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Hedge and Correlation Strategy

  • #3,281
  • Aug 20, 2011 3:42am Aug 20, 2011 3:42am
HI! this is where it get dangerous,
the dominant factor is the current trend for one pair,
I think that must also be taken into consideration,
if we rise the lot size for one pair but not for the other
you might be right about the hedge will be more balanced,
but what about when the trend for the higher lot pair suddenly reverses?
isn't that going to make our drawdown larger very fast?
that seems unbalanced to me, but maybe Im wrong?
thoughts?
Bulls are stupid Animals!especially when Im short!
  • #3,282
  • Aug 23, 2011 3:35am Aug 23, 2011 3:35am
Quoting roughtrader
HI! this is where it get dangerous,
the dominant factor is the current trend for one pair,
I think that must also be taken into consideration,
if we rise the lot size for one pair but not for the other
you might be right about the hedge will be more balanced,
but what about when the trend for the higher lot pair suddenly reverses?
isn't that going to make our drawdown larger very fast?
that seems unbalanced to me, but maybe Im wrong?
thoughts?
Hi roughtrader,

The point of trading two correlated pairs is to exploit the occassional difference between them when the correlation moves further apart.

The ideal objective is to be market neutral whilst you do this because you want to trade the correlation difference and not the price movement of the pairs.

In order to achieve this without caring which way the pairs move you need an equally balanced risk for the long and the short pair.

Say for example pair 1 was worth $10 per pip and pair 2 $8 dollars, the first part would be to balance the lots so that each has an equal $ value so in this case we take: pair 1 - 1.0 lot pair 2 - 1.25 lot that way each pip on each pair is now worth $10 per pip.

Next you need to adjust for volatility, for example if pair 1 has a daily range of 100 pips and pair 2 has a daily range of 50 pips then you are taking twice the risk on pair 1 because it is twice as volatile and likely to move 2x whatever pair 2 does but our objective is to be market neutral

so by adjusting for volatility you could trade: pair 1 - 1.0 lot pair 2 - 2.5 lots.

Now each pip is worth $10 and the risk on each side of the trade is the same so if the market makes a 100 pip swing on pair 1 against your position what would happen?

pair 1 goes -100 pips @ 1 lot * $10 = -$1000
pair 2 goes -50 pips @ 2.5 lots * $8 = +$1000

so you are still netural and only trading the correlation difference. It is the whole essence behind pairs trading - be neutral to the market moves trade the inconsistencies.

I hope this makes sense, it is how I trade any market neutral strategy obviously not everyone does it the same but this is the essence behind stat arb trading.
  • #3,283
  • Aug 23, 2011 5:56am Aug 23, 2011 5:56am
Quoting MaxDoom
Hi roughtrader,

The point of trading two correlated pairs is to exploit the occassional difference between them when the correlation moves further apart.

The ideal objective is to be market neutral whilst you do this because you want to trade the correlation difference and not the price movement of the pairs.

In order to achieve this without caring which way the pairs move you need an equally balanced risk for the long and the short pair.

Say for example pair 1 was worth $10 per pip and pair 2 $8 dollars, the first part would be to balance...
thanks that make sense,
could you please make an example how you apply the ATR ratio in a trade where the volatility is higher than the other pair?
still don't understand how to apply this, thanks
Bulls are stupid Animals!especially when Im short!
  • #3,284
  • Aug 23, 2011 5:58am Aug 23, 2011 5:58am
max doom i have a question...

i understand and I think i suggested making sure pip value = the same... however do you look at volatility (which can change) or when you open the trades the % difference between both pairs...

for eg...

spreading GBPUSD and EURUSD.. pip value is the same at 1 lot = $10 a pip,

now despite them having different volatilities the EURUSD is at parity in this example at 1.0000 and the GBPUSD is at 1.2000, so the GBPUSD is 20% more in price so in order to spread you have to use 1.2 lots for EURUSD and GBPUSD use 1 lot???

is this correct?
Grabbing the bull by the horns!
  • #3,285
  • Aug 23, 2011 6:02am Aug 23, 2011 6:02am
Quoting roughtrader
thanks that make sense,
could you please make an example how you apply the ATR ratio in a trade where the volatility is higher than the other pair?
still don't understand how to apply this, thanks

simple just work out % difference between two number... pair A is 60pips, pair B is 30 pips , pair B is 50% less movement so has to be double the size...

or simply:

1 / (Pair B/Pair A) = the lot multiplication
1 / (30/60)
1 / 0.5 = 2 multiply
Grabbing the bull by the horns!
  • #3,286
  • Aug 23, 2011 6:10am Aug 23, 2011 6:10am
Quoting whitegoodman
simple just work out % difference between two number... pair A is 60pips, pair B is 30 pips , pair B is 50% less movement so has to be double the size...

or simply:

1 / (Pair B/Pair A) = the lot multiplication
1 / (30/60)
1 / 0.5 = 2 multiply
so if my ATR pair 1 is 0.0027 and pair 2 is 0.1651
then ?? Im using the standard MT4 ATR
maybe thats the wrong one?
Bulls are stupid Animals!especially when Im short!
  • #3,287
  • Aug 23, 2011 6:20am Aug 23, 2011 6:20am
Quoting whitegoodman
max doom i have a question...

i understand and I think i suggested making sure pip value = the same... however do you look at volatility (which can change) or when you open the trades the % difference between both pairs...

for eg...

spreading GBPUSD and EURUSD.. pip value is the same at 1 lot = $10 a pip,

now despite them having different volatilities the EURUSD is at parity in this example at 1.0000 and the GBPUSD is at 1.2000, so the GBPUSD is 20% more in price so in order to spread you have to use 1.2 lots for EURUSD and GBPUSD use 1...

not quite, you should forget the prices because you want to be neutral and using a direct price will mess that up using percentage differneces does not.

So in your example the $ value per pip is the same so that is ok 1 lot each pair for example = $10 per pip.

But they may have different price ranges so I would use the ATR percentage difference at time of entry to alter the lot sizes so if the ATR value of pair 1 is say 40 pips and or pair 2 10 pips then I would use a 4:1 ratio ie: trade 1 lot on pair 1 and 4 lots on pair 2 to give equal risk.

Use a sensible ATR period that matches the timeframe of chart you are using.

roughtrader I think this answers your question as well
  • #3,288
  • Aug 23, 2011 6:50am Aug 23, 2011 6:50am
Quoting roughtrader
so if my ATR pair 1 is 0.0027 and pair 2 is 0.1651
then ?? Im using the standard MT4 ATR
maybe thats the wrong one?

what pairs are you trading and what timeframe?
  • #3,289
  • Aug 23, 2011 6:51am Aug 23, 2011 6:51am
Quoting MaxDoom
what pairs are you trading and what timeframe?
chfjpy gbpchf 15m
Bulls are stupid Animals!especially when Im short!
  • #3,290
  • Aug 23, 2011 10:33am Aug 23, 2011 10:33am
Quoting roughtrader
chfjpy gbpchf 15m

ok so they both equal out at about $13 per pip so for financial risk you would you an equal amount on each pair lets say 1.0 lot each.

I just looked at the ATR 8 period on the 15m charts and I see that GBPCHF is at an ATR of 0.0026 (26 pips) and the CHFJPY is at 0.15 (15 pips) so the GBPCHF is higer volatility by a factor of 26/15 = 1.73.

So if I was takign this trade now I would use 1.0 lot GBPCHF and 1.70 lots CHFJPY.

hope that helps
  • #3,291
  • Aug 23, 2011 11:36am Aug 23, 2011 11:36am
Quoting MaxDoom
ok so they both equal out at about $13 per pip so for financial risk you would you an equal amount on each pair lets say 1.0 lot each.

I just looked at the ATR 8 period on the 15m charts and I see that GBPCHF is at an ATR of 0.0026 (26 pips) and the CHFJPY is at 0.15 (15 pips) so the GBPCHF is higer volatility by a factor of 26/15 = 1.73.

So if I was takign this trade now I would use 1.0 lot GBPCHF and 1.70 lots CHFJPY.

hope that helps
yes thank you very much for your explanation,
Im begining to get a grip of this now I think,
but what if the ATR change on CHFJPY
after you made the trade from 1.70 to 1.60
should I then close 2 minilots CHFJPY
to keep it balanced?
Bulls are stupid Animals!especially when Im short!
  • #3,292
  • Aug 23, 2011 1:52pm Aug 23, 2011 1:52pm
Quoting roughtrader
yes thank you very much for your explanation,
Im begining to get a grip of this now I think,
but what if the ATR change on CHFJPY
after you made the trade from 1.70 to 1.60
should I then close 2 minilots CHFJPY
to keep it balanced?

No, you enter the trade on a neutral risk profile, for such a short trade (15min chart) you should not need to adjust it once open
  • #3,293
  • Aug 23, 2011 2:03pm Aug 23, 2011 2:03pm
Quoting MaxDoom
No, you enter the trade on a neutral risk profile, for such a short trade (15min chart) you should not need to adjust it once open
I don't know about short,
I noticed on 15M
they usually take 3-4 days to a week
and sometimes longer,
this one didn't really start to move yet,
they moved a bit from -97 friday
today there is a retrace on going,
they are about -50 correlated now,
expecting a pullback to start soon to go back
to atleast zero or even cross.
possibly another week there
Bulls are stupid Animals!especially when Im short!
  • #3,294
  • Aug 29, 2011 6:10pm Aug 29, 2011 6:10pm
Quoting Hugh Briss
To be really honest it just seems logical to me. If two pairs have a correlation then the number of pips difference between them will stay within a range and you should be able to spot the points where the pips difference may be about to drop back into the range.

Like I said I haven't perfected an entry or exit method completely yet but I am trialling this as from Monday on a live account with small lot sizes.

I think I have left an indicator out of the list that you will need, this does USDCHF when you apply it to the eurchf chart. The second...
would it be possible to share the mq4 files also?
Bulls are stupid Animals!especially when Im short!
  • #3,295
  • Aug 29, 2011 7:19pm Aug 29, 2011 7:19pm
I have to say, this system of trading is very profitable. Great trades, until these couple of days. Which is killing my profits.
  • #3,296
  • Aug 30, 2011 8:42am Aug 30, 2011 8:42am
drawdowns can be huge,
Im currently +200 down on CHFJPY GBPCHF, microlot,
but Im confident the gap will close sometime and then Im in profit,
so I will just hold out until then, you just have to sustain the drawdown,
I only enter 1 trade at the time, one buy and one sell so that I have enough equity, and margin,
you need a big acount so you can cover,
then it's just to wait until the gap close,
no matter if it goes against you keep hold on to the position,
you know they allways cross, thats a fact.
thats something you can be sure on.
remember you didn't loose until you close your positions,

this strategy is very profitable,
but you gotto be cool and stay calm,
one way to reduse the drawdown could be to enter a hedge
on the side in the oposit direction
Bulls are stupid Animals!especially when Im short!
  • #3,297
  • Edited 8:56pm Aug 30, 2011 8:55pm | Edited 8:56pm
These pairs seems to be only 42% in correlation. I guess it doesn't matter, since all pairs cross at some point. You just have to position it so that they run about the same speed. I currently have 15 micro lot on AUD/JPY and 5 micro lot on CHF/JPY. That seems to be almost equal to the same pips. One thing though, when they gap bigger and bigger they sure can add up the losses quick. This system is gave me a heartache at times but, when the profits comes they sure come fast too. I'm still holding.
  • #3,298
  • Aug 31, 2011 2:01am Aug 31, 2011 2:01am
Quoting Agent-Pipen
These pairs seems to be only 42% in correlation. I guess it doesn't matter, since all pairs cross at some point. You just have to position it so that they run about the same speed. I currently have 15 micro lot on AUD/JPY and 5 micro lot on CHF/JPY. That seems to be almost equal to the same pips.
Hi Pipen what are you using to adjust the lot sizes? as they are both JPY contracts the so the pip amount is identical therefore your adjustment of 15 versus 5 suggests that AUDJPY is 3x more volatile than CHFJPY
  • #3,299
  • Aug 31, 2011 7:13am Aug 31, 2011 7:13am
Quoting MaxDoom
Hi Pipen what are you using to adjust the lot sizes? as they are both JPY contracts the so the pip amount is identical therefore your adjustment of 15 versus 5 suggests that AUDJPY is 3x more volatile than CHFJPY

I do not use any indicators, just recording how many pips each pair travels in a day. It would be nice to have such an indicator. I just got out of the position I was in, with a nice profit. Just in time, since the US news is coming out in 2 mins.
  • #3,300
  • Aug 31, 2011 1:39pm Aug 31, 2011 1:39pm
CHFJPY GBPCHF are really nice to trade,
allmost like a mirror,

EURUSD USDDKK even more

the spread is high on USDDKK but I find the mirroring very valuble,
you won't get stuck at one pair going sideways while the other moves
in the oposite or the same direction like on many other not so correlated pairs,

I been using the 15 minute chart but it's too long for me,
trades take weeks before closing the gap,
I will try to go down to 5M next trade
I also don't use stoploss on these trades,
I just let it go until the gap close then I close at the crossings
or slightly before,
I found that sometimes they don't cross but reverses back.
Im using a 200 EMA and 20 EMA for entrys,
seems to work ok, but sometimes it fakes out,
also a 1500 k line stoch seem to do the trick on 15M
forward testing 10 trials no losses
Bulls are stupid Animals!especially when Im short!
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