- The idea of a near perfectly correlated trade is appealing
- With such trades, we wouldn't need to be worry about market direction or volatility
- Efficient market pricing says buyers pay a premium to receive assets immediately
- Buyers in contango situations would rather wait to receive assets
We go in search of a near perfectly correlated trade. Photo: iStock
Take a look at specialist bookshelves for trading strategies and you will find a plethora of systems and charting techniques available to traders. It can be astro or Fibonacci, Elliot wave, Gann, seasonal spreads, turtle trading, Gartley/harmonic patterns etc. The list goes on. Many traders rely on lagging indicators such as the 200-day moving average, relative strength index 14 or Wilder's average directional index. A quick glance at the tools tab on your charting facility will show at least 30 different functions.
Gone are the days of simplistic candlestick charts as promoted by Steve Nison
. But why? Because the very strength of those patterns became so entrenched that everyone knew what to expect other traders to do. When a trade strategy of any type becomes totally entrenched into the psyche of traders' mindsets, we see bigger players trading in the opposite direction. That style of trade has became known as stop running.
We can describe the statistical theory of ''curve to fit'' (and I highly recommend you google it, as it should make you question the accuracy of your trade parameters and entry points). But suffice to say that some strategies need a bit of ''slack'' or leeway before a change in trend occurs in the expected manner. The trick is to know the optimum stop level to ensure a successful trade results – and that you haven't tied your trading account up by running too large a trade for your account size.
Perfectly correlated trades
Perhaps what we need is a near perfectly correlated trade, where we don't need to be concerned with market direction and volatility. Some option trades, such as strangles and straddles, can be built in such a way. These can be made as an aggressive single standard deviation apart or the more normal two standard deviations apart. But this article will leave the world of options alone, as there are more learned option writers to describe the various structures available along with margins etc.
Again we need to look for liquidity in the general markets. It can be mainstream indices or forex. So for the moment let's ignore any curve to fit analysis. We do not want to consider any potential reversal zones for a trade entry, and we want as near perfectly correlated a trade as possible.
Forex is generally accepted as a zero-sum game. That is, there is a perfect correlation between buyers and sellers in liquid markets. For every 10 winners, there will be an equal number of losing trades. And it is the supply/demand dynamics that force price movements, whether it is a change in base rates or an extreme world event. Obviously trading the forex market in one direction exposes you to such risks and volatility. Clearly we want to be on the correct side of such movements.
Staying with forex, we also know when seasonal factors and economic data releases will arise that will adjust our financial exposures to the market. Looking at the futures markets, we also know that at some point in the future there will be a cash settlement/expiry day, which is usually the spot price market value at the time. So can we predict the future price settlement? Again let's leave the beauty of Theta trading for the options team here at Saxo (with its 84% probability of success over any year of trading history). If you want this trade posted, then let me know.
If you were to buy a new house for £100,000, but see that the plot next door remains vacant. You are willing to wait for construction of a house identical to the one that is currently for sale at £100,000. Then the builder would give you a discount for the house that is yet to be built. Let's say you could buy the same yet-to-be-built house for £90,000.
Home truths ... home buyers would pay a premium to receive a house now, but buyers in contango situations would rather wait to receive assets. Photo: iStock
Efficient market pricing theory suggests normal market conditions permit cash buyers to pay a premium for having the house now, as they do not want cash tied up for a future purchase unless they are rewarded for such a transaction. So they get a discount to secure the deal.
Contango situations occur when people do not want a product immediately and would prefer to wait for future time frames to buy. So the future price becomes a higher value than the cash market. Just watch the oil market for example.
So we know that cash markets and futures markets will match price at some point in the future trading period. A trade of say the FTSE100 cash price against the FTSE futures index will not earn you anything as dividends need to be paid out/received along with dealing costs and interest charges. Doing this trade will result in a net loss over a three-month future.
When we use a synthetic derivative, however, something interesting occurs. A synthetic is an index that doesn't pay out or receive dividends. It merely tracks the index tick by tick. If you look at Saxo trade tickets on a normal CFD, you can see that they obviously adhere to efficient market pricing models. Their index is a synthetic. If you were to trade the FTSE cash market short against a FTSE future contract, while long expecting the two prices to meet at some point, you would find the daily interest cost and transaction set-up cost exactly match any profit gain. So again, this is not a viable trade.
But ask yourself if it could be a good trade. Again let's ignore the Theta trade for greatest time decay price moves. What if you traded Saxo's Self-invested Personal Pension facility? Leverage is dramatically reduced to 2.5 times. The interest and dealing costs remain the same, and surprise, surprise, yes, you would earn every quarter in your pension facility. This is an easy pension build-up trade. It doesn't earn you anything to spend now. But it is worth costing out for anyone building their pension pots.
Let's consider how to adapt the pension trade for today's traders wanting to earn income for immediate use. Trading spot cash markets against the same index future assures an exceedingly tight correlation. If the market rises or falls, you are immune to the effect, as you are trading 1:1 long or short. We can adjust the ratio, but why bother? You could cheaply trade in one direction anyway. So we look to the defensive structure of a 1:1 trade.
Now let's consider a real calendar spread on the general futures markets. Currently we are in the opening window for a normal cycle on eurodollar futures. A long on the June eurodollar future against the December eurodollar has its maximum rate of change between now (March 4 at time of writing) and May 10 this year. Between 1987 and today, we have had an 84.7% success rate! We are trading the same instrument and rely on repo market adjustments on FX calendar spreads (not bonds this time). The monetary liquidity on the December contract is very, very low, but this rapidly changes, and this is what you want to take advantage of. We are merely playing against future rollover positions to December contracts, which often start mid-April on this trade.
Interestingly, normally the trade is the opposite short near term and long far term. But this trade – if you had the patience – would work as a sell spot cash and long December contract, but the interest cost is very corrosive. The trade seems wrong, but the history shows an interesting quirk for the eurodollar.
On a rolling 15-year data sample, we experienced three losses, which lowers the success percentage slightly. The volatility of markets over the last 15 years has encompassed some major world events, and yet we still see consistent profits, on balance.
Come the start of June another market spread trade takes advantage of seasonal illiquidity. That is, the rate of change in spread and illiquid markets becomes volatile as the efficient market pricing that you are trying to maximise takes hold. Forex markets and even liquid indices can be traded much the same way. I can, if required, post the optimum dates for each of the mainstream markets for the above events.For more on forex, click here.
– Edited by Robert Ryan
*fxtime is an alias