Zeusjoes Market-Neutral Hedge Strategy

Hi Everyone. I’ve been a long time lurker on FF and since I’ve finally reached some level of success in my trading I thought it would be a nice thing to share some of my findings with the rest of the community.

The ideas of this system were given to me by my sisters’ long time ex, a former hedge fund tech who I happened to come across in a bar about a year ago. He told me that he’d been doing some research on correlated movements of currency pairs and that his former employers were making a killing in the forex market with strategies based on his work. I was a bit intrigued by the thought of creating a strategy which success was based, not on the direction of one pairs movement, but rather the correlation between two currency pairs. After doing some research of my own and reading up on a lot of the mathematical theories behind correlation trading I’ve managed to put together a strategy that has delivered some remarkable performance over the last couple of months. Last month I was up 34 % on my account with very few draw downs.

The idea is quite simple and tries to mimic the so called pairs trading done on stocks by many major StatArb hedge funds. I look at two currency pairs that seem to have a correlated price movement in the past like for example EURJPY and GBPJPY (see chart 1).

When the spread between the two pairs deviates from their past behavior I simply sell the over performer and buy the underperformer. In this case I would sell GBPJPY and buy EURJPY. This way I have isolated the success of my position to the spread between these two pairs and hedged out the risk of the market in general moving in either way. As long as the spread between the two pairs shrinks back to normal I’ll make money without regard to the market direction.
I have found that exotic pairs like the Nordic countries SEK/NOK/DKK seem very good when using this strategy. But I’ve also had some great success with GBPJPY and EURJPY and I have recently been looking at pairs including oil, silver and gold which look very promising but I have yet to start trading these.
The system can be used both for long term and short term trading depending on the amount of correlation between the pairs traded. If you have a look at the daily chart of GBPJPY vs. EURJPY (Chart 2) you can see that there have been some great opportunities over the last two years with long term trading these pairs.

I hope that some of you will find this strategy useful and I will continue posting here with more information on the strategy. If you have questions I am happy to answer them or suggestions on how the strategy can be made even more profitable.

Best of trading luck to all of you. /Zeusjoes

Hi!

I've studied a strategy like this some time ago, but seems that you have to be very aware of the parameters you use to establish a normal spread and wider spread so you can take positions.

If you can I'd like to know for you what is a regular spread for eurjpy and gbpjpy and the rules you use to enter and exit a trade and if you considered using much smaller time frames i.e. 5min when trading small spread pairs like eur/usd .

Regards,

Guilherme

Can you explain more detailed what is spread betwen 2 pairs? I know what is spread.....but i don't know what is spread betwen 2 pairs.....

What parms are you using in this? How do you balance the hedge? I'd be interested in seeing the math, only reason I've never cross-hedged like that is I can't find a setup that actually reduces my net risk.

If you hedge GBPJPY with EURJPY or vice versa, you are in effect trading EUR/GBP

and you pay more spread

He may be taking either a long or short EUR/GBP position.
We don't know. He hasn't given any details.

please i will like to know wat u mean by the spread betwn d two currencies thanks

I have one thought about the position size of the two orders. Seeing that GBPJPY have a daily range that is approximately 2x the size of EURJPY, is the position size of the EURJPY 2x the position size of the GBPJPY?

Right... volatility would be important. In balance it'd be a long eurgbp, which isn't exactly hedging, unless he's also short that. In the case the hedge value would be the difference between the actual pair and a virtual pair. That'd end up as arbitrage really, with 3x the cost of spread.

Would really like to see the numbers there.

Edit: Crunching the details I don't see how the above could pay off. So...

Looking back at this period (H1 TF) and what the close of the bar was we have these numbers for the pairs:

Date Time GBPJPY EURJPY EURGBP
2008.05.05 09.00 208.18 162.84 0.7822
2008.05.06 10.00 205.82 162.34 0.7887

Difference (in pips) -236 -50 +65

So as you can see if you would have bought EURJPY and sold GBPJPY you would have won 186 pips. On the other hand buying EURGBP would have only giving you 65 pips.

This means that buying 1 lot EURJPY and selling 1 lot GBPJPY is not the same as buying 1 lot EURGBP, although it would seem like that would be the case.

EDIT: Looking at the tickvalue at the moment I see that the tickvalue for GBPJPY and EURJPY is about $9.55 while the tickvalue for EURGBP is $19.70 and I guess that is something that one has to take into account as well. But there's still a difference.

Hi Zeusjoes,

I have heard of something similar used by a Forex managed fund using 2 or more correlated pairs but I am not sure whether this is the same. (FYI, that managed fund got blown out with a total lost of $8 million worth of funds).

Since you mentioned using GBP/JPY and EUR/JPY as an example, it will be helpful if you can show us an example on what are the entries for each pair to enter and exit to illustrate your point. It can be something of the past as well. A chart will help too. Thanks.

Goes to pair volatility, GBPJPY moves more than EURJPY, so assuming equal lot sizes yes this would be true. But in order to do a real hedge you'd need to adjust your lot size to volatility. What I don't get is how this method is any less risky than simply taking a single directional trade. In other words this isn't "market neutral" it's just a directional trade with higher spread costs.

Unless there's something I'm missing...

In his words he is waiting for them to go out sync, eg when they are not as correlated as they should be and on that he decides which pair to sell and which to buy thinking that they would get back to their correlated state. That is how I am understanding this, but I think we'll have to wait for him to come back and gives us more info.

NowAndLater - this is how I get it as well.
Traditionally, pairs-trading would work as follows;

Continuous analysis - Find highly correlated assets:

1. Do the correlation calcs. Check the Mataf site tables for initial ideas when dealing with FX.
2. Aim for a correlation at > 0.90. But not too high - this would only mean that "out-of-correlation" movements are too rare.
3. Be careful with the sliding window size! Too old values would distort your model.

Spot the oppertunity - When correlation changes in a drastic way:

1. Wait until the "gap" is about to close.
   That is, the difference is on its way back to the "normal state".
2. Go short / long on the two underlying
3. Take profit based on previous calcs and assumptions.

Restart - Recalculate correlation very often

1. Depends on time frame...

I started to build an EA out of this once but things came in between.
Anyone else tried this "for real" and have charts/results? Perhaps I will try to find the code and have a look at it again during the weekend...

Regards,
Maki

As regards to market neutrality with these two pairs in specific - if we have a look at the two pairs we can see the correlation between the value of the EUR and the GBP. The two currencies tend to move close to each other since the economies are intertwined and the bank of England and the ECB both want to keep them close. Every now and then one of the two over performs but in the long run the ECB and BOE will have their say and correct the difference. (Simply put)

What we want to do is play with this relationship, we use the JPY as a benchmark to measure the currencies against each other to make visable the spread between the two. The market neutrality in this case refers to 1) the value of the JPY does not matter 2) Since the GBP and the EUR are highly correlated they will eventually revert back to mean. So, if we make our trades when the differances are big we take little risk and have a good chance of a successful trade. I use this strategy also for stocks and futures but since this is a forex forum I will keep to this subject.

Someone asked how I keep track of the spread. We'll acctually I have a second version of metatrader installed with a demo account. Everytime I recalibrate my pairs I simply take the two positions in the demo account. That way I can track the spread easily.

You might be right that the same position can be created with a directional trade on EURGBP at lower spread costs. This is something I havent even considered so cheers for pointing that out. Either way the USD would be a cheeper benchmark currency.

Could you please go more into detail and perharps post some charts as well?

Total silence from the author.

The problem is how to see that both are losing correlation.
Is it possible to overlay to linecharts with MT4?
And if the move away from each other you still don't know when they are going to close the gap.

I'm sorry for not replying in a while. Had a pretty bad breakup a couple of weeks ago but now I'm back on my feet. I realise now when reading my first post that it is a bit unclear. I have made a indicator that I think will help everyone who is interested to understand what I'm talking about. Will post it this weekend.