Saturday, February 26, 2011

EURUSD-USDCHF Correlation Strategy


“The market does not reward iconoclasts.” – Joseph Trevisani


Technical analysis is essentially the study of human behavior. Many price actions can be used to the trader’s advantage provided that he understands how each price action functions. Correlation as a price action is of enormous importance. Markets are generally uncorrelated during consolidation periods and correlated while trending. We generally operate under the assumption that losses generated when the trend weakens will be recovered when the trend resumes.

The Pedigree of the Strategy

There had to be better ways of curtailing risk and correlation strategies are proving to be one of the answers. Correlation is good profit in itself, as well as being an effective check on risk. For those who weren’t aware of it, the EURUSD tends to be negatively correlated with the USDCHF, whereas it often gets positively correlated with the GBPUSD. Furthermore the AUDUSD and the NZDUSD generally get positively correlated; and so are the EURAUD and the EURNZD. Likewise, the EURJPY and the GBPJPY are positively correlated. There are other examples that time wouldn’t permit me to mention.

This article would focus on the EURUSD-USDCHF correlation. It’s very rare to see both the EURUSD and the USDCHF going up, but it isn’t rare to see both of them coming down. What would happen if the EUR is weaker than the USD while the USD itself is weaker than the CHF? Both the EURUSD and USDCHF would be caught in bearish moves (as evident on December 2010). With this strategy, I consider it sensible to call short trades only since it’s assumed that a pair that rises would eventually fall. Short positions are opened each on the EURUSD and USDCHF. A loss from one pair is recovered by a profit from the other pair. Plus profit would be maximized if both pairs are falling. It’s easier for spot Forex prices to drop than to rise, and there’s no such thing as a permabull market.

Entries and Exits

This is an NFA-compliant cum non-directional strategy: it’s a purely discretionary system – incorporating rule-based entry and smoothing techniques. In order to know when to enter and when to exit, the RSI (Relative Strength Index) 14-period is used. There’s a need to avoid too many or too scanty signals, and that’s why a 4-hour chart is used. The chart we watch is the EURUSD chart. We enter 2 ‘sell’ orders on the 2 pairs when the RSI is in the overbought region and exit when it gets to the oversold region (with the understanding that there would be a positive difference between the result of the EURUSD trade and the result USDCHF trade). We don’t enter the market again until the RSI reverts back to the overbought region. Please, bear it in mind that it may sometimes take a long time for the RSI to move from the overbought region to the oversold region and vice versa.

Trade Management

As said earlier, loss from one position is compensated for by profit from the other position. Moreover, profit is usually optimized in that the EURUSD moves faster than the USDCHF. A position size of 0.01 lots per trade is used for each $1000 (thus making it 0.1 lots for each $10000). The Stop Loss is 500 pips from the entry price and no take profit is set – for profits are always taken when the RSI is traded thru. The wider the Stop, the larger the annual returns, but the tighter the Stop, the smaller the annual returns (whereas tighter Stop reduces the exposure of a portfolio). The tighter the Stop, the higher the number of trades, and vice versa. The tighter the Stop, the lesser the trading accuracy while a wider Stop brings more accuracy (but lesser accuracy can also bring good results). Coupled with small position sizing, a tighter Stop brings higher drawdown whereas a wider Stop brings smaller drawdown.

A Trade Example

The accompanying chart depicts the EURUSD when it was falling and how I took an advantage of it. Between December 31, 2010 and January 10, 2011, the EURUSD fell by over 450 pips. You’d get more insight into this correlation methodology by trying to check the 4-hour chart movement on the USDCHF during and after this period. The vertical red line on the left shows where a short trade was entered and a similar line at the right shows where it was exited. The strategy you need to make money should be simple, but powerful.

Conclusion: It’s very much important that enough patience is exercise as regards the entry and exit criteria of this strategy. The article above is a free gift for all my readers (it shouldn’t be used for any commercial purposes), and therefore any questions and opinions about it are welcome. Finally, it doesn’t entail any solicitation to assume a market decision.

NB: An article about effective gap trading in Forex is coming soon (but only my clients would have access to the account on which it’s being traded).

I’ll end this article with a quote from Christian Lukas:

“The enormous effort that goes into collecting information can be considerable reduced by using a systematic approach … If a trader achieves profits after careful analyses, then these are based on his own skill, which creates confidence. And if he makes loses despite spending a great deal of time conducting an analysis, he knows at least that those losses are just part of the system.”

Your questions and opinions are highly welcome.

Thank you.

With best regards,

Azeez Mustapha

Forex Signals Strategist, Funds Manager &Coach

Senior Analyst

FX Instructor, LLC


Yahoo! Messenger ID: saazalmu

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