Forex Arbitrage

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Category: Arbitrage

Published: 21 December 2017

Trade on the forex market with the help of programs (terminals) and computers has become for many an exciting activity, compared to which attempts to call brokers and give them orders during a panicking market seem simply a nightmare.

At the same time, electronic (online) trading has revealed to observant and active traders one pattern, which will be discussed in the material. Today, a large number of brokers (DCs or dealing centers) provide their services on the market, but each of them, although built on similar principles, has its own algorithms of work and translation of quotations to user terminals. Now we are not talking about attempts to deceive the DC, but about the technical features of online trading, which allowed to perform operations such as forex arbitrage.

If we open terminals of two or three brokers, we notice that the quotes of one may lag behind the others, but in general it is possible to repeat or almost repeat the price curve of the remaining brokers. This is what we need: when we see the price movement in a fast terminal and its lagging behind in a slower terminal, then in the latter we open the position in the direction of price movement. To open a position, the price difference in the terminal must exceed the spread / commission. It takes very little time to make a decision in this situation and it is almost impossible to make such operations by hand. To work on the system of forex arbitration, special programs have been created - trading robots that open and close transactions in accordance with the specified terms of trade, usually when prices are leveled in terminals. This system is not designed for the average retention of positions and refers more to scalping trade. Too long position hold (more than 10 minutes) in this case is not advisable, because the price difference in the terminals is most likely not caused by the beginning of large movements or other price hikes, but by technical hiccups or adjustment of equipment. The chances of catching a serious movement are extremely low, but getting a drawdown on your account, and then for a long time and, often, it is useless to wait until the account comes out of it, it is quite possible, therefore a deviation from the rules can negatively affect the balance.

Sometimes there are situations where the difference in terminals is impressive, but the transaction does not open due to requotes - this is the standard situation and it is also necessary to act in it standardly. In order to profit from such situations, it is necessary to open at a time when the difference has not yet reached the size of the spread, and the closing is effected in a situation of a reopening. Thus, the number of transactions will become noticeably larger, and the statistics and account will tell us about the profitability of the system.

This trading algorithm, in which only one position is opened, is called "one-legged", that is, the transaction occurs in one of a pair of terminals. Profitability of work is calculated by statistics, which must contain enough data for the conclusions (minimum of 30 transactions).

Arbitrage strategies

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Category: Arbitrage

Published: 21 November 2017

Arbitrage strategies are rightly recognized as one of the most reliable in any market, since they make it possible to earn on the movement of prices, as such, without binding to a specific direction. Like most other approaches, the first arbitration tactics appeared on the stock and commodity markets, and only after the 1980s the process of their optimization for Forex began.

In part, this was due to the late appearance of the modern currency market, but the main reason is still in the architecture of the Forex market, but today we will not blow out the dust from history, of course, we will consider the most popular arbitrage strategies.

So, the very first method, which occurs in any forum or worse - at seminars, is called "triple arbitration". It is reduced to trading three currency pairs in the hope of catching the discrepancy between the synthetic rate of the third pair and its real current price. Such an approach does not bring results, so we will not even waste time on its detailed description.

Of course, sometimes it happens that someone, ostensibly, earned a triangle, but in reality everything amounts to an erroneous calculation of the volume of orders.

In simple terms, the profit was obtained not on the price difference, but due to the fact that the volume of one pair was more than the other. Therefore, it is better to go directly to effective arbitration strategies, proven time.

INTERMARKET ARBITRAGE

In the environment of beginning Forex traders, a negative stamp is attached to arbitrage strategies, as many understand them playing the game on the difference in the quotes of several DCs, which appears due to technical failures. In fact, such an approach has nothing to do with arbitrage.

Before understanding further, remember, and what is Forex? As a rule, this term means a spot currency market or in other words - an interbank, and this is absolutely true. But on the stock exchanges there are also currency futures, the dynamics of the prices of which may differ from the trend on the spot market.

Thus, from time to time it becomes possible to earn honestly on the resulting exchange rate difference of the same currency, performing opposite operations on completely different sites. In this situation, the speculator sells an expensive instrument and buys the one that turned out to be cheaper.

It is not necessary to have a serious capital for such operations, as now the CME (the Chicago Mercantile Exchange) can start trading in a contract for the euro with only $ 500, and transactions on a real interbank bank may well replace the dealing center (hereinafter DC) with low spreads and commissions.

Some enterprising speculators are building even more cunning schemes with exchange offices, electronic payment systems, "special unique" are not lazy to travel with suitcases, even in different regions, where there are profitable courses in banks, but this is more of an ordinary gamble, and not business, .

ARBITRAGE STRATEGY ON CORRELATION, SPREAD TRADING

In order not to cause confusion, we recall that in this case, under the "spread" (hereinafter we will write it in quotation marks) is understood not the difference between ask and bid, but the difference between the prices of two or more instruments. Perhaps this is one of the most reliable ways to multiply the probability of a profitable transaction, while minimizing the risks. Before opening orders, you will need to perform several actions:

• choose DC with minimal spreads, in this case even the floating spread will not be a hindrance, since stop-loss is not used;
• select high-correlation instruments in the long term, as an example, a combination of the dollar index and the pair usdsek (Swedish krona);
• at the last preparatory stage, we plot the pair "spread" either in the form of a difference, or in the form of a price ratio (this is not in principle) using special indicators.

Currently, there are a lot of such indicators, but it is better to limit the modification of the known dollar index, which can be edited in any way in MetaEditor, in particular, for our example we get the following result (to edit the parameters, we'll have to open the editor):

As you can see, thanks to the high correlation, partly due to the algorithm for calculating the dollar index, the "spread" spreads most of the time within a certain range, periodically testing the boundaries. This is the main for most arbitrage strategies on Forex.

At the very beginning of the publication, we mentioned that arbitrators absolutely do not care which way the price will go. With regard to the situation with the crown this will mean the following: a pair of "pre" usdx / usdsek will decrease if:

• The dollar as a whole becomes cheaper faster than the crown;
• Crown as a whole rises in price faster than the dollar;
• The dollar rises in price more slowly than the crown.

Thus, the main thing is that the dual "spread" spreads from the upper limit of its range, and which scenario from the above will develop - it does not matter. After the newly made "synthetics" fought off and went in the right direction, we sell usdx and buy usd / sek. After some time and exit of the "portfolio" in profit, it is recommended to include a script or an adviser, which will close both transactions when the breakeven level is reached.

A private type of spread trading is the purchase and sale of the calendar "spread", which can also be rightfully called an arbitrage strategy, but they do not presume trading from the range boundaries, but the purchase (sale) of a short-term contract (futures on the underlying asset) and simultaneous sale (purchase) distant contract.

As a result, the speculator's financial result will depend only on how fast the demand for individual contracts will grow or decrease, but what kind of market there is formed - bull or bearish, it does not matter. By the way, such arbitration strategy helped the funds to save tens of billions of dollars during crises with their long trends.

Season spread

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Category: Spread trading

Published: 21 November 2017

Every modern person is familiar with the concept of seasonality, for example, we are all accustomed to the rise in prices of fresh vegetables in the winter or the rise in price of fuel in severe frosts, but few know that on such patterns one can earn by trading spreads.

Spread here is not the difference between the ASK and BID prices, which many forex traders are used to, but the difference between the prices of two (or more) commodities or securities. For example, if a bushel of corn costs $ 4, and wheat $ 3, the spread between them will be $ 1.

From the point of view of technical and fundamental analysis, spread-trade is no different from ordinary speculation, i.e. on these synthetic indicators, trends, impulses and kickbacks are formed, which can be used to extract profit, but the most interesting in this case is the seasonality, since it makes itself felt even at such moments when the underlying assets strongly correlate.

A BIT OF THEORY

As we noted above, seasonal trends are familiar to every person, moreover, if the price increase provoked by devaluation and high inflation always causes anxiety and indignation, then the periodic increase in price tags in stores for certain products is perceived by the consumer absolutely normal.

For example, in virtually all countries of the northern hemisphere, the demand for refreshments is increasing in summer, and their retail prices are also rising slightly. If we look at global macroeconomic trends instead of retail, we can give another example: in December grain traditionally becomes more expensive, as the next harvest will not be collected in the near future, and spring sales of balances will begin closer to April / May, when the prospects of the new season will become clear.

In the financial market (if more precisely - commodity), a similar principle works, i. quotes of some derivatives depend on a number of factors that manifest themselves almost every year and stimulate key players to sell / buy the asset. Such trends are called seasonal.

Now about spreads. There is a logical question - why not trade in conventional contracts (CFDs or futures), because they are subject to seasonal trends in the first place? The fact is that due to the influence of specific factors on inter-commodity spreads, there are sometimes such tendencies that are imperceptible on the underlying assets.

For example, in the current market realities, corn and wheat synchronously increase in price, while this trend can not be described as a long-term pattern. At the same time, the spread between these goods increases seasonally, i.e. corn grows in price faster than wheat.

A similar seasonal trend on the spread could have formed under other initial conditions, namely:

• Corn went up, the wheat became cheaper;
• Wheat became cheaper faster than corn.

Thus, when trading the spread, we eliminate the influence of unpredictable events (a speculative factor) and work out only the most reliable patterns that reflect the dynamics of supply / demand for goods in the real sector of the economy.

MARKET OF CEREALS AND OILSEEDS

Since we have already mentioned corn with wheat, we will begin our survey with them, in particular, in order to obtain the appropriate trends in the MetaTrader4 terminal, we can use the indicator Ind_Seasonal_Trade, which automatically brings some quotes to a comparable kind. It can not be said that this algorithm is very popular, but you can easily find it in the MQL5 database.

As for the actual calculations, it is allowed to use conventional glued CFDs as the base. Of course, this technique is inferior in accuracy to the analysis of futures contracts, but, from the statistical point of view, this error is insignificant.

So, in the graph above was the dynamics of the average seasonal trends on the spread "corn-wheat" for the last 3, 5 and 15 years, respectively. As you can see, the first obvious trend is formed from December to mid-May, i.e. it lasts winter and spring.

Within the framework of the indicated trend, corn is in great demand than wheat, so in the first days of December it is advisable to buy maize contracts and simultaneously sell an equivalent volume of wheat CFD. Of course, there is no year for a year, so sometimes the signal considered will be a loss, but statistics show that the probability of working out this pattern is about 87% (13 out of 15 cases).

The law just considered is very easy to explain. Firstly, in winter the demand for corn is increased by livestock complexes, since this cereal is one of the most nutritious feedstuffs. Wheat does not receive such powerful support, as it is used mainly in the food industry, the demand for products of which keeps at a stable level almost all the year round.

Secondly, closer to spring, farmers and consumers of corn closely monitor the weather conditions in the US / Europe and, with the slightest hint of late planting, begin to hedge the risks by purchasing the relevant fixed-term contracts. With wheat such an acute problem is not observed, since it gives two crops - winter and spring.

The latter reason is indirectly related to the previous one. The fact is that in April and May (when the potential of a new crop can be estimated as a spring field in the fields), farmers and wholesalers start to get rid of old wheat stocks. These actions put pressure on prices.

And the second trend on this spread is the diametrical opposite of the cycle just considered. In particular, long-term observations show that from June to mid-August demand for wheat exceeds the market demand for corn.

As you can see, the sale of corn and the simultaneous purchase of wheat at the specified time interval brought profit in 13 cases out of 15, therefore this regularity can be considered quite reliable .

As for the reasons for the formation of this trend, then here again the explanation should be sought in the real sector. Recall, CFD quotes are tied to futures traded on CBOT, and the prices of the latter, in turn, depend on the moods of large producers and processors of raw materials in the US and Canada.

In June, the above subjects begin to closely monitor the situation in the fields, i.e. study the publications of the US Department of Agriculture on the state of crops, look at the forecasts of the meteorological service, and monitor the research of independent organizations engaged in collecting and processing statistics, etc. In other words, they react painfully to any negative news.

In this regard, the prospects of corn are almost not a concern, yet maize is one of the most unpretentious cereals, which is important to sow in time, but with wheat the situation is quite different. The fact is that at the stage of active vegetation the grain is afraid of any deviations from the climatic norm, i.e. it equally badly tolerates downpours, heat and frosts. And what summer does it cost without local anomalies? Hence the imbalance in supply and demand.

And another spread, related to the agricultural market, involves studying the differences between the prices of soybeans, corn and wheat. As practice shows, in the period from October 12 to May 29, it is advisable to buy oilseeds and sell grain (the volumes in each knee of such a transaction should be equivalent).

If we move away from the stock market a little, this transaction will look like this - we buy a bushel of beans and at the same time we sell corn and wheat to the bushel. Of course, the actual volume of the speculative operation will be much larger, since even a minimum lot for CFD involves working with several dozen bushels.

When the bull cycle on the spreader comes to an end, it makes sense to "roll over", since from June 1 to October 11 soybeans start to become cheaper in relation to corn and wheat. The fact is that in the designated time interval, a fresh harvest of soybean is harvested to the market, assembled in Brazil, which puts pressure on quotes.

Statistics show that over the past 15 years, the sale of the "bean-corn-wheat" spread has brought profit in 12 cases, i.e. The probability of working out this movement tends to 80%. In addition, within this trend, one bearish sub-cycle is formed, which continues from September 7 to 11.10 - it can be used to "top up".

So, as we could just see, inter-commodity spreads provide good opportunities for earning CFD-contracts, in fact, we have additional tools that are missing in the terminal and broker specifications.

SPREAD-TRADE IN SUGAR, COFFEE AND COCOA

In addition to cereals, so-called "soft goods" are very popular on the exchanges, so some dealing centers began to add coffee, sugar (USA) and cocoa to the specification, whose prices, in turn, also depend on weather factors and the vegetative cycle.

It should be noted that analyzing the listed instruments is slightly more complicated than the grain market, since their quotes are more susceptible to various force majeures, for example, a strong drought in Brazil can lead to a decrease in coffee yields for the next 2-3 years, resulting in the usual seasonal trends will malfunction.

Nevertheless, statistics are stubborn, in particular, it shows that over the past 15 years, a rather strong upward trend has been forming on the spread of "cocoa-coffee" from April 22 to May 31, which can be used to generate profit.

Since 2002, this signal was worked out in 11 cases out of 15 - is it a lot or a little? Compared to cereal patterns, the calculated probability seems "unprepossessing," but with regard to financial markets in general, the chances seem to be not so and bad.

By the way, earlier we did not focus on the dimension of contracts, as the prices of soybeans, wheat and corn are quoted as "cents per bushel", but when working with the "cocoa-coffee" spread, several important specific nuances must be considered:

• The price of cocoa is measured on a scale of "dollars per ton";
• The price of coffee is measured in cents per pound (0.4535 kg.).

On the chart above, this discrepancy has already been recalculated, but when making a deal it is necessary to make the spread knees equal. For example, if you work with CFD, the cocoa lot is equivalent to 100 kg. product, then the volume of the "coffee" operation should also be equal to 100 kg. (220 pounds). Since the specifications in different DCs are very different, recalculation is best performed at the price of a tick (this is the easiest way to do it).

As for signals to sell the spread of "cocoa-coffee", in this regard, quality entry points are difficult to find. Apparently, the deficit of cocoa beans played its role, which last decade did not allow quotations to decrease significantly.

The only interesting "bearish" interval is observed from June 1 to September 1, but even in this case it is advisable to open short positions on the spread only after the formation of strong UP pulses, i.e. on the return of the indicator to the average price. In our opinion, it is better for beginners to refrain from such trade.

And another important commodity spread is sometimes called "coffee with sugar", as it reflects the discrepancies between coffee and sugar quotes. For the sake of fairness, we note that such an analysis does not seem quite logical, yet the products listed differ greatly in many parameters, but in spite of this, a strong seasonal up-trend is formed on this synthetic instrument from the first days of February to May 8-9.

In particular, the probability of working out the signal considered (simultaneous purchase of coffee and sale of sugar) is about 73%, which is quite good. And since it came about the specifics of the goods, we recommend that you pay attention to the following important nuances:

• Quotes of sugar are highly dependent on the dynamics of the Brazilian real, as Brazil is the largest producer of sugar cane (ie strong strengthening of the BRL can completely eliminate the seasonal factors that put pressure on the prices of the "sweet" product);
• The deficit of arabica is partially compensated by robusta supplies, as a result of which the abnormal outbursts on the coffee market are also rapidly dying out;
• In recent years, sugar is increasingly used in the production of biofuels, so in the future, the demand for it can grow significantly.

Thus, if it is still possible to open seasonal transactions in the grain market without additional filters, then when working with soft goods it is better to insure yourself with technical tools, for example, you can screen out false entry points in the direction of the moving average.

OIL SPREAD

And the last tool, which can not be forgotten, reflects discrepancies in the moods in the US and European oil products markets. Incidentally, if access to CFD for agricultural products can still cause problems, then there is no difficulty with oil, since both brands are represented in almost all dealing centers.

From the point of view of seasonal analysis, it is reasonable to keep the long position from the spread of "WTI-Brent" from April 25 to June 24, as preparation for the "car season" begins at the designated interval in the USA. This term is understood as an increase in the activity of both private motorists and commercial carriers.

All the rest of the time the spread is mainly located in the "outset", therefore it is not possible to recognize the seasonal impulses on it (that is, the probability of their development leaves much to be desired). By the way, trade from the corridor borders of spread traders is also very popular, but this topic is beyond the scope of today's review.

CONCLUSIONS AND ADDITIONAL RECOMMENDATIONS

Today we have once again made sure that the movements in the financial markets are not at all random, on the contrary, the quotes of many assets depend on the fundamental factors that manifest themselves almost every year. If we summarize, for seasonal analysis, we can note the following advantages:

• In its essence, it is elementary, i.e. it is enough to compare the dynamics of several instruments and average the results over the N-th number of years;
• Seasonal entry points are known in advance, i. E. a trader does not have to explore the market every day;
• The likelihood of working out the pattern is also known long before the opening of the position, so the speculator can calmly and weighedly assess his capabilities.

On the other hand, our own observations and responses from Western traders show that, some time after the start of seasonal trade, beginners begin to lose enthusiasm and are disappointed in this method, since it has certain drawbacks:

• First, force majors sometimes violate long-term patterns;
• Secondly, not all speculators have the patience to wait for the development of the trend, which can last up to six months;
• Thirdly, sometimes brokers close the CFD trade without warning, as a result of which the whole strategy collapses;
• And the last obvious minus - the spread often reaches the seasonal peak / bottom before the specified time (for example, according to statistics, the trend ends on May 5, and the maximum of floating profit was fixed on April 15).

In fact, the listed problems only seem serious, but experienced speculators have long learned to deal with them, in particular, to increase the effectiveness we recommend stop-loss, activate the swap-free service (which will allow you to hold the position for a long time), and also use Take-profits equal to the average profit. In addition, you can split the position into parts and fix the result as the price moves in the direction of the forecast.

How to Trade in Spreads: Expert Tips

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Category: Spread trading

Published: 21 November 2017

Types of spreads, how they differ and how to make money on them.

Today, markets are unstable and often completely unpredictable. Therefore, a trader who wants to protect his investments should learn how to use spread operations. What it is? A trader playing on the spreader buys one futures contract and sells another similar futures contract, taking profit from the difference in their value and assuming the risk not of the entire futures contract, but only the risk associated with the difference in the price of the two futures. Spreads are of different types, and, accordingly, the ways of using them are also different.

Calendar spreads. To make money on a calendar spread, you should simultaneously buy two futures contracts for the same product or option with different maturities - this can be simply a mechanical hold on a long and short position in the period when the option expires or the game is over. The difference in the dynamics of two related markets. The further you move in time, the more volatility your operation implies. CME Group offers variants of a calendar spread for corn, wheat, soybean, soybean oil and soybean flour. In general, calendar spreads are common in grain markets due to seasonality of planting and harvesting. For example, if it is corn, then it makes sense to consider the spread of July-December: you are selling the old harvest (in July, mostly sold grain last season) and buying a new one. You can do the opposite, buy a December-July spread, selling a new crop and buying an old one. You can trade year-round spread December-December. For wheat, these will be spreads in December-July, July-December or July-July, and for soybeans - July-November (old harvest / new harvest), January-May, November-July and year-round - November to November.

Joe Burgoyne, director of institutional and retail marketing for the American Options Association, explains: "If it's a calendar spread to options, then you're actually buying an option that will not be out soon, but sells expiring this month. So time works for you, since the option of the last month is the most expensive." He adds that it's best to buy a spread at the time when the expired option is the least time left. Burgoyne says: "The calendar spread is a long position where you bet on volatility, which means that you need to represent the level and nature of volatility - especially in a long position; for the cost of short is much more important time factor."

However, in the commodity markets, the usual mechanisms for trading spreads have changed in connection with the emergence of commodity funds, aimed only at long positions. These funds are guided by various commodity indices and extend positions at a predetermined time on the basis of the prospectus of the index. For example, the S&P GSCI (Goldman Sachs Commodity Index) extends positions from the fifth to the ninth working days of the month preceding the expiration of the options. Funds focused on these indices have become so large, - the positions in some crops exceed the commodity balances of last year, - that the nature of some spreads has changed. For example, in seasonal bull markets, supply contracts for the next month were traditionally more expensive than longer options, but due to the scale of the extension, when huge amounts of expiring options are sold, and long positions are extended for the next month, this has changed. There were cases when due to this effect the "bullish spread" (when an option expiring during a month is bought, but longer is sold) lost money in the bull market.

As a countermeasure, many traders began to practice the "bear spread" (selling the expiring option and buying a longer one) before the period of extending the spreads of index funds, trying to make money on this powerful move. This was often effective. But in case of some problems with supplies, spot prices may rise, and in September 2006, it happened - according to some estimates, traders of the Chicago Chamber of Commerce specializing in wheat, then lost more than $ 100 million.

Thus, it can be stated that some traditional mechanisms have changed, and now the trader entering the spreading position should take into account the availability of such funds.

Intermarket spreads. In the case of intermarket spreads, a trader buys and sells various, though often related, goods, and usually deals with contracts with the same maturity. CME Group offers inter-market treasury and swap-spreads between futures on US Treasury bonds and between US Treasury bonds and CBOT Interest Rate Swap futures. ICS Curve Tracker is also offered to track these spreads.

Jeff Quinto, a sales coach with electronicfuturestrader.com, says: "In intermarket spreads, you trade relative changes. Markets tend to some average values ​​and fluctuate in a certain range, respectively, if now it is in its upper part, then we should expect a return to the average."

One example of an intermarket spread is the spread between hard red winter wheat (it is traded at the Kansas City Chamber of Commerce) and soft red winter wheat (it is traded on the CME Group site). Quinto explains that, since hard wheat is used for baking bread, and is exported, and soft cakes and cakes are made, the demand and prices for this raw material will react differently to changes in market conditions. He says: "If you believe that exports will grow, it is logical to buy hard wheat and sell soft. First of all, it's worth drawing graphics and feel how the prices for these two contracts are related. Then see if one of the types of wheat is sold more than the other. If you think that exports will grow, then the situation is favorable for hard wheat. Now look at the graphs, whether this really is happening - whether the market is reacting to a fundamental factor in the way that, in your opinion, it should. Then, after looking at the charts, you decide whether to go into a long position for hard wheat and short for a soft one."

Crack-spread and crash-spread. For some types of goods there are also unique strategies of spread trade. For example, you can buy futures for fuel oil and unleaded gasoline, and sell futures for crude oil, that is, work with the rate of profit of oil refining - this is called crack-spread (from the word "cracking"). If the crack-spread is positive, this means that the cost of processed products is higher than the price of the raw materials, and if negative, then vice versa. There is an important ratio of 3: 2: 1 - this means that of three barrels of crude oil you can get two barrels of unleaded gasoline and one barrel of fuel oil. However, in the US market, unleaded petrol and fuel oil are counted in gallons (in one barrel 42 gallons).

"The idea is simple: you compare the product with its raw material, that is, you play at the cost of processing. If it is a question of crack-spread, the question is how much the finished product is obtained from a barrel of oil. For each of these processes, there is a certain mathematical equation, and on the CME Group website - the appropriate calculator," explains Kevin Kerr, president of Kerr Trading.

Kerr says: "The spread spread plan will depend on your forecast of the specific market's behavior. If you have a mathematical estimate of the amount of crude oil required to produce a certain amount of petroleum products, this is quite enough. Spread trade is one of the most flexible methods in commodity markets," Kerr said. 

Another spread, which reflects production processes, is a crash spread - trading a spread between soybean futures and the products of its processing, that is, soybean oil or soybean meal.

Trading techniques. Trading spread is usually less risky than a direct futures position, but it can also be different, so you should be careful. Yes, related markets usually move more or less in one direction, but it happens that information appears that affects only one part of the equation, and then the spread can be as volatile as a direct contract - recall the 2006 example with wheat. In addition, this can occur in markets prone to seasonal factors - such, in particular, the natural gas market.

Quinto says: "Yes, the risk of spread trade is lower than that of a direct contract. Volatility here is usually lower, because it's not about the price of the product, but about the difference between the two prices."

Burgoin agrees: "Compared to a simple purchase of options, spread trading is an excellent means of hedging risk. Both volatility and the funds invested - all this is partly hedged."

"Another advantage of the spread is that it moves slower than a direct contract, which additionally reduces the risks," Kerr adds.

However, those who are just beginning a spread trade are looking for a lot of common mistakes. One of them is a misunderstanding of what is happening in the market.

Quinto says: "Sometimes people imagine the processes taking place too simplistic. My advice: specialize in a limited number of spreads, perhaps even on one - the one that you know best."

Burgon, in turn, indicates that the trader should represent the volatility of options with which he works: "It is important to understand at least about what the price of your instrument will be when its time comes. Just the value of the spread falls and if it is more expensive than the price of performance, and if it is much cheaper. You need to feel volatility, because spread trading is, in fact, a long position on volatility. If, after buying the spread, the volatility begins to decline, the losses can be greater than the drop in the price of the expiring option, where you are in a short position."

Quinto notes that it is necessary to know the stop-loss point: "With spread trade, this is a problem, because there are no automatic stop-loss, you have to do it manually. At some pre-selected moment you need to stop. The people are lulled by the slow spread movement, and they wait, wait until it's too late, so you need clear criteria for the level of risk. When you enter the transaction, you need to decide how much you are willing to invest in it, and clearly adhere to this decision."

Kerr advises to trade a "ready" spread on the exchange, rather than trying to form it independently in the form of two transactions. Yes, sometimes it can be a little more profitable, but the additional risk that after the completion of one part of the transaction the second one will be heavily moved is not worth it. "In addition, he recalls that transaction costs are doubled in the case of spread trade, and he also warns: "If you create a spread yourself, it's very important to carry out the actions in the right order. You first buy and then sell. Markets change quickly, and one should not take on unlimited ny risk."

Pair trading on Forex

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Category: Pair trading

Published: 19 February 2018

Do you know what strategies hedge funds use? How to make money regardless of the direction of the market with a minimum risk for the deposit? The answer lies in the use of so-called market-neutral strategies. Private such a strategy is arbitrage. But unlike classical arbitrage, the use of which is available only to a limited number of persons, statistical arbitrage, of which paired trading is a variety, is available to all traders.

In the article we will talk about how to find statistical dependencies, what tools to use for this purpose, and what potential this technique has against the background of a more traditional single-currency trade.

MARKET-NEUTRAL STRATEGIES

Neutral strategy with respect to the market means that the profitability of the strategy does not directly depend on the direction of movement of the price of a particular instrument. This is achieved by creating a hedging position between two or more instruments, the profits and losses of which compensate each other.

One of the main characteristics of such a strategy is a minimal risk, since we exploit low-level market dependencies. Such strategies, for example, include market-making and arbitrage. However, unlike classical arbitrage, statistical arbitrage does not imply a risk-free profit.

In the context of statistical arbitrage, the main task is to create a market-neutral portfolio. To achieve the effect of neutrality, the portfolio must consist of highly dependent instruments, roughly speaking, so that the growth of one compensates for the fall of the other. That is, we need to create a semblance of a closed system where the funds are redistributed between portfolio instruments. Paired trading is a special case of statistical arbitrage and the most popular strategy of such a plan.

PAIR TRADING

By pair trading means simultaneous opening of positions on two interconnected instruments. Dependence is usually determined by their correlation coefficient. The most popular way to evaluate the relationship between two time series is to calculate the Pearson correlation. The stronger the correlation of instruments, the greater the probability of their movement in a single direction.

In this case, there is both a positive and a negative correlation. In the first case, the tools move in a co-direction. Example - GBPUSD and EURUSD.

With negative correlation, the instruments move in opposite directions. Example - EURUSD and USDCHF. Both cases are examples of strong dependence.

In pair trading, the pair's spread is traded, that is, the difference of the two instruments. Since we know that the instruments are moving in a single direction, it means that with the next discrepancy they will likely come back together with a high probability.

The easiest way to illustrate trading on the strategy of pair trading is based on the pair EURUSD and GBPUSD. So, if the spread (difference) between the two instruments is widened to a certain threshold, we buy a lagging instrument and sell it ahead of schedule. When the instruments come together again, we fix the profit.

The magnitude of the threshold discrepancy is determined by the statistical method, by analyzing the history of past discrepancies. For example, this may be an average discrepancy over the past year.

As a result, for us it is absolutely unimportant in which direction a separate tool will go. It is important for us that they come together, that is, their spread is returned to zero. At this point, we fix the profit equal to the size of the discrepancy.

To make this strategy profitable, there must be a constant relationship between the instruments. EURUSD and GBPUSD have a fairly strong positive correlation. However, this dependence is not constant, because of what the pair can disperse for a very long distance and do not converge back.

In fact, trading the spread of EURUSD and GBPUSD is similar to trading their cross - EURGBP.

If the pair had a permanent strong correlation, the EURGBP would always be in a flat state. However, the dependence periodically collapses, in connection with which trends are formed.

DRAWING A SPREAD CHART

Now we turn to the practical part - the construction of a spread of two instruments. There are different ways of calculating the spread, slightly differing in the final result. Which one should be chosen is a matter of individual preferences. The simplest way is to calculate the spread by the difference. That is, the spread formula for EURUSD and GBPUSD will look like EURUSD - GBPUSD.

You can also build a spread with respect to, for example, EURUSD / GBPUSD. It is worth considering that the resulting signals may vary depending on the chosen method, but they do not fundamentally differ.

Next, you need to decide when to enter the position. The task is to enter the market with a strong expansion of the spread, that is, when the connection between the instruments is temporarily lost. A strong expansion of the spread is an expansion more than average. Therefore, a good indicator for the entry can serve as the difference between the spread graph and the moving average.

Thus, we get the spread oscillator. To trade such a spread is extremely simple. When the line enters the overbought zone, that is, the spread has deviated significantly from the average - we sell the spread, when it enters the oversold zone, we turn the position.

In this case, to buy the spread, you need to buy EURUSD and sell GBPUSD. To sell the spread, the opposite is true: we sell euro and buy pounds.

Another method is to trade a spread from the borders of the Bollinger Channel. To do this, just add the Bollinger Bands indicator to the chart of the spread. In this case, the crossing of the canal boundaries will also indicate a significant deviation of the spread from the mean.

CALCULATION OF THE SIZE OF ORDERS

Another important point - the correct calculation of the size of orders for the pair position. It is logical to assume that two orders should be of equal volume, so it is enough to open two positions with the same number of lots. But not everything is so simple. If we consider the discrepancy between the instruments in points, then we assume that the points are equal for both instruments.

In fact, to equalize positions, we need to take into account the different cost of a point of two instruments relative to the dollar. Let's say you want to open a pair position for EURUSD and USDJPY. The cost of the item for EURUSD is $ 1. The value of the item on USDJPY at the moment is equal to 0.87788 $. Thus, to equalize the position sizes, the position volume for USDJPY should be 1.14 times larger than the volume for EURUSD (1 / 0.87788).

CONCLUSION

The most important part of the pair trading strategy is the proper selection of instruments for trading. It should be understood that the strategy itself is not a grail, but with the right selection of correlating assets it is able to produce a stable profit with minimal risk. If you want to start studying the statistical arbitrage, it's definitely worth starting with pair trading.