Trading Forex With An Edge

by: Brett Steenbarger
A little while back, I wrote a post on surface vs. deep reasoning in technical analysis. The gist of that post was that technical analysis, like any form of analysis, may be conducted simplistically by following untested, linear relationships or in a more sophisticated manner by exploring supply/demand relationships within and across markets.

While I sometimes call permabears to task for their simplistic analyses (and the untold number of Dow points they have cost their followers), I'd have to say that the retail currency markets are the bastion of simplistic technical analysis. Perhaps this is because (apart from the currency futures markets), there really isn't a consolidated market (and hence consolidated volume figures) for spot currency trading. It is difficult to investigate price-volume relationships when volume data are not available.

As a result, many retail currency traders trade some variation of the theme: past price change informs us about future price change. There is no consideration of *why* currency markets would be rising or falling; only a (simplistic) analysis of whether markets are rising, falling, overbought, oversold, etc.

Professional traders of currency markets, on the other hand, seem to have a broader grasp of intermarket relationships. They will look at various currency crosses and use these to better gauge whether, say, a rising Euro/Dollar is a function of a strong Euro, a weak Dollar, or both. They will also look keenly at economic reports and central bank decisions--not just in the U.S., but worldwide--to better understand relationships among currencies. Finally, the pros carefully watch interest rate trends--interest rates and yield curve dynamics worldwide--to gain a better sense of how money will flow to attract the best returns.

A simple test of Forex traders in the U.S. is to ask them about recent ECB and BOJ policy and recent movements in European and Asian interest rates and what those mean for the currency markets. If you get blank looks, you know that you're dealing with market participants who are a couple of toys short of a happy meal.

But that doesn't mean that all technical analysis applied to currency markets need be simplistic. Studies of interest rate movements vs. future currency behavior, for example, may be most enlightening and will be the topic of a future post.

Even within the domain of price action, relationships may be informative. Consider the volatility of currency price movement. In a volatile currency regime, there is considerable uncertainty over the proper valuation of one currency vs. another. In a stable regime, valuations are more settled. In that sense, we can view currency price volatility as a kind of sentiment gauge.

I went back to the start of 1978 (N = 7437 trading days) and examined the British Pound (GBP) vs. the Dollar on a daily basis (cash market). Specifically, I took the median size of daily price changes over a moving sixty-day period and examined the relationship to price changes in the GBP/Dollar over the following 60 days.

This is a relevant analysis, because the Pound has not only been strong vs. the dollar, but the median volatility of daily price movements over the last 60 days has been historically low-- below the median level since 1978.

Based on a simple median split of the data, when we've had a relatively volatile Pound/Dollar over a 60-day period, the next 60 days in the Pound have averaged a loss of -.31% (1760 up, 1959 down). On the other hand, when we've had a relatively calm Pound/Dollar over a 60-day period, the next 60 days in the Pound have averaged a gain of .65% (2042 up, 1676 down).

Interestingly, when the Pound has been up vs. the Dollar over the past 60 days *and* volatility of median daily price movement has been low, the Pound has averaged a gain of .94% over the next 60 days of trading (1167 up, 895 down).

What that suggests is that volatility may be an important variable in determining prospective currency market returns. A strong currency in a regime of relative daily consensus regarding valuations may be likely to continue its strength until economic fundamentals and/or central bank policies dictate a change. Such analysis takes us just a little closer to a deeper understanding of why foreign exchange markets move, enabling us to tilt probabilities a bit in our favor.