Process Driven, Limited Risk FX Trading. 08 April 2008

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Leslie Harrington
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1 Process Driven, Limited Risk FX Trading 08 April 2008

2 The Theory FX Markets trend approximately 15% of the time. The key is to avoid non-trending markets and focus on the currency pairs that are trending. However, there is always an FX market that is trending. The decision to enter a trade is made up of three factors: A technical trend signal is essential. Implied volatility must be close to or below actual volatility. Supporting macro factors. A portfolio of positions is highly dependent on hourly and daily correlation matrices. Once a trade is entered, it is expressed with a delta neutral long option position. Once a trade is entered, gamma hedging is strongly process driven. 2

3 The Process Examine Daily and 10 Minute bar charts with the same two indicators, using the same variables to reduce curve fitting. Use daily data to determine if a market is trending. Both daily indicators must agree a trend exists to consider a position. If both daily indicators do not agree then there is no position. On average, there is a trend approximately 15% of the time (i.e. no position in a particular asset 85% of the time). 3

4 The Process Assuming a daily trend exists, then own gamma in that currency pair as long as implied volatility is not at a large premium to actual volatility. Close out the long gamma position as soon as a strong trend signal disappears. There are tradable up moves and down moves in a trending market that make rebalancing a long gamma position a more structurally sound process. Use the correlation matrix of trending currency pairs to enter trades with lower correlation in the underlying currency pair. 4

5 Option Trade Characteristics Option maturities in the 4 week area provide a trade-off between gamma and time decay. Initial option strikes will normally be approximately delta in the direction of the primary trend so initial premium per trade is limited. (The caveat is when there is extreme skew in that direction). Normally, if delta reaches 60%, the strike will be rolled down to 25-30% again and size adjusted for the market conditions. 5

6 Gamma Management Use 10 minute data to determine when to rebalance delta positions. In short term uptrends net delta is only flat or long up to 10% of option notional. In short term down-trends net delta is only flat or short up to 10% of option notional. When there is no short term trend signal, rebalance frequently with net delta of +/- 5% around short term technical levels particularly out of liquid time zones. The aim is to avoid using any stop loss orders and improve the average on the delta. The offset to not using stop losses on the delta is the daily time decay expense. Time decay is a more stable cost than stop losses on outlier moves in markets. 6

7 Liquid Time zones vs. Illiquid Time Zones FX markets have two kinds of behaviour depending on when they have liquidity. Liquidity is correlated to when the dominant currency pair s country is active (e.g. USD/CAD is most liquid during Toronto daylight hours) Delta management is different depending on liquidity. Trending behaviour is more robust when FX markets are most liquid. This can be predetermined by back testing short term trend following models that switch on and off at different times of the day. Trend needs to be given more benefit of the doubt when markets are liquid. More active delta management is required in less liquid time zones. This means leaving looping limit orders in illiquid times at predefined fractions of Average True Ranges. 7

8 Volatility Components At times implied volatility may look expensive relative to actual volatility or a GARCH equivalent. This filter also needs to have some impact on the currency pair selection process. I have defined implied volatility as relatively cheap when one month at-the-money implied is less than 20 day actual volatility. I have defined implied volatility as expensive when one month at-the-money implied is more than two vols over 20 day actual volatility. However, given a maturity profile of a maximum of 4 weeks, this process is less impacted by vega rather efficient management of gamma exposure. 8

9 Current Daily and Hourly FX Correlations. An important part of Currency Portfolio Selection. AUDJPY AUDUSD AUDNZD AUDCAD CHFJPY EURAUD EURCAD EURCHF EURUSD EURJPY EURGBP GBPCHF GBPJPY GBPUSD NZDUSD NZDJPY CADJPY USDCAD USDCHF USDJPY AUDJPY AUDUSD 27% AUDNZD 11% 62% AUDCAD -22% 53% 36% CHFJPY -23% 59% 70% 64% EURAUD -93% -12% 10% 43% 53% EURCAD -81% 9% 20% 70% 65% 95% EURCHF 88% -11% -16% -29% -41% -81% -74% EURUSD -72% 39% 41% 66% 79% 86% 92% -80% EURJPY 61% 44% 50% 31% 53% -27% -10% 56% -3% EURGBP -73% 23% 34% 71% 74% 89% 96% -72% 94% 0% GBPCHF 84% -21% -30% -61% -67% -92% -95% 88% -96% 21% -96% GBPJPY 94% 2% -5% -46% -37% -91% -88% 91% -83% 51% -86% 94% GBPUSD -47% 57% 40% 35% 64% 53% 54% -71% 78% -7% 53% -64% -50% NZDUSD 27% 81% 4% 41% 22% -23% -3% -2% 19% 19% 4% -4% 6% 43% NZDJPY 96% 11% -16% -32% -42% -95% -86% 92% -82% 48% -81% 91% 95% -57% 25% CADJPY 94% 6% -3% -53% -42% -95% -94% 87% -85% 43% -87% 93% 97% -52% 9% 94% USDCAD -51% -61% -36% 35% -6% 54% 55% -16% 19% -21% 41% -33% -45% -30% -51% -42% -56% USDCHF 79% -33% -36% -58% -72% -88% -90% 90% -98% 18% -91% 98% 88% -80% -16% 88% 89% -18% USDJPY 89% -19% -18% -48% -52% -89% -88% 95% -92% 42% -85% 96% 95% -74% -11% 93% 94% -24% 97% AUDJPY AUDUSD AUDNZD AUDCAD CHFJPY EURAUD EURCAD EURCHF EURUSD EURJPY EURGBP GBPCHF GBPJPY GBPUSD NZDUSD NZDJPY CADJPY USDCAD USDCHF USDJPY AUDJPY AUDUSD 51% AUDNZD 28% 8% AUDCAD 31% 82% 45% CHFJPY 71% 54% 71% 62% EURAUD 1% 14% 83% 49% 67% EURCAD 20% 57% 74% 87% 75% 85% EURCHF 88% 27% 32% 13% 51% 0% 8% EURUSD 40% 84% 51% 89% 78% 65% 90% 21% EURJPY 86% 51% 66% 52% 95% 51% 60% 75% 68% EURGBP 33% 44% 86% 67% 82% 88% 90% 27% 81% 73% GBPCHF 8% -32% -72% -62% -60% -90% -88% 20% -73% -38% -89% GBPJPY 88% 25% -1% 0% 45% -24% -14% 79% 6% 63% -7% 44% GBPUSD 23% 83% -34% 58% 17% -14% 26% -2% 56% 12% -3% 1% 21% NZDUSD 16% 65% -70% 24% -15% -52% -15% -5% 22% -13% -34% 32% 19% 86% NZDJPY 66% 38% -53% -8% 7% -64% -40% 53% -5% 25% -38% 64% 79% 46% 68% CADJPY 80% 0% 0% -31% 33% -29% -34% 80% -15% 54% -9% 47% 89% -13% 1% 72% USDCAD -48% -68% 43% -14% -15% 37% 13% -30% -32% -23% 9% -24% -44% -69% -81% -76% -40% USDCHF -7% -75% -39% -85% -59% -65% -87% 17% -92% -39% -71% 81% 24% -57% -24% 25% 46% 21% USDJPY 62% -35% 23% -40% 28% -12% -30% 71% -33% 47% -4% 38% 73% -51% -42% 38% 88% 9% 61% 9

10 LHS = Intraday The Information Screen in GBP/CHF RHS = Daily Data 10

11 Indicators Two trend indicators use used in tandem One is a modified moving average crossover rule adjusted for noise (i.e. you need more than just a crossover to generate a trend signal). One is related to the Average True Range indicator based on research by Wells-Wilder. Both must indicate trending markets to generate a signal. On average this only occurs about 15% of the time in both up and down directions. 11

12 The Information Screen RHS = Daily Data Daily Data Indicator #1 defines trend as +1 for up trend and -1 for downtrend, and zero for trend unclear Indicator #2 defines trend as +1 for up trend and -1 for downtrend, and zero for trend unclear. 12

13 LHS = Intraday The Information Screen Intraday Data Indicator #1 defines trend as +1 for up trend and -1 for downtrend, and zero for trend unclear Indicator #2 defines trend as +1 for up trend and -1 for downtrend, and zero for trend unclear 13

14 Process Strengths Well defined option entry and exit points VAR is always limited by the long optionality. Large daily losses are unlikely due to positive gamma Very scalable Opportunity to diversify risk in less correlated exchange rates and other futures contracts. 14

15 Process Weaknesses Opportunity cost of not buying options on the best ex-post trend signals. Time decay drain of not rebalancing efficiently when there are poor short term trend signals Not enough daily movement in the underlying to make back time decay plus additional gains. 15

16 Example The Currency Matrix Currency Pair Trend Spot ATR 1m Implied 20 day Actual Vol Test Vol Spread 1m 25d RR Rebalance Points Equalised Base Currency Amount 1 AUDJPY % 24.6% Buy? 7.3% ,600,000 2 AUDUSD % 14.3% 3 AUDNZD % 7.7% ,700,000 4 AUDCAD % 10.8% 5 CHFJPY % 8.2% 6 EURAUD % 13.2% Buy? 1.5% ,400,000 7 EURCAD % 15.5% Buy? 3.3% ,000,000 8 EURCHF % 9.1% Buy? 2.9% ,900,000 9 EURUSD % 11.5% Buy? 1.2% ,500, EURJPY % 13.6% 11 EURGBP % 12.0% Buy? 1.9% ,500, GBPCHF % 19.3% Buy? 5.7% , GBPJPY % 22.2% Buy? 7.9% , GBPUSD % 10.0% 15 NZDUSD % 13.5% 16 NZDJPY % 25.4% Buy? 5.2% ,700, CADJPY % 25.3% Buy? 6.3% ,400, USDCAD % 11.6% 19 USDCHF % 17.5% Buy? 4.8% ,200, USDJPY % 19.0% Buy? 5.1% ,100,000 The summary of trend signal is on the left. Trend is defined as +1, 0, or -1. There is also a comparison of 1m implied vol to 20 day actual vol as a ready reckoner as to value on the vol curve. A buy is defined as implied below actual vol. A Sell is defined as implied more than 2 vols over actual vol. Risk Reversal skew needs to be a discretionary overlay on strike selection. For example, in AUD/JPY as 40 delta AUD Call is probably better value than a 30 delta AUD Put. Rebalance points is a guide to number of FX pips to target rebalancing. Equalised Base Currency Amount is a guide to relative position sizing. 16

17 AUD/JPY Trade Purchase Date 12-Mar-08 Price 1.18 JPY pips Premium JPY 295,000 Type AUD Put/JPY Call Expiry Date 11-Apr-08 Strike Amount AUD 250,000 Initial Spot Initial Delta 28% Initial Greeks are to the right. Sold: 20-Mar-08 Final Spot: Price: 1.7 JPY Pips Premium: JPY 425,000 Spot Delta % Theta Delta Amount % 112 -AUD 52, % -AUD 55, % -AUD 60, % -AUD 62, % 139 -AUD 67, % -AUD 72, % -AUD 77, % -AUD 82, % 155 -AUD 87, % -AUD 92, % -AUD 100, % -AUD 105, % 167 -AUD 112, % -AUD 120, % -AUD 127, % -AUD 135, % 164 -AUD 142, % -AUD 150, % -AUD 157, % -AUD 165, % 134 -AUD 172, % -AUD 180, % -AUD 187, % -AUD 192, % 94 -AUD 197,500 17

18 Delta Trading History Profit on Option: JPY 130,000 Profit by Improving Average on Delta Hedge JPY 67,000 AUD/JPY Trading History Trade Date Amount Price Traded Value Net Position Average 3/12/ :38 AUD 25, JPY 2,372,500 AUD 25, JPY 2,372,500 3/13/2008 0:30 -AUD 25, JPY 2,382,500 AUD 0 JPY 10,000 3/13/2008 3:28 AUD 25, JPY 2,360,000 AUD 25, JPY 2,350,000 3/13/2008 4:16 AUD 25, JPY 2,352,500 AUD 50, JPY 4,702,500 3/13/2008 5:38 AUD 25, JPY 2,348,750 AUD 75, JPY 7,051,250 3/13/ :00 -AUD 25, JPY 2,353,500 AUD 50, JPY 4,697,750 3/13/ :53 AUD 25, JPY 2,351,250 AUD 75, JPY 7,049,000 3/13/ :44 -AUD 25, JPY 2,361,250 AUD 50, JPY 4,687,750 3/13/ :10 -AUD 25, JPY 2,372,500 AUD 25, JPY 2,315,250 3/13/ :36 -AUD 25, JPY 2,386,500 AUD 0 JPY 71,250 3/13/ :28 AUD 25, JPY 2,378,250 AUD 25, JPY 2,307,000 3/14/2008 4:36 AUD 25, JPY 2,362,500 AUD 50, JPY 4,669,500 3/14/2008 8:44 -AUD 25, JPY 2,368,750 AUD 25, JPY 2,300,750 3/14/ :47 AUD 25, JPY 2,363,000 AUD 50, JPY 4,663,750 3/14/ :30 -AUD 25, JPY 2,367,500 AUD 25, JPY 2,296,250 3/14/ :48 AUD 25, JPY 2,355,000 AUD 50, JPY 4,651,250 3/14/ :00 -AUD 25, JPY 2,353,250 AUD 25, JPY 2,298,000 3/14/ :02 -AUD 25, JPY 2,350,750 AUD 0 JPY 52,750 3/14/ :23 AUD 25, JPY 2,345,000 AUD 25, JPY 2,292,250 3/14/ :13 AUD 25, JPY 2,337,500 AUD 50, JPY 4,629,750 3/14/ :29 AUD 25, JPY 2,327,500 AUD 75, JPY 6,957,250 3/14/ :30 -AUD 25, JPY 2,340,000 AUD 50, JPY 4,617,250 3/14/ :41 AUD 25, JPY 2,328,750 AUD 75, JPY 6,946,000 3/16/ :02 AUD 25, JPY 2,302,500 AUD 100, JPY 9,248,500 3/16/ :58 -AUD 25, JPY 2,322,500 AUD 75, JPY 6,926,000 3/17/ :01 AUD 50, JPY 4,460,000 AUD 125, JPY 11,386,000 3/17/ :25 AUD 25, JPY 2,215,000 AUD 150, JPY 13,601,000 3/17/ :57 AUD 25, JPY 2,216,250 AUD 175, JPY 15,817,250 3/17/ :40 -AUD 25, JPY 2,230,000 AUD 150, JPY 13,587,250 3/17/ :37 -AUD 25, JPY 2,247,500 AUD 125, JPY 11,339,750 3/17/ :49 AUD 25, JPY 2,245,250 AUD 150, JPY 13,585,000 3/17/ :55 AUD 25, JPY 2,244,250 AUD 175, JPY 15,829,250 3/18/2008 5:54 -AUD 25, JPY 2,237,000 AUD 150, JPY 13,592,250 3/18/2008 8:01 -AUD 25, JPY 2,257,500 AUD 125, JPY 11,334,750 3/18/ :44 -AUD 25, JPY 2,255,250 AUD 100, JPY 9,079,500 3/18/ :17 -AUD 25, JPY 2,264,500 AUD 75, JPY 6,815,000 3/18/ :50 AUD 25, JPY 2,284,500 AUD 100, JPY 9,099,500 3/18/ :02 -AUD 25, JPY 2,293,250 AUD 75, JPY 6,806,250 3/18/ :01 -AUD 25, JPY 2,327,750 AUD 50, JPY 4,478,500 3/19/2008 0:09 AUD 25, JPY 2,312,500 AUD 75, JPY 6,791,000 3/19/2008 1:08 -AUD 25, JPY 2,327,500 AUD 50, JPY 4,463,500 3/19/2008 4:46 AUD 25, JPY 2,311,250 AUD 75, JPY 6,774,750 3/19/2008 5:11 AUD 25, JPY 2,305,000 AUD 100, JPY 9,079,750 3/19/2008 6:23 -AUD 25, JPY 2,308,250 AUD 75, JPY 6,771,500 3/19/2008 8:36 AUD 25, JPY 2,297,500 AUD 100, JPY 9,069,000 3/19/2008 8:52 AUD 25, JPY 2,275,500 AUD 125, JPY 11,344,500 3/19/2008 9:04 -AUD 25, JPY 2,290,000 AUD 100, JPY 9,054,500 3/19/2008 9:14 -AUD 25, JPY 2,280,750 AUD 75, JPY 6,773,750 3/19/ :31 -AUD 25, JPY 2,307,500 AUD 50, JPY 4,466,250 3/19/ :08 AUD 25, JPY 2,306,750 AUD 75, JPY 6,773,000 3/19/ :35 AUD 25, JPY 2,292,500 AUD 100, JPY 9,065,500 3/19/ :51 -AUD 25, JPY 2,307,500 AUD 75, JPY 6,758,000 3/19/ :40 AUD 25, JPY 2,266,250 AUD 100, JPY 9,024,250 3/19/ :13 -AUD 25, JPY 2,275,250 AUD 75, JPY 6,749,000 3/19/ :36 AUD 25, JPY 2,265,000 AUD 100, JPY 9,014,000 3/19/ :23 AUD 25, JPY 2,260,250 AUD 125, JPY 11,274,250 3/20/2008 4:22 -AUD 25, JPY 2,271,250 AUD 100, JPY 9,003,000 3/20/2008 6:40 -AUD 25, JPY 2,267,500 AUD 75, JPY 6,735,500 3/20/2008 6:40 -AUD 25, JPY 2,267,500 AUD 50, JPY 4,468,000 3/20/2008 6:40 -AUD 25, JPY 2,267,500 AUD 25, JPY 2,200,500 3/20/2008 6:40 -AUD 25, JPY 2,267,500 AUD 0 JPY 67,000 18

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