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Statistical Arbitrage, Market Correlations & GBPJPY vs S&P 500
One BIG reason why two different markets track each other so closely is because of statistical arbitrage. Statistical arbitrage is when professional traders, think Wall Street trading desks, identify two markets that for various reasons are currently tracking each other. They then set up operations to take advantage of this by trading the spread between the two markets. Generally speaking when that spread deviates a certain distance from the mean they take positions in anticipation of it reverting back in line with its previous behavior. Once professionals hone in on a profitable strategy betwen two markets, and get paid interest (carry) on it to boot, they maximize their operations and positions, meaning they get very greedy and trade very large. The bulk of derivitives volume -- is this case meaning futures and forex -- is involved in statistical arbitrage. There is no comparing the huge volume involved in these arbitrage operations to retail position traders, which is what the majority of us are. It's like comparing a battleship to a bass boat. Professionals generally chose two intruments which would be equally influenced by fundamentals, such as German bunds and Euro -- think of fundamentals as a balanced force, but have been known to trade more diverse spreads such as Japanese Yen and US bonds where the risk is a fundamental event that could be an unbalanced force. It is these massive trading accounts that have the effect of binding markets together. The threat to such strategies is if either side of the spread is effected differently by fundamantals -- think an unbalanced force. My partner Jake is the most experienced forex guy on our desk and he's whose pointed out to me how so many currency pairs track the S&P's. NewstraderFX is also obviously an expert on this relationship prefering to follow GBPJPY vs US stock indices. The recent mortgage mess has had the effect of an unbalanced force on the spread between the carry trades and the US stock market. Before I touch on that let me explain the effects that modern savers/investors have on the stock market. The S&P's enjoy a huge bid every two weeks due to 401K inflows. Many employees in America have the option of contributing a portion of thier pay checks into a tax deffered 401K plan. Almost all those plans give thier participants the option of putting a portion of thier savings/investment into stock indices -- think S&P 500. -- along with cash and bond choices. What this means is you can count on BIG money being shoveled into the indices every pay-day. IMHO it's been the most front run trade over the last 20years. I've done a bit of work on it and Jack references it occasionally on his CNBC shots. So we have this bid coming into US stocks regardless of outside influences. On the other hand we have GBPJPY, the carry trade of choice for so many traders. Initially the mortgage mess was a balanced force on both US stocks and the carry trade and we saw how both collapse in July/Aug for fairly straightforward reasons. Many Wall street firms got crushed, and many stocks got whacked. Wall Street traders had no choice but to pull back thier trading operations on orders from above -- the brass had a good idea of the garbage on their books and likely felt they could not afford to let thier traders keep operating on the large scale they were accustomed to because the firm could not afford the risk. What that meant was was when the smoke cleared and the markets gave buy signals again, the biggest traders had to go back in on a smaller scale. Stock market investors however, more specifically 401K holders, who are by nature and function dollar cost averagers, just kept right along buying, every two weeks, like clock work. At this point the force became unbalanced. Wall Street desk traders had to pullback thier horns, but middle class America kept shoveling the coal into the stock market engine. So there was less money going back into the carry trade and the same amount of money going into the S&P's. The mortgage backed garbage is also having an unbalanced effect on British institutions and Asian institutions. Whether this is because the British books are more transparent then the Asian books, we don't know and have to take price as the judge. And that is my simplified explanation as to why the S&P's eclipsed the summer highs in Oct while GBPJPY only recouped approx 2/3rds, and why the S&P's have currently retraced over 50% of the Oct/Nov sell off, while GBPJPY is lanquishing in the the lower 1/3 of the 220 to 240 range. Jay Norris 800-971-2154 [email][email protected][/email] [url]www.brewerfx.com/jnorris/[/url] DISCLAIMER: Forex (off-exchange foreign currency futures and options or FX) trading involves substantial risk of loss and may not be suitable for every investor. The value of currencies may fluctuate and investors may lose all or more than their original investments. Risks also include, but are not limited to, the potential for changing political and/or economic conditions that may substantially affect the price and/or liquidity of a currency. The impact of seasonal and geopolitical events is already factored into market prices. Prices in the underlying cash or physical markets do not necessarily move in tandem with futures and options prices. The leveraged nature of FX trading means that any market movement will have an equally proportional effect on your deposited funds and such may work against you as well as for you. In no event should the content of this correspondence be construed as an express or implied promise or guarantee from B.I.G. Forex, LLC and Brewer Investment Group, LLC or its subsidiaries and/or affiliates that you will profit or that losses can or will be limited in any manner whatsoever. Loss-limiting strategies such as stop loss orders may not be effective because market conditions may make it impossible to execute such orders. Likewise, strategies using combinations of positions such as “spread” or “straddle” trades may be just as risky as simple long and short positions. Past results are no indication of future performance. Information contained in this correspondence is intended for informational purposes only and was obtained from sources believed to be reliable. Information is in no way guaranteed. No guarantee of any kind is implied or possible where projections of future conditions are attempted.
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