the 13 week results. The USD result in particular looks excellent, with a fairly consistently rising equity curve, and a shallower draw-down during the earlier part of the back test compared to the 13 week results. The USD pairs performed better, at 317.43%. The combined return for both was 388.19%. This also looks like a good time period to use as a look-back.

52 Week Period

USD4
EUR4

The results for 52 weeks (corresponding to 1 year) do not appear to look very good, although the results are considerably better than the 4 week results. The EUR result in particular looks interesting, with return of 196.83%. The USD pairs performed much worse, at only 49.89%. The combined return for both was 246.72%.

Analysis of Results

Time Period USD Performance EUR Performance TOTAL Performance Maximum Drawdown Longest Drawdown
Table1
One further consideration has to be accounted for: the transaction cost. There would be approximately 3,000 trades taken, which might account for a deducted of about 30% from the overall profit, and would increase somewhat the size of the maximum drawdowns and lengthen the longest drawdown.
Taking this into account, we can draw a few conclusions:
1. The results for the USD pairs look better than the results for the EUR pairs and crosses.
2. The form of the USD results look more logical, with each time period showing a profit, which seems to form a bell curve, peaking around 13 to 26 weeks.
3. It appears likely that this strategy can suffer an approximately 4 year drawdown, even with an excellent long-term performance.
4. The obvious ways the back test might be improved would be by sticking to USD pairs only, and perhaps taking only the trades that qualify under both the 13 and 26 week time period look backs, as a type of “multiple time frame trading” filter. The results for this variation are shown below.
USD5
The USD performance was 310.90%, comparable to the USD results for both the 13 and 26 weeks as standalone periods.
However the maximum drawdown was considerably lower at only -54.51%.
The longest drawdown was 237 weeks, which is quite comparable to the earlier results.
The methodology also lowered the total number of trades, thus producing a greater return per trade and lessening transaction costs.
Adding the EUR pairs and crosses does not improve the drawdown results.
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