Article / 09 March 2016 at 14:00 GMT

In search of the perfectly correlated trade

Hypothesis Testing
United Kingdom
  • 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
Arcade
 We go in search of a near perfectly correlated trade. Photo: iStock

By fxtime*

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.

Discounting deals

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.

nnn
 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.

Synthetic derivatives

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.

Eurodollar futures

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

3y
fxtime fxtime
The point of the strategy is not to have a directional bias. Had we shorted FGBLH6 March Bund and Longed FGBLM6 the June bund in January we would have seen the same trade scenario whereby you are trading the near term highly liquid future against an illiquid June future. It is the trading against the illiquid month that is of interest and as you trade the same derivative product eg the Bund or the euro etc you are merely looking for a rebalancing of spread. What option players call Theta trading.
3y
Michael O'Neill Michael O'Neill
Hi fxtime- Great article. On point that I would make is that even though some strategies become entrenched and are exposed to stop running, it doesn't diminish the validity of the signal, merely blurs it.
Knowing the stop runners out are out there means that a prudent trader,who still believes in the signal, just needs to adjust his stop loss accordingly. Sure, it exposes you to a bigger loss which can be compensated, to a degree, by managing the entry level.

Just a thought
3y
fxtime fxtime
Totally agree mate. I should have said as such too. When I trade mean reversion trades I know I can have a large drawdown so have to scale my trades accordingly and as you rightly say adjust the stops to match the trade. The above trade really is a 1:1 strangle via near and far dated futs to neutralise positional bias and await liquidity to appear in the distant futs having re-read the above I could have phrased things better. Thanks for the comments though....honestly it's very much appreciated.
3y
zefy zefy
Excellent article again, thanks. I'm glad it is implemented using futures, not options (because with options things can get often too complicated IMHO...). Are there optimum dates for FGBL?
3y
fxtime fxtime
I'll post a FGBL# chart later for rollover periods. Contrary to popular belief they don't automatically occur two weeks prior to expiry dates. Repo houses start far earlier on Bonds as spread ''rates of change'' effects enhances returns :-)
I am away until Monday lunch time so apologies unable to post a relevant chart until then.
3y
fxtime fxtime
Finally back to my trade screens...sorry for the delay @Zefy.
As mentioned above the trade structure relies heavily on the very far dated contract being illiquid. With regards to expiries we look at the classic quarterly expiry...the next being June, Sept and Dec. However bond/treasury spread traders do not await the last moment to roll their contracts. Informally we see major influences for rates of change in May, Aug and November. There is no need to open a Bund trade yet as you simply tie up funds for little gain yet accrue daily interest costs so I would await near the end of April for the Bund my self. Spreads should be more than wide enough for trade purposes on a lowered gearing to eliminate excess interest charges and you should gain the rapid rate of change between the spread as the far contract becomes ever more liquid.
3y
fxtime fxtime
Option traders would be looking at the Theta curve which implies for options that 45 days or less to the expiry date time decay/erosion becomes more pronounced and they benefit from this but the above futures relies more on rapid rate of change and that you do not run to expiry as the max rate of change occurs far earlier and can be more efficient for futures traders to ONLY seek this part of the trade....after all you earn the rapid rate of change then take your profits to open a different trade and earn elsewhere !
3y
zefy zefy
Perfect, this is exactly what I needed to do my own calculations. I'll check contracts and how to fit to my systems. Many thanks!!!
3y
fxtime fxtime
Zefy tomorrow a new article of mine appears but relates to account reporting as opposed to strategies however there is a XAG spreadsheet that utilise these trades....may I suggest you look at the results? Also if you were to apply in one direction trade there is the same scenario on FGBL as a comparison and you will see the more successful trade is for the above trade set up as opposed to one way trades. The spreadsheets give one year results for both types of trade and a means of recording data.
3y
zefy zefy
Thanks, I'm really looking forward to read your new article tomorrow.
3y
zefy zefy
I guess FGBL positions based on this strategy should be opened soon, perhaps in the beginning of next week?
3y
fxtime fxtime
I am looking at Monday !! I will post the contract epic codes and values for you.
3y
zefy zefy
Opened FGBL positions. Let's see :)
3y
fxtime fxtime
I have too but used very low leverage (x5) as you need to watch the interest costs remember.
3y
fxtime fxtime
I have also opened the same on SP500 but as an option. No interest cost to bear. However I have made synthetic eg reversed the trade write up. So have sold a call to open and sold a put to open both OTM at 2 std dev away. 84% probability of success (rolling 10yr data) on a monthly option so each and every month I trade these. If I want a more aggresive bis then I will look to sell premium as when we get high IV you can sell a call to open with max premium looking for the call to expire worthless and you thereby gain all the premium because you made as a synthetic option by reversing the trade at the open eg you SOLD an OTM CALL....theta (time decay) kicks in quickly to your advantage. Gamma is aggressive to b/e which is more favourable anyway and margin cost falls as the trade was synthetic :-)
3y
zefy zefy
Not sure how you can control leverage if using standard FGBL contracts....
3y
fxtime fxtime
Yikes....may I suggest you look at your normal trade tickets as it will usually give you a daily interest charge? Look at both contracts as there is a difference between them. These costs obviously come out of the potential spread contraction....however if you have a normal cfd contract let me know and I will post a theta curve to show when you've reached the max rate of profit before costs become corrosive.
3y
zefy zefy
Shorted standard FGBLM6 and Longed standard FGBLU6 futures contracts in EUREX.
3y
fxtime fxtime
As you know I shorted Monday and the near dated is in profit and the stop is now set at 162-000 to ensure some profit can be banked if need be. Any rally will bring the far dated contract upwards but initially that reaction will be slow. I will keep you informed on how I trade this....having looked at the trade tickets for the trade the daily interest rate is minimal so lets concentrate on revenue growth first and await time decay to perform. If I make any action to the trade I will post here for you.
3y
fxtime fxtime
Looking at your comments you too opened yesterday so you are in profit too?
3y
zefy zefy
Yes. Near dated is in profit. From original article I understood that trade will be let run weeks in order to time decay to do its job. I was not prepared to do any short term trade management, thanks for putting updates here if any trades or adjustments needed in short term!
3y
fxtime fxtime
This is as you say a trade that will run for weeks but if I go into profit on one side I secure that trade. If you look at the trade stop I have set it gives plenty of room for the trade to run and run. Time decay hasn't as yet triggered to our advantage but it will however out of pure bloody mindedness of mine I never let a profitable trade turn into a loss even though I know this trade is perfectly equalised LOL.
3y
zefy zefy
Very good point, thanks. I think I was too focused on the original long term time decay opportunity and wasnt thinking at all short term opportunities to bank profits.
3y
fxtime fxtime
Even if my adjusted stop is hit it implies the far dated contract is rising and in profit. I can always re-enter the closed side of the trade at a better b/e and adjust the far dated stop to at worst b/e...hope this makes sense?
3y
zefy zefy
Need to think this more... Obviously totally different trade management is needed if only one side is left open...
3y
fxtime fxtime
It is possible to simply leave along and await cash parity of the spreads but the revenue can be enhanced and interest costs can be quickly eliminated by management such as the one suggested. This is not a quick trade so there are few adjustments but they do make a large difference.
3y
zefy zefy
Fully understood the idea of adjustments to enhance revenues. But I am again struggling with calculating stop levels and time exposure / risk of only one side of the trade open.
3y
fxtime fxtime
I have asked Martin (Editor) on this site about writing a risk management and stop management article. That is proving difficult as it is a subject that isn't lightly covered. I have started writing the article but it would be a long article as too many areas to consider for winning and losing trade stop management scenarios so I am toying with the idea of posting a graphic instead which is basically a ''flow chart'' for efficient trade management ! Let me know what is best a graphic or text?
3y
zefy zefy
I'm engineer so flow chart would be perfect :)
3y
fxtime fxtime
OK....I will adapt. The first will be a flow chart for successful trades and the subsequent one will be for losing trade management/permutations. Also a separate chart for the current Bund trade too :-)
3y
zefy zefy
Sounds good. After several hours spent with Excel sheets I start to understand separate stop rules for short side and long side to adjust breakeven level in this trade. All flow charts to further explain stop management sure highly appreciated!
3y
zefy zefy
FGBLM6 now 162...
3y
fxtime fxtime
It is....suggest reading Steens comments for 30yr and 10yr bonds just posted.
A rally implies that the far dated contract will start to rise too especially when time decay and rollover periods come to the fore. These trades run for some time so lets be patient today and watch. I will ofcourse keep you informed :-)
3y
zefy zefy
Yep, read Steens comment already :)
3y
fxtime fxtime
zefy I assume you are still in the original trade? I had to re-enter a short near dated contract at 162.2
3y
zefy zefy
Yes, I am still in the original trade.
3y
fxtime fxtime
Great...I have almost finished the flow charting for this trade so will post this weekend for you :-)
3y
zefy zefy
Great, many thanks!
3y
fxtime fxtime
Having shown the flow chart to friends it seems my white board explanation was better ! Or that I simply typeset the programme listing for the various arrays to appear and follow however here is a screengrab for you.
Green arrows denote the trade entries. Black arrows denote stops.
Track the chart as a vertical line ONLY for trade entry purposes and money management however the chart can viewed as per normal for the totallity of the trade.
So when a trade goes into profit by 25 points or more adjust the stop to b/e. The first trade went easilly in excess of this so my stop was adjusted to +50pts on the near dated short.
The white line shows the expected move for the far dated contract. It isn't as volatile by you can see the expected move and the orange line has been randomly drawn to show that I expect to make two or possibly three more entries to the short side of the near dated contract.
3y
fxtime fxtime
The aim is to enhance b/e and maximise returns. As the original article suggests I have given the basics or bare bones strategy where as this version is a more profitable spread trade. It is a messy chart as needs to be viewed as a rolling vertical alongside the usual panoramic xy outcome version. Hope it makes sense?
If not I will typeset a numeric programme scenario and just follow the command numbers to see the loops/arrays play out.
3y
fxtime fxtime
Oops one other thing the yellow line shows enhance profits as spread tightens towards the first settlement date.
Off topic my first article of trade management of an existing trade appears this coming Wednesday. Hopefully the site might be surprised at the stats for just how many trades actually lose as a percentage when traded by using charts preset for a; minute/hourly/daily/monthly/quarterly/annual trading and results compared to the benchmark index using a Sharpe value !! If it changes the trade management for just one reader that would be a success imho LOL.
3y
zefy zefy
Many thanks, highly appreciated. Still need some time to go through all scenarios for b/e adjustments of far dated contract.
3y
zefy zefy
So I am still in the original trade and havent't done any adjustments to enhance yet.
3y
zefy zefy
This is excellent stuff, I am learning so much all the time!
3y
zefy zefy
And sure looking forward your new article tomorrow!
3y
fxtime fxtime
I have some friends testing the programme print out for you as far clearer to understand.
3y
zefy zefy
Great!
3y
fxtime fxtime
Zefy...I am re-entering the short side at 163.90 on the near dated contract. As you know two prior shorts covered when a trailed stop triggered to secure the profits. The spread is effectively wider now which means there is a greater premium to accrue with the time decay. Far dated has risen too which is always good.
3y
zefy zefy
Indeed FGBLM6 have had amazing rally from 27-Apr.
3y
fxtime fxtime
Can you see how this is working? By now risk as it was has been eliminated. My shorts have twice had their trailing stop hit to secure profits. The spread effectively widens permitting a better mean reversion and enhanced profits. Far dated long contract has also risen again profits are protected etc etc.
3y
fxtime fxtime
erm....hopefully this is a learning curve for everyone? It's bad news if everyone does this anyway as I am wasting everyones time !! :-(
3y
zefy zefy
During this week I have put my focus and effort to other strategies so I haven't tried any enhancements for this trade.
I understand now that even though the article says this is perfectly correlated trade, it does not mean that both sides need to be open all the time.
Thank you for posting updates here, highly appreciated. I will sure try enhancements at some point of time.
3y
zefy zefy
Definitely this is a learning curve!!!
3y
fxtime fxtime
LOL....I should have wrote another article on this subject instead of leaving a very basic trade set up here. The little chart I drew above will show you where we are now. Approx on the third black arrow position on the upper half of the chart and the first on the lower half. Hope this makes sense?
3y
fxtime fxtime
Actually reading your comment re learning curves....I am now concerned about next weeks article as there is no charting for that three way trade. I suspect I will need to write an additional article for this strategy and for next weeks. Thanks for the feedback mate. Have a good weekend.
3y
zefy zefy
Yep, makes sense. Have a good weekend too.
3y
zefy zefy
Ou yeah, it starts to be about time to open FGBLU-FGBLZ position. I so much like the slow pace of this trade.
3y
zefy zefy
I am like Captain Slow.
3y
fxtime fxtime
Yeah good timing for this.

Disclaimer

The Saxo Bank Group entities each provide execution-only service and access to Tradingfloor.com permitting a person to view and/or use content available on or via the website is not intended to and does not change or expand on this. Such access and use are at all times subject to (i) The Terms of Use; (ii) Full Disclaimer; (iii) The Risk Warning; (iv) the Rules of Engagement and (v) Notices applying to Tradingfloor.com and/or its content in addition (where relevant) to the terms governing the use of hyperlinks on the website of a member of the Saxo Bank Group by which access to Tradingfloor.com is gained. Such content is therefore provided as no more than information. In particular no advice is intended to be provided or to be relied on as provided nor endorsed by any Saxo Bank Group entity; nor is it to be construed as solicitation or an incentive provided to subscribe for or sell or purchase any financial instrument. All trading or investments you make must be pursuant to your own unprompted and informed self-directed decision. As such no Saxo Bank Group entity will have or be liable for any losses that you may sustain as a result of any investment decision made in reliance on information which is available on Tradingfloor.com or as a result of the use of the Tradingfloor.com. Orders given and trades effected are deemed intended to be given or effected for the account of the customer with the Saxo Bank Group entity operating in the jurisdiction in which the customer resides and/or with whom the customer opened and maintains his/her trading account. When trading through Tradingfloor.com your contracting Saxo Bank Group entity will be the counterparty to any trading entered into by you. Tradingfloor.com does not contain (and should not be construed as containing) financial, investment, tax or trading advice or advice of any sort offered, recommended or endorsed by Saxo Bank Group and should not be construed as a record of ourtrading prices, or as an offer, incentive or solicitation for the subscription, sale or purchase in any financial instrument. To the extent that any content is construed as investment research, you must note and accept that the content was not intended to and has not been prepared in accordance with legal requirements designed to promote the independence of investment research and as such, would be considered as a marketing communication under relevant laws. Please read our disclaimers:
- Notification on Non-Independent Invetment Research
- Full disclaimer

Check your inbox for a mail from us to fully activate your profile. No mail? Have us re-send your verification mail