By Terry Flanagan

FX Traders Seek to Predict Extreme Price Swings

Trading foreign exchange tends to be riskier during periods of extreme volatility, making the identification of “early warning indicators” to large movements important.

Extreme moves in currencies are much more problematic than extreme moves in equities or futures because the normal volatility of currencies is typically smaller than that of equities or futures.

“The fat tails of a currency can be much fatter than that of an equity index,” according to a presentation by Ernest Chan, managing member of QTS Capital Management, a quantitative investment firm. “When coupled with high leverage, a few days of these extreme currency moves can account for the large part of a drawdown of a currency fund.”

For example, the volatility of the Mexican perso (MXN) versus USD is about 17% per year, while that of the S&P 500 index E-mini future is 25%. Because of this lower volatility, currency strategies are typically traded at higher leverages than equity or futures strategies in order to earn the same returns.

So called “risk-on” trades are currently not applicable in FX, according to Tyler Yell, a trading instructor for DailyFX.
When the risk is on, a favorite play is often to short the Japanese Yen as traders from that part of the world who were once concerned about safety now hunt yield, he said in a blog posting,

For an 8 month span of October 2012-June 2013, this play was on as the JPY weakened and the Nikkei 225 (Japan’s equivalent of the Dow Jones) strengthened.

Another option is to sell USD across the board or open a USD Basket – Sell, but that would not work well in the current risk-off environment.

“The beauty of trading in a clear risk-on or risk-off world is that the trades become clear,” Yell said. “In a risk-on environment, the USD and JPY are sold by the masses as they seek higher yielding plays for their portfolio with other major currencies. In a risk-off environment, you’re looking for simple entries in the direction of the trend, which is currently buying the U.S. dollar.”

Chan said that the Volatility Index (VIX) is a surprisingly good leading indicator for extreme risk. When the previous day’s VIX is greater than or equal to 35, one should avoid risky asset trades.

“Our study of the VIX index suggests that it is predictive of extreme moves in various risky assets including an emerging market currency (MXN), an equity index future and a high-yield corporate bond ETF,” he said.

Chan’s has focused on the development of statistical models and advanced computer algorithms to find patterns and trends in large quantities of data. He has applied his expertise in statistical pattern recognition to projects ranging from textual retrieval at IBM Research, mining customer relationship data at Morgan Stanley, and statistical arbitrage trading strategy research at Credit Suisse First Boston, Mapleridge Capital Management, Millennium Partners, MANE Fund Management, EXP Capital Management.

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