You can't always get what you want in FX

Mick Jagger and Keith Richards once wrote "you can't always get what you want". They later noted "but if you try sometime you find, you get what you need". I am too young to remember this song being released, although, perhaps for some of you reading, the year in question, 1969, represented the springtime of your life. I was instead a child in the era of Lionel Richie and his "Can't Slow Down" album. I came across an original vinyl version of it quite randomly several months ago outside an Amsterdam record store (see above). The reason why I bring up the Rolling Stones and Lionel Richie, which are perhaps the most unlikely musical combination you could ever conjecture, is that their lyrics might (just) help to describe currency markets recently.

Following currency markets for nearly a decade, I cannot remember a more despondent time amongst market participants. To paraphrase the Rolling Stones somewhat, currency traders have failed to get either what they want or need in terms of returns. Volatility has been so sapped from currency markets, that, for a time over the summer, EUR/USD and USD/JPY short dated vols were on a 4% handle, an indication of the severe lack of activity or interest in the market. Is it true that currency markets just "can't slow down" any more to use the words of Lionel Richie? In retrospect, the plethora of media articles earlier this summer on the lack of volatility was perhaps an indication that we had reached a low. Why should currency volatility matter for traders? Generally, currency market makers are more profitable when volatility (& volume) levels are higher. In terms of the buy side, broad based indices for currency funds show it has been a tough time for them as a group too. If we take for example the HFRX Currency Fund index, it is close to flat on the year as of end of July.

It has not simply been a lack of volatility that has adversely affected the currency markets. The furore over the 4pm FX fix has rumbled on for a year. Indeed, the first inklings of the subsequent controversy were sown in August 2013, by a Bloomberg article and it is now a focus of regulators. For those of you interested in reading more on the 4pm FX fix story, I have written an earlier blog article on the subject and some of my research on the topic was featured in the Wall Street Journal. A lot of the debate around the 4pm FX fix has revolved around the notion that currency markets are supposedly "rigged". The way I view it is that markets are never easy places to make money. You need to do a lot of work in order to be profitable. Even then, it is remains frighteningly difficult to be consistent in your profitability. This is something strikingly different to being "rigged". If you fail to spend the time and effort required, markets will appear even more unfavourable.

However, despite what might appears to be the glum message of the post so far, for currency traders there does seem to be some light ahead. In Mohamed El Erian's recent article (see FT: Rising risk of currency market volatility 26 Aug 2014), he noted that the conditions for a pick up in currency market volatility are here. Indeed, we have already seen some pick up in EUR/USD implied volatility in the second half of August. There have also been the return of trends within the market, notably seen in the decline in EUR/USD in recent weeks. Positioning data suggests a large amount of net short speculative positioning in EUR/USD, indicating that this is likely helping to buoy currency traders returns.

El Erian notes that the beginnings of monetary policy divergence, a factor which is crucial for driving currency markets, is likely to push up currency volatility. A pick up in volatility, is unlikely to be helpful for high beta trades (like currency carry trades). Indeed, for example in equities markets typically high levels of vol tend to be coincident with weaker equities markets.

However, rising currency volatility is likely to aid trend followers. Macro traders examining relative interest rates amongst currencies are also likely to welcome divergences in monetary policy, after a period of extraordinarily low rates. We also note that, from a seasonal viewpoint, historically currency volatility tends to pick up through the autumn as well (see Thalesians: Seas-onal the day - Understanding seasonality in market volatility - 2 May 2014).

Whilst, opportunities have been far between in currency markets for much of this year, it does appear that times are changing, if this pick up in currency volatility is sustained and we see a continued divergence in monetary policy. So whilst currency traders might not have got they wanted for most of 2014, perhaps it is time that they'll get what they need. The time is surely coming for some dancing on the ceiling...

To read more about vol seasonality, see my Thalesians quant paper listed below. My book Trading Thalesians also has some colour on market volatility (mixed in with a bit of ancient history). Pre-order on Amazon UK here and Amazon US here.

Thalesians - Seas-onal the day - Understanding seasonality in market volatility - 2 May 2014 (Available for Thalesians clients only. Ask me for subscriber details! Shortened versions are available for free)

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Burgers & implementing trading strategies

It has been a (light hearted) challenge of mine to find if there is a link between trading strategies and burgers, which are probably the best invention involving sliced bread. At long last, I found some inspiration at Mr. Hyde's National Burger Day inspired burger festival, which recently took place by the disused Battersea Power Station. 

The festival brought together 12 different burger joints, each producing their own take on the humble burger. As somewhat of a burger aficionado, I took it upon myself to sample as many burgers as possible, to such an extent, that I am currently on a self-imposed burger exile. Whilst, I did not quite manage to sample burgers from all 12 vendors, I had quite enough to ascertain that the burgers were of varying quality and also taste, despite looking the same. The most wacky example was the "cake" burger pictured above. Yes, it really is made of cake, and no it doesn't taste like a beef burger.

By this stage, I suspect, you, the reader might doubt my claim that this ode to burgers really does have something to tell us about trading strategies. However, bear with me, a bit longer. Just as the concept of a "burger" can encompass many different types of beef inspired sandwiches, terms such as trend, carry and value can cover a very broad umbrella of trading strategies. Obviously, we would expect that the various trend following strategies employed by CTAs to display a modicum of correlation. Furthermore, if a certain trend following strategy appears to be consistently profitable, whilst all others are losing money during the same period, we might conclude that perhaps, the strategy might be doing something than simply trading price momentum. More succinctly, just as most burgers consist of a bun with a patty of minced beef, so families of strategies share various characteristics. 

However, just as with burgers, whilst there are similarities, it is the details that can separate various strategies. Let us again take the example of a trend following strategy. How precisely is the trend following signal calculated? How is risk allocated between the assets? Are there filters to reduce risk when markets are in a more range bound state? When all these details are added up they can explain the variation in returns between the various implementation of such a trading strategy across different funds. So, when it comes to trading strategies, it's not so much a secret sauce, which describes some super secret unknown strategy. Instead, it is a matter of lots of incremental details which are added to a relatively common strategy which gives it value. Indeed, I am sceptical of the notion of there being a some sort of "secret sauce" when it comes to building models.

So next time you indulge in a burger, remember it's the details which count. A Big Mac most definitely does not taste like every other burger, just as various implementations of trend following strategies can differ, when it comes to returns, even if on the surface they seem quite similar!

My book Trading Thalesians also has some colour on the idea of secret sauce in markets and my thoughts on whether it really does exist (mixed in with a bit of ancient history).

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Lenses, Bart Simpson & Gatsby

The Simpsons is perhaps the most famous cartoon of our age, featuring Homer, Marge, Lisa and Bart Simpson as a dysfunction family from Springfield. During this month, FXX are screening every episode (see Forbes: Every 'Simpsons' Ever: Is FXX Using Netflix's Business Model On Cable? 21 Aug 2014), a testament to its continued popularity. I suspect most of you have seen at least one episode. I have lost count of the number of Simpsons episodes I have seen, although I must confess much of my viewing was skewed towards my childhood.

Despite that, whenever I have seen an episode recently, I rarely fail to enjoy it. As I child, whilst I enjoyed watching the Simpsons, I rarely understood all of the jokes and simply took the dialogue at face value. However, whenever I watch it now, the satirical references which pepper every episode are far more evident. The cartoon has not changed: it is I, who has changed in these intervening years.

Of course, this is not purely a matter of the Simpsons. I have also reread books, which I read as a child. I remember racing through the Great Gatsby as a 13 year old. At the time, I recall being suitably entertained by the novel. Rereading the same book a few years ago, as an adult, the experience was totally different. I saw the deliciousness of Fitzgerald's prose, which effortlessly envelopes a reader in Gatsby's world, a man whose greatness was a façade. Fitzgerald's last line ends with perhaps one of the most famous sentences in the English language, which encompasses Gatsby's failure to break away from his the "current" of his past:

So we beat on, boats against the current, borne back ceaselessly into the past.

As a 13 year old teenager, my "past" had hardly been formed. Hence, it would have been quite difficult to reconcile such a line with my somewhat limited experience. Whilst, I am hardly what could be termed as "old" now, my past has certainly become a richer place, filled with more events, some successes, some failures. Even now, I am simply to young at this thing called life, for me to truly understand comprehend this line.

Just as with interpreting Bart, Lisa and Gatsby, in markets our understanding of events can differ with other market participants, depending upon our varied experiences of markets. My experience of markets started in 2005 and includes the tumultuous year of 2008. The way I might view price action, differs with those who have started work in the past few years, Their experience of financial markets has been fuelled by an interest rate environment which is unusually low, and a growth picture which is mixed at best, with an equity market which appears to mainly go "up".

Contrast that to a trader with 20 years experience, who has lived though not only Lehman, but also the various Asian crises in the late 1990s and the dotcom crash in the early part of this century. Memories of bear markets are likely to skew his or her perception of the current rally in equities. Furthermore, for a foreign exchange trader whose memories of the EUR/USD include levels such as parity, the valuation of the single currency in the mid-1.30s is likely to be seen as "expensive". This is not to say that such views are right, but they are likely to subconsciously skew how price action is viewed. The difficulty is that trading floors can often be skewed towards the younger end of the age spectrum. For an investor, diversification is key to reducing drawdowns, but do investors think about a diversification of trading experience, as much as they think they should do? I haven't got a proper answer, although my suspicion is no.

So pick up a book you haven't read in years. Watch an episode of the Simpsons you haven't seen in years. Look at a chart of historic price action at a time near the start of your career. How has your interpretation changed over the years? Can you see things now, that you couldn't see before? I suspect the answer is yes to both questions. Our different experiences are like spectacles, we all have different lenses to view the world and these prescription of these lenses change continually over time.

My book Trading Thalesians also has some colour on understanding how different experiences can impact how different traders interpret the market (mixed in with a bit of ancient history).

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Janet Jackson Hole

I am probably not the first person to note that firstly, Janet Yellen and Janet Jackson share a first name and secondly, that Janet (Yellen) is speaking at Jackson Hole. Hence, the juxtaposition of the three words Janet, Jackson and Hole, provides a suitably confusing headline to this article. The one way to clear up this misunderstanding is obviously to place a comma somewhere in the statement. Hence, the correct headline should read "Janet, Jackson Hole".

Traders are actually trying to do the same! Should they take a view on what is essentially a binary event (Janet Yellen speaking at Jackson Hole)? Will Janet (Yellen) be hawkish or dovish (see the plot above which gives relative number of hawkish versus dovish news references for Yellen)? Or should they place a pause or a "comma" in their trading and simply cut their risk, taking no view over the event?

The question does more broadly open up the question of how traders should deal with scheduled event risks. From a systematic trading perspective, if a longer term trading model has been backtested over a large history which includes such events, the bias might be to simply let a model run. Alternatively, we can investigate what has happened over these specific events historically to create an overlay model for a specific event risk. For example, I wrote a Thalesians quant paper yesterday on this (cited below) and found that generally stocks have rallied over the past decade of Jackson Hole events. However, whilst there might be similar events in the past, notably previous Jackson Hole speeches by a Fed chair, the expectations around each event can be different. Our sample size is also quite small, which complicates such analysis.

We can see this behaviour of how varied expectations can be, in all scheduled events. Notably this can be observed in the way in which implied volatility event add-ons can vary. For example, before payrolls, EUR/USD overnight implied vols could be marked up by as much as 5 vol points, if the market is particularly jittery about the number. Other times, it could be much lower. Unfortunately, vol tends to be overpriced over scheduled events. Hence, the notion of always hedging scheduled event risks through options can be very expensive over time.

A more realistic answer is actually to combine ideas of cutting risk and using options to manage risk over events, using some discretion in when to use either or both. In addition, we can often have cases where we might want to actively take risk over binary events if we have a particularly strong view. The key of course is to be flexible, rather than having a very rigid approach when it comes to scheduled events. Whilst events might well be scheduled, the outcomes can be far from "scheduled".

If you liked this have a look at Trading Thalesians, my book on investing (mixed in with a bit of ancient history).

Thalesians - Jackson Hole in one - Historical market moves during Jackson Hole - 21 Aug 2014 (available for Thalesians clients only - sign up for free to shortened versions of my papers)

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History binds and tears apart

The recollection of facts might seem like the overriding objective of history, to the causal observer, such as myself. My world is coloured by maths and markets, an inevitability given my education was in the world of maths and my entire professional career has been in currency markets.

To some extent, history's objective is this. However, even for someone quite removed from being a historian such as myself, the study of history seems far more important than a simple reallocation events. It is the question of "why" events have occured, which is the focus of historians. The ancient Greek historian, Herodotus was the "father of history". This title was bestowed upon him by Cicero centuries after Herodotus wrote his epic series of books entitled "The Histories" or "The Histories of Herodotus". Herodotus recounts the Greco-Persian wars in the fifth century BC in his epic work. The first volume begins with the following words:

This is the Showing forth of the Inquiry of Herodotus of Halicarnassus, to the end that neither the deeds of men may be forgotten by lapse of time, nor the works great and marvelous, which have been produced some by Hellenes and some by Barbarians, may lose their renown; and especially that the causes may be remembered for which these waged war with one another. (Herodotus & Macaulay/trans, The History of Herodotus, 1890)

Herodotus thus stresses that his book is not merely a recollection of the wars fought between the Greeks and the Persians. More importantly, he seeks to understand why they fought. If we can answer the question of why, it enables history to spirit our minds away to that place where we can learn from the mistakes of the past. However, history can also have the power to perpetuate the mistakes of the past, reminding enemies precisely why they always hated each other, using previous arguments to rerun grievances anew. We need not stray far in the modern world, to see this in the Middle East today, where conflicts have been repeated over time, like some sadistic version of Groundhog Day: wars are fought, no side wins in that fabled place called the "long term", thus setting up enemies to rerun the fighting for another day...

It is all a matter of degree. The question is thus: when does history pivot from an understanding of the past, to a glorification of mistakes? Indeed, when does history become not a power to bind but in fact to tear apart?

From a market perspective, understanding how markets have behaved in the past is crucial. Experience serves as a subconscious history of the past. However, experience is just one facet of history. Just as historians analyse the past, so traders can also seek to understand the past, through the judicious use of market data. That is of course what systematic traders do. They use a historical dataset to verify the behaviour of systematic trading models. However, simply reeling off the historical returns of a strategy or a market is just one part of historical market analysis, but should not be the only one.

Just as Herodotus sought to understand "why", so traders need to understand "why" a strategy or a market behaved in a certain way. Simply using strong historical returns of a strategy to justify it going forwards, without having some comprehension of "why" it seems to capture market dynamics is risky. After all, we might simply be indulging in a glorification of trading "mistakes" which just so happened to be profitable? Now you wouldn't want to be placing your money on an idea like that, would you?

History is there to inform and understand, not to justify the mistakes of the past. Good luck trading!

My book Trading Thalesians also has some colour on understanding trading history (mixed in with a bit of ancient history).

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The changing soul of a city

It's close to midnight. I really shouldn't be writing something at this hour. Yet, despite this, words seem intent on leaving my brain via my fingers, tapping away on this keyboard into a screen, music in the background, supposedly to inspire, but more likely to distract. Looking from my window I see the lights from the City of London and other parts of the town reverberating against a clear sky, the crispness of the breeze whispering that summer is about to pass. It's times like this, that I think I am very lucky to live in London, a metropolis whose soul seems to change repeatedly throughout everyday. Rewind to earlier today and the drabness of grey clouded London, specks of rain cavorted with one another in a journey to earth and hapless pedestrians without umbrellas. As for tomorrow, the sun, I hear is likely to shine, bringing out the masses to lounge in parks.

The changing soul of a city, is like the changing soul of the markets, that overarching stage, on which investors play act. During sunnier times, the market becomes a magnet for good news, whilst bad news is taken in its stride, unable to shatter markets. Seeking yield is the game. At times bad news even becomes good news, as remarked by Mohamed El-Erian in his recent article for Business Insider, discussing the recent positive reaction of markets to poor data out the Eurozone. The rationale was that poor data would spur the ECB to act more dovishly, thereby supporting risky assets. Contrast that to cloudier times, when the market becomes mesmerised by bad news, anything to aid the washing out of market positioning. The game shifts to the preservation of capital. Indeed, we have discussed this in our recent piece Fruit carry filtered, where we suggested ways of systematically identifying risk sentiment.

However, the themes in markets can be a whole multitude of things, not purely related to risk sentiment. Are flows the main driver? Or is it inflation? Are we focusing more on employment data? The list of course is endless. The whole idea of shifting themes is important to bear in mind when trading markets. It is not simply have the right view which matters, it is having the right view about the right theme. Having the right view about the wrong them, can perversely end up costing money. Like the soul of a city, the soul of markets is forever changing.

My book Trading Thalesians also has some colour on understanding market themes and risk (mixed in with a bit of ancient history).

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Traders carve their imprint on capital

Life is carved from time, as a carpenter carves his designs on wood. In the same way, traders carve their imprint on capital. In Dublin and Ireland more broadly, the financial crisis and the failed banks have carved their imprint upon the land. During my recent visit, it was difficult to ignore the recent wave of construction projects, some finished, some unfinished, usually emblazoned with shiny billboards noting 2007 completion dates.

Yet these various pockets of unfinished construction are hardly what a visitor notices first. The Emerald Isle is Europe's windswept Atlantic garden. Its Western shore has been sculpted by the Atlantic's fierce waves over the ages. Its countryside has a certain lushness and greenness, which can only be achieved through lashings of rain. Despite the financial crisis and later the Eurozone debt crisis, Irish yields have managed to recover and at least to my untrained eye, it does seem to be on the recovery.

Of course, this does not negate the damage done to the economy from excessive risk taking during in the pre-Lehman period. I recently had Twitter conversation (with @LadyFOHF, @SardonicaX, @PolemicTMM and @ericbeebo) on the subject of excessive risk taking. I used the term "excessive" leverage relatively casually, before I was asked to define it (by @LadyFOHF).

The difficulty is that the notion of excessive leverage is dependent on your viewpoint. Investors can obviously be classified by their capacity for risk taking. A pension fund's notion of excessive leverage is likely to be different from that of a hedge fund. We can all think of funds or sovereigns which have suffered when markets have turned, due to excessive leverage. Of course, such problems are not purely confined to modern times. Take for example the credit crisis of 33 AD, which was ominously similar to the recent credit crunch (more on that in my book!)

In a sense, the only way to understand whether excessive leverage is to try to assess what the potential downside is on a trade. In a "bad" scenario, how much could a trade lose? If the answer is too much to withstand the pain, then it's too much. Furthermore, if we ignore any diversification in our portfolio, what could be the potential loss in our portfolio? Again, if the answer is too much, it suggests that we have too much leverage. Diversificaiton can often fall apart during times of severe risk aversion, simply because correlations explode. Hence, an allowance must be made for this, when judging maximum losses in a portfolio.

The key point to understand is that excessive leverage can force investors to exit positions simply to remain solvent, regardless of their underlying views. Hence, what might eventually end up a winning trade could be exited early. Of course, you might find the opposite scenario, where a massive trade comes in your favour, but if the alternative scenario is being totally wiped out due to excessive leverage, surely that means the leverage was excessive?

As Keynes once remarked "Markets can remain irrational longer than you can remain solvent." So when you carve your imprint on capital, make sure it's a lasting one, at least in the positive sense.

My book Trading Thalesians also has some colour on understanding the risk of trading strategies and a discussion around targets investors can use (mixed in with a bit of ancient history).

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New York is the finest factory for human ingenuity

As long as human breaths have been taken, the human imagination has waltzed its way to the future. A place which epitomizes what can be built through imagination is the city of New York. Each time I approach New York and see the shadow of the Manhattan skyline punctuated by the Empire State Building, I wonder at its beauty, that mankind could build such a marvel. New York is the finest factory for human ingenuity on earth. Walk around New York and you will always find interesting messages, sometimes scrawled on signs (such as above), other times, even on the ground, such as on Williamsburg Bridge. Despite my love of New York and numerous visits to the city, I realise that I can hardly claim to know it intimately. A lifetime is needed to accomplish such a feat.

In an attempt to better acquaint myself with the city, I have read numerous books about New York, most recently The New York Nobody Knows: Walking 6,000 Miles in the City by William Helmreich. As the name suggests, the author has walked through New York City and condensed his findings into a single volume. Reading the book, made me realise how comparatively little I know about New York. My perspective on the city consists of brief snapshots of time. It is like a slide show, taken at random intervals over the past few years, becoming grainier over time. By contrast, Helmreich's book is more like a film, seemingly linking together the few disparate snapshots of New York in my mind into a cohesive story, whilst simultaneously adding to my collection, numerous "slides" of parts of the city I have never visited.

Whilst his book his peppered with many interesting stories, possibly one of my favourite is that of the French restaurant Le Veau d'Or on 60th Street near Lexington Avenue, in the Upper East Side. Helmreich notes that in the front window of the restaurant, there is a stack of books from an eclectic array of authors, which include Michael Lewis and Danielle Steele. It transpires that all the books are by authors who have either mentioned the restaurant or who have dined there. On my next visit to New York, this November, I shall have to see whether I can persuade them to display my book (I shall not mention that my favourite food is the burger).

Obviously, these authors are not representative of all the diners who have been to the restaurant (I would hardly expect this establishment to be exclusively one for authors). The window provides a selective snapshot into the restaurant's collective memory, which has been filtered to provide a bit of showbiz and hence a talking point.

The notion of a selective memory is not purely something which might explain the windows of New York French restaurants. It is something very prevalent in financial markets. Ask me which days have been the worst in my professional career, in terms of profit and losses of models I have run and I can recall them instantly. I can give the precise figures, the dates and also the market backdrop at the time. Pain resonates in my trading memory in a way that somehow joy doesn't (even more so when I have been trading my own cash)! I might struggle however, to recall which were my best trading days. I can recall periods of time when my model did well, but it is difficult for me to isolate better days (without consulting a graph). One exercise I did find useful in the past however, was simply to write some a quick summary of my profit & losses to highlight which trades had done well and which had done worse.

A selective memory does not simply impact how you interpret the past. Your experiences and your memory can also cloud how you view the market going forward. Talk to traders who have been in the market for 20 years and their experiences of price action are very different from traders who have just started. VIX at 15 might panic new traders, but for veterans used to much higher levels, their perspectives will be very different.

So when trying to understand markets, the way you might interpret what has happened, can be very different to how others do. We all have the same news, the same price feed, but crucially different experiences, when it comes to markets.

My book Trading Thalesians: What the ancient world can teach us about trading today also has some colour on how your perspective can impact how you interpret the market and also examining how to interpret historical performance (mixed in with a bit of ancient history).

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