I wanted to post a what if scenario. It is good to look at possible situations and see what may happen in an account. This scenario is for real accounts, demo accounts will be affected the same, but demo users will not really care if this happens. I hoe this helps some new traders. Research scenarios as this one will only improve your knowledge as time goes on.
The scenario I am referring to is hypothetical BOJ intervention as early as this sunday(?). The reference point is Oct 30th, 2011 also a sunday in US but monday morning in Japan. Us / Europe is very quiet, and the sneaky BOJ decides to smash the market and create a havoc.
What happens next is that any pair containing quote currency of JPY goes through the roof, and here is where we can begin the analysis on a what if scenario. Doing this analysis will help every single trader to get an inside depth knowledge and understanding of what is behind pair trading and the effects on other correlated pairs.
The first thing to observe that may be helpfull to a new trader is that we are trading a basket that is basically an index that more or less is closelly tracking to usd/jpy.
Buys:
AUD/USD
NZD/USD
EUR/GBP
EUR/USD
GBP/USD
Sells:
USD/JPY
NZD/JPY
EUR/JPY
GBP/JPY
AUD/JPY
With the above composition notice how we are mainly buying usd and selling jpy. Therefore one can reason that our basket performance can correlate to the performance of USDJPY. Well open a chart for the last week using 1d interval and you will see why many people got very excited this week about the cycle of profit loss. You will see that USDJPY did basically a JO-JO this week, which is absolutelly wonderfull for the above setup.
There however is a slight hidden twist here, that once learned will help any trader inyears to come . The above pairing is not equal. That is if we put the above together like so, where buy is on the left side and sell on the right:
AUDUSD AUDJPY
NZDUSD NZDJPY
EURGBP USDJPY
EURUSD EURJPY
GBPUSD GBPJPY
We still have one problem. The dollar value of 1 lot AUDUSD is NOT equal to AUDJPY. Pairs that contain JPY as a quote currency are more expensive and therefore the hedge will be heavier to the side of the yen.
So we know now 1. We are trading a type of USDJPY index and 2. We are heavier on the JPY side.
Also notice that where we have JPY always on the sell side / usd is not always there on the buy side. So we have basically a kind of EURUSD / JPY position.
The above is very interesting to evaluate and we can learn a lot from this. In fact understending the above can make you money consistentlly just simply by comparing USDIndex and JPYIndex.
But now back to the what if situation...
I went through the BOJ intervention, with have usdjpy positions. While doing excellent on the overall fundemental situation there have been a few spects that a whatif, can solve and improve.
If we are trading the demo basket, then at this point a simple strategy of reversing USDJPY and going long on it will make all the difference, and this offcourse you can same time reverse EURUSD to maintain the ratios.
Offcourse we will forfit some interest, but at the pice of mind, of knowing that we are protected against a propable move from boj.
Until this week boj move was getting less and less likelly, however after the Fed statement things are completelly changed. We are @ 76.60 and keep going lower, and the chances grow that BOJ will do something.
Now the last part of the analysis should be Risk Protection, or Risk assesment.
If you are trading with stop loss, then your risk is the extent of the stop loss. If you are not, then here comes the art of understanding past implications of bank interventions, and understanding the complete picture of all the pairs that will be affected. The art and technique are now the key to define a trading plan.
The best, and really the only way for anyone to learn, it to open MT4 or preffered charting tool, point to Oct 30th, 2010 and switch to 1h or 4h.
First look at USDJPY and you will notice a massive move up ~500pips or so. Now switch to NZDJPY and look that is also very large 200 -300 pips, tnen look at GBPJPY, another 300-400 move. EURJPY similiar 300 Pip move. All of these are pairs on the sell side above in our basket and all them have JPY as quoted currency, therefore all of them will be affected.
Now you say... Thats ok after all we are hedged and that is what limits our risk, right ?
Well do exactlly as above and now looks at the chart for all the buy pairs. I will leave that to you as to what you see.
The point of the above is that this is a Prime example where hedging techniques can fail.
This does NOT mean that the techniques presented here are wrong inavlid etc, in fact conecpts present here are great and long standing. You have seen from Chips, JC and other how well it can work, but as a trader you are responsible for understanding what you are trading, and further YOU are the one who ultimatelly is responsible for your loss or gain, not the Market or someone else.
So that said what if we switch our pairs, and assign some numbers ...
For this example lets take the following :
Long Short
AUDUSD 2.0 AUDJPY 1.5
NZDUSD 1.5 NZDJPY 1.0
EURGBP 0 uSDJPY ??
EURUSD .5 EURJPY .3
GBPUSD 1 GBPJPY 1
There are reasons why you could have the above positions. Nothing in the above factors in any price or draw down thus far just the sizes of your position and how to effectivelly protect your self in case of an unforseen event using a correlated hedge.
Pip Cost per 100,000 1 lot.
EUR/USD = 10.00
USD/JPY = 13.04
GBP/JPY = 13.04
NZD/JPY = 13.04
USD/JPY = 13.04
EUR/GBP = 15.7330
GBP/USD = 10.00
NZD/USD = 10.00
Also from the above we can see that our basket generally costs more on the JPY side, which means that if usd/jpy is trending down we can expect to aggreagte more profit then when JPY is recovering.
It also means that any down move will always have higher magnitude to our basket then up move as compared to profit.
Now the question become what should we do with USDJPY and how much of it should we do?
We can buy X units of USDJPY, and if we do Buy X units how many should we buy to cover our exposure? We can offcourse simply buy 3.8 lots of USDJPY and consider that we covering the JPY exposure, but as always any action in one pair will have some ripple effect on other pairs, and it may not be necessary to buy all 1:1 ratio to cover the move. Notice what happens right after the move..., also if we do that we will unblance all the other buys short term, so should we not hold the buys over the weekend? and thus fofit the nice interest on AUD?
Personally I use a broker that offers continous interest, and allow fractional positions, which allows me to trade in percentages vs pips, and redefines the swap concept, but still I do want to keep those AUD and NZD positions, but now I should look at offseting these with some other trade.
One way is to consider the USDJPY trade as an insurance option, which will quickly be resold, begining of next non asian session. In fact you may even gain on USDJPY since it is very oversold as is.
Eventually if we did cover 1:1 - we could use retracement of the price to our adventage, and offcourse the added benefit is that we would part take in the entire move on that currency.
But what if there is no intervention yet ? - when do we get out of the insurance trade?
These are only the beginning questions that need to be answered. A good trading plan has to incorporate for scenarios like this, perhaps this is why for many traders a stop loss is a simple way of dealing with the problem, even if it will give up profits.
The scenario I am referring to is hypothetical BOJ intervention as early as this sunday(?). The reference point is Oct 30th, 2011 also a sunday in US but monday morning in Japan. Us / Europe is very quiet, and the sneaky BOJ decides to smash the market and create a havoc.
What happens next is that any pair containing quote currency of JPY goes through the roof, and here is where we can begin the analysis on a what if scenario. Doing this analysis will help every single trader to get an inside depth knowledge and understanding of what is behind pair trading and the effects on other correlated pairs.
The first thing to observe that may be helpfull to a new trader is that we are trading a basket that is basically an index that more or less is closelly tracking to usd/jpy.
Buys:
AUD/USD
NZD/USD
EUR/GBP
EUR/USD
GBP/USD
Sells:
USD/JPY
NZD/JPY
EUR/JPY
GBP/JPY
AUD/JPY
With the above composition notice how we are mainly buying usd and selling jpy. Therefore one can reason that our basket performance can correlate to the performance of USDJPY. Well open a chart for the last week using 1d interval and you will see why many people got very excited this week about the cycle of profit loss. You will see that USDJPY did basically a JO-JO this week, which is absolutelly wonderfull for the above setup.
There however is a slight hidden twist here, that once learned will help any trader inyears to come . The above pairing is not equal. That is if we put the above together like so, where buy is on the left side and sell on the right:
AUDUSD AUDJPY
NZDUSD NZDJPY
EURGBP USDJPY
EURUSD EURJPY
GBPUSD GBPJPY
We still have one problem. The dollar value of 1 lot AUDUSD is NOT equal to AUDJPY. Pairs that contain JPY as a quote currency are more expensive and therefore the hedge will be heavier to the side of the yen.
So we know now 1. We are trading a type of USDJPY index and 2. We are heavier on the JPY side.
Also notice that where we have JPY always on the sell side / usd is not always there on the buy side. So we have basically a kind of EURUSD / JPY position.
The above is very interesting to evaluate and we can learn a lot from this. In fact understending the above can make you money consistentlly just simply by comparing USDIndex and JPYIndex.
But now back to the what if situation...
I went through the BOJ intervention, with have usdjpy positions. While doing excellent on the overall fundemental situation there have been a few spects that a whatif, can solve and improve.
If we are trading the demo basket, then at this point a simple strategy of reversing USDJPY and going long on it will make all the difference, and this offcourse you can same time reverse EURUSD to maintain the ratios.
Offcourse we will forfit some interest, but at the pice of mind, of knowing that we are protected against a propable move from boj.
Until this week boj move was getting less and less likelly, however after the Fed statement things are completelly changed. We are @ 76.60 and keep going lower, and the chances grow that BOJ will do something.
Now the last part of the analysis should be Risk Protection, or Risk assesment.
If you are trading with stop loss, then your risk is the extent of the stop loss. If you are not, then here comes the art of understanding past implications of bank interventions, and understanding the complete picture of all the pairs that will be affected. The art and technique are now the key to define a trading plan.
The best, and really the only way for anyone to learn, it to open MT4 or preffered charting tool, point to Oct 30th, 2010 and switch to 1h or 4h.
First look at USDJPY and you will notice a massive move up ~500pips or so. Now switch to NZDJPY and look that is also very large 200 -300 pips, tnen look at GBPJPY, another 300-400 move. EURJPY similiar 300 Pip move. All of these are pairs on the sell side above in our basket and all them have JPY as quoted currency, therefore all of them will be affected.
Now you say... Thats ok after all we are hedged and that is what limits our risk, right ?
Well do exactlly as above and now looks at the chart for all the buy pairs. I will leave that to you as to what you see.
The point of the above is that this is a Prime example where hedging techniques can fail.
This does NOT mean that the techniques presented here are wrong inavlid etc, in fact conecpts present here are great and long standing. You have seen from Chips, JC and other how well it can work, but as a trader you are responsible for understanding what you are trading, and further YOU are the one who ultimatelly is responsible for your loss or gain, not the Market or someone else.
So that said what if we switch our pairs, and assign some numbers ...
For this example lets take the following :
Long Short
AUDUSD 2.0 AUDJPY 1.5
NZDUSD 1.5 NZDJPY 1.0
EURGBP 0 uSDJPY ??
EURUSD .5 EURJPY .3
GBPUSD 1 GBPJPY 1
There are reasons why you could have the above positions. Nothing in the above factors in any price or draw down thus far just the sizes of your position and how to effectivelly protect your self in case of an unforseen event using a correlated hedge.
Pip Cost per 100,000 1 lot.
EUR/USD = 10.00
USD/JPY = 13.04
GBP/JPY = 13.04
NZD/JPY = 13.04
USD/JPY = 13.04
EUR/GBP = 15.7330
GBP/USD = 10.00
NZD/USD = 10.00
Also from the above we can see that our basket generally costs more on the JPY side, which means that if usd/jpy is trending down we can expect to aggreagte more profit then when JPY is recovering.
It also means that any down move will always have higher magnitude to our basket then up move as compared to profit.
Now the question become what should we do with USDJPY and how much of it should we do?
We can buy X units of USDJPY, and if we do Buy X units how many should we buy to cover our exposure? We can offcourse simply buy 3.8 lots of USDJPY and consider that we covering the JPY exposure, but as always any action in one pair will have some ripple effect on other pairs, and it may not be necessary to buy all 1:1 ratio to cover the move. Notice what happens right after the move..., also if we do that we will unblance all the other buys short term, so should we not hold the buys over the weekend? and thus fofit the nice interest on AUD?
Personally I use a broker that offers continous interest, and allow fractional positions, which allows me to trade in percentages vs pips, and redefines the swap concept, but still I do want to keep those AUD and NZD positions, but now I should look at offseting these with some other trade.
One way is to consider the USDJPY trade as an insurance option, which will quickly be resold, begining of next non asian session. In fact you may even gain on USDJPY since it is very oversold as is.
Eventually if we did cover 1:1 - we could use retracement of the price to our adventage, and offcourse the added benefit is that we would part take in the entire move on that currency.
But what if there is no intervention yet ? - when do we get out of the insurance trade?
These are only the beginning questions that need to be answered. A good trading plan has to incorporate for scenarios like this, perhaps this is why for many traders a stop loss is a simple way of dealing with the problem, even if it will give up profits.
