Wednesday, April 16, 2014

High Frequency Trading and other tricks | The Tobin Tax

Please note that as this coming Friday (Good Friday, 18th April) is a holiday for all important Forex markets, there will be no OmiCronFX commentary on that day.

Since the publication of Michael Lewis’s new book “Flash Boys”, there has been much discussion of the way in which larger hedge funds and other traders utilise various methods of gaining an advantage over the great majority of traders, not only in Forex but wherever electronic trading takes place, whether that is in equities, indexes or any other asset class.

It turns out, however, that the regulatory authorities around the world had been examining these practices already. In Europe, in particular, there have been proposals, for some time, to curb activities that might be perceived to be anti-competitive. The most basic was the idea that a half-second delay might be imposed on the sending of a trade by a trader to an exchange. This would take care of, with one stroke, the activities of High Frequency Traders (HFTs), who utilise very high speed computer (low-latency) connections that allow them to capture trades as they are being transmitted by others to the brokerage servers, add on a tiny amount to the price for themselves, and then allow the trade to go through. This is known as “front running”. It is manifestly unfair.

But there are other ways in which advantage can be taken – other methods of front-running. One of these is the ability of well funded traders to purchase the outcome of reports that can be expected to move the markets, before these results are known to the bulk of participants. It is not suggested that this can happen in the case of, say, the US Non-Farm Payroll reports, as these are released by the government, but there are others where the playing field is not so level. One is the University of Michigan Consumer Sentiment Index, which is released in conjunction with Reuters.

The debate is on as to whether it is anti-competitive, on the one hand, to allow this, or a legitimate exercise in market analysis, for which the analysts deserve to be paid, on the other. Our own view is that the question, at this level at least, is not that important. The reason for this is that, very often, it would appear that when they get them, the recipients of these reports do not know what to do with them. There is often no consensus as the whether it is better to buy or to sell when the results are known. The chart above illustrates what happened in the minutes before, during and after the Univ. of Michigan / Reuters Consumer Sentiment Index release for January of this year.

Something similar happened on Tuesday of this week, when UK inflation figures were released. The consensus expectation was for a year-on-year drop to 1.6% from 1.7%. When this proved to be absolutely correct, the value of Sterling initially dropped, presumably on the belief that this is a low level for inflation. A few minutes later it reversed totally, when other traders seemed to come to the conclusion that, hey, this was as expected - at least the figure did not come in lower than that.

The point here is that any traders who had received this information ahead of time and had reacted as the first lot did when we were watching the chart, would have been burned. That is, unless the move down was an attempt to hunt for stops in the sure knowledge that the rate was about to rise thereafter. OK, call us cynical – and our stops were not triggered.

The Tobin Tax

Back in 1972 the economist James Tobin who, sadly, is no longer with us (he died in 2002) proposed that there should be a very small tax on currency exchange transactions in order to “cushion exchange rate fluctuations”. In his view this would limit the amount of volatility that takes place and which sometimes give rises to distortions, of exactly the kind that High Frequency Traders are sometimes accused of causing.

While the idea of a Tobin Tax is under active consideration in the Eurozone, it is opposed strongly by the USA. Britain and Ireland have made it known that they will veto the introduction of such a tax in Europe, as to allow it would mean the abandonment of London, in particular, by currency traders who would have no difficulty in today’s world of easy international communications in moving their operations elsewhere.

We sometimes wonder if it would not be better to allow a Tobin Tax, of a very small size, in return for the regulators making sure that High Frequency Traders cannot skim similar amounts off the value of trades that go through electronic exchanges but in what, up to now, has been a hidden and opaque manner. At least a Tobin Tax would have the virtue of being transparent.

Tuesday, April 15, 2014

Is the Yen Carry Trade about to be dismantled? | The study of economics is not a science

Please note that as this coming Friday (Good Friday, 18th April) is a holiday for all important Forex markets, there will be no OmiCronFX commentary on that day.

The “Carry trade” is the name given to the practice of attempting to borrow money in low cost environments and invest it, or loan it out, in high return situations. Depending on the combination of funding currency and carry instrument chosen, the level of risk is either increased or limited. As is normal, the higher the risk assumed the greater the return the investor would expect to attain.

The operation of the carry trade can have an effect on currency exchange rates. It tends to drive up the value of currencies in those regions where high interest rates exist, and drive down rates where interest is low.

Above is a schematic of the makeup of the carry trade. It is not cast in stone, and indeed it changes from time to time. Right now, for example, there is a suspicion that the carry trade in Yen crosses is in the course of being dismantled. This should have the effect of strengthening the Yen. The reason for this is that some investors believe that the ultra-low interest rate environment in Japan might be in danger of coming to an end.

If this is true, the depreciation of the Yen, which has been in train since late 2012, might be about to come to an end. In that case the USDJPY chart could be about to undergo a reversal from a dominant rising trend to one that is in decline.

The study of economics is not a science

The study of economics is not a science. Note that I did not write “exact science”. It is not a science at all. It is a set of beliefs that are held by individual practitioners and invoked under any and all conditions. Economists are Keynesians, Monetarists or follow the Austrian School in the same way as the devout adhere unquestionably to Mohammed or Christ or L. Ron Hubbard. Economists cannot agree among themselves on the right course of action under any given set of circumstances and they most certainly cannot predict what will happen in the future.  

This should be of concern to those who subscribe to fundamental analysis of stocks, bonds and other investments, including Forex. Those who rely on technical analysis are likely to be somewhat more focused, but the state-of-the-art here is also one of flux. Up front and centre at present is the place that computers have to play in developments. Automation is now a requirement for price action research, for learning, for trade entry and management, and for testing assumptions and determining the optimum values for the parameters to be used in algorithmic routines.

That is what we do at OmiCronFX.

Monday, April 14, 2014

Unemployment and the Aussie dollar | Pressure on the ECB to increase inflation

Please note that as this coming Friday (Good Friday, 18th April) is a holiday for all important Forex markets, there will be no OmiCronFX commentary on that day.

For a long time we have been writing about the tendency of the Forex market to react to any and all individual periodic reports when they are announced, while policy makers, particularly in the central banks, are focused exclusively on the trend that becomes apparent over time. This is true in relation to all markets.

Now, according to Callam Pickering, writing in the Australian Business Spectator, even the individual reports on Australian unemployment are not to be relied on at the present time. See his article on the subject here: “The truth about unemployment in Australia”. This is primarily because of a recent change in the sampling methodology for by the labour force survey, but there are other issues too.

In the meantime the Australian dollar has been on a tear, which has been fueled to a very large extent by those same labour force surveys. Are Australian dollar bulls deluded? Read Pickering’s article and make up your own mind.

Pressure on the ECB to increase inflation

The pressure is well and truly on the ECB to carry out measures that will raise inflation in the Eurozone. After a meeting of the IMF in Washington over the weekend just past, it was reported that Mario Draghi, who was in attendance, and his colleagues are considering the reduction of the ECB overnight deposit rate into negative territory. The last time that was mooted there was a sharp reduction in the value of the Euro against all its global counterparts.

While deflation is the bugbear, as it was in Japan during its “lost decade”, it is also recognised that consistent low inflation is equally damaging to an economy. Senor Draghi, when reminded of this by Christine Lagarde of the IMF prior to the last ECB press conference, retorted with comments thanking Madame Lagarde for her input that were dripping with irony. It is one thing to have the IMF as a partner in the bailouts of recalcitrant Euro zone peripheral states, but quite another to find yourself on the receiving end of a lecture from Washington DC, where the IMF is based, and this is particularly so when you are being told something you already know.

Another new development is the rhetoric from the ECB chief that seems to recognise explicitly that the value of the Euro is a factor in all of this. Up to recently, the ECB had held itself above the mundane matter of exchange rates to concentrate on measures that might, or might not, affect the currency. It is probably realised too that attempts to talk down a currency, as Central Bankers from Switzerland to Australia, where such activity is known as “jawboning”, have found to their chagrin, are almost always doomed to failure.

The bottom line in all of this is that there is now definite risk on the side of a reduction in the value of the Euro, by one means or another.


Sunday, April 13, 2014

A possible sea-change for the Yen | The economic plane

Please note that as this coming Friday (Good Friday, 18th April) is a holiday for all important Forex markets, there will be no OmiCronFX commentary on that day.

Since the end of 2012 Japan has been practicing a form of monetary and fiscal policy that has become known as Abenomics, after the Prime Minister who was voted into power in December of the that year, Shinzō Abe. He formulated and activated measures that were designed to stimulate the Japanese economy. One of the cornerstones of this policy has been the elimination of deflation, and a major tool was the weakening of the Japanese Yen, particularly as it stood against the US dollar.

The outcome has been a rise in Japanese shares and the Yen has, indeed, weakened considerably during Mr. Abe’s tenure as Prime Minister. Many investors link the two – they see a strong negative correlation between Yen valuation and the growth of the Nikkei 225, the most representative Japanese stock index.

Now there are influential voices within Japan that are questioning the efficacy of Abenomics. This tendency is influenced by a number of factors: the very large Japanese government debt, a fear of what excess inflation might do when and if deflation is eliminated and, perhaps more than any other, the effects on Japan of economic events that are taking place in other jurisdictions, most notably in the USA and Europe.

Now there is another element. This is the prospect of a period of consolidation, if not severe correction, in all equity markets. Experience shows that a falling Nikkei 225 index should be expected to correspond to a strengthening of the Yen. This could mean a reduction, as opposed to the rise that most Forex market participants have been long expecting, in the USDJPY rate. Technically, our own belief is that the chart above has been setting itself up for a fall.

The economic plane

I am indebted to the author of a new book, “Money Blood and Revolution”, by George Cooper, for the chart above. I have not yet read the work but the chart stands on its own in terms of interest. It indicates where the various schools of economic thought exist on a matrix which relates their belief in the stability of markets with their advocacy of the place of government in attempting to control the economy.

Those of us who got their early introduction to the subject through the good offices of the late and great John Murray, in the MBA class of Trinity College, University of Dublin, will be interested to see the Austrian School, of Schumpeter et al, holding exactly the same position in relation to a belief in the stability of markets with Marxism, although they are, of course, diametrically opposed when it comes to their stance on the amount of influence / interference that government should affect in the regulation of the economy.

I am looking forward to Mr. Cooper’s other insights.

Thursday, April 10, 2014

Equities meltdown and Forex | FOMC minutes, interest rates and the fate of the US dollar

The news from the Wall Street close last evening was not good. The NASDAQ was down 3% on the day and the S&P, which is the standard measure for the strength of equities, was off over 2%. This is on top of what was perceived to be a sizeable correction in January / February of this year, although the market bounced back on that occasion.

Along with a reported rush of cash into equity funds in the last week, which could be the kind of contrarian “exhaustion” buying that many professionals perceive as marking the very top of a cycle, these are the kind of volatilities that can be the forerunner of a serious meltdown.

So the question is: How will all this impact on the Foreign Exchange market? The answer is: Not a lot. In Forex trading, there is nothing like the same distinction between going long (buying) and going short (selling) as there is in equities. To short a stock, it is normally necessary to have a friendly broker who will loan you the shares you wish to sell, as you do not own them, but you would nevertheless like to dispose of them so that you can buy them back at a cheaper price when your judgment that they were about to go down proves to be correct.

With Forex, there is no such requirement. “Shorting” a currency pair means nothing more than deciding that you will use one or other global currency to deal in a position in another, and you can choose to buy or sell the pair at will. The arrangement of the currency pairs owes its existence to nothing other than convention.

One buys long and sells short. Since its inception, OmiCronFX has been doing both as a matter of course in the currency pairs in which it trades, as dictated by the Fundamental and Technical Analysis research it carries out, and then using its algorithmic routines as the power tools to enable it to do so efficiently and to manage the trades once they are in place.

So the good news is that the OmiCronFX methodology is totally indifferent to the Foreign Exchange market direction of any particular currency.

FOMC minutes, interest rates and the fate of the US dollar

So, the minutes of the last FOMC meeting have been released and the market has taken the contents as a confirmation of what it should have already known - that interest rates in the USA will not be raised anytime soon. 

There had been some confusion because, at her last outing to Capitol Hill, Janet Yellen, the Fed chair, was asked a question she was not specifically prepared for. This was about when interest rates might be raised after the end of Quantitative Easing, which is scheduled to be tapered fully out of existence by the end of this year. In reply she said: “…about six months”.

Those three words have been dominating market action since then, creating an almost psychotic condition in the minds of participants, particularly as far as the Greenback is concerned.

In the meantime the Fed is watching the trend in economic indicators, as opposed to individual data points that are released weekly or monthly, short term bonds are being sold and yields are rising, emerging markets, which had a windfall of capital inflows when QE started, have suffered the trauma of seeing that process reversed, and equities have started a serious meltdown (sorry – correction). Oil prices are stable and oil price volatility is lower than it has been for very many years.

Each and every one of those things points to a strong US dollar, eventually. As usual, the market will make sure that it does not achieve its destiny in anything like a straight line on the chart.

Wednesday, April 9, 2014

Use of leverage in FX trading | The relationship with position size in OmiCronFX trades

One of the world’s most successful traders, Jim Rogers, is famous for not using it at all, most notably in his well documented short trade in gold in 1980, but nearly all of those who are involved in Forex are also involved in leverage.

Leverage is powerful. Foreign Exchange and other brokers use the principle to allow their clients to trade with amounts that are many times the value of what they have available in their accounts (known as equity). Typical leverage ratios are 100:1, meaning that a person with €100,000 in their account could, in theory, take on positions, or one single position, valued at €10 million.

In the event of the exchange rate moving in their favour, this would mean that all profits would be multiplied by a factor of 100 over what they would have been if no leverage was used.

To place such a trade would not be wise, however, because a move in the opposite direction would mean losses that were 100 times the value of those with 1:1 leverage (no leverage at all). A relatively small move in the wrong direction would then wipe out the account.

The ability to trade with many times account value is possible because the broker, in effect, provides a loan. This is secured on the equity in the account, or the amount that could be withdrawn in the event that all positions were to be closed. If that equity looks like disappearing, because of the unwise use of leverage, for example, the broker has the right to liquidate any or all positions in order to protect his loan.

Leverage is used when OmiCronFX places a trade. However, the Value at Risk (VaR) is at all times the focus of our calculations, and the leverage is only required as an enabler. An example will illustrate the principle:

The relationship with position size in OmiCronFX trades

In the event that a view has been taken that the AUDUSD pair is about to rise, for example, we will carry out a calculation, based in part on the principles of the Kelly Criterion, which will determine the value of the trade. Because our account is in Euro and we need to buy Aussie dollars with US dollars, the first thing that is determined is the amount we will put at risk, in Euro terms. This will, typically, be 2% of equity, or €2000 on a €100k account.

This is converted into USD and a calculation is made to decide the size of the trade, which takes into account the buy price, the level of our Stop Loss order, which we ALWAYS use, and the amount we want to put at risk. We do not have to do this ourselves as the OmiCronFX Mandelbrot algorithmic routine works it all out as a matter of course at the time, interrogating the account on a real-time basis in order to determine the amount of equity available. It also takes care of the conversions between the account currency and the Base and Quote currencies in use for the trade, in this example the AUD (Aussie dollar) and the USD.

When the calculation is made it will consist of dividing the proposed Value at Risk (VaR), properly adjusted for conversions from the account currency, by what we term the Reach, or the difference between the Buy price (or Sell price in the case of a short trade) and the Stop Loss level. In a typical trade this could result in the placing of an order to buy 250,000 Australian dollars. This amounts to leverage of approximately 2.5 : 1, which represents prudent use of the facility when 100:1 is allowed by our broker.

Tuesday, April 8, 2014

Euro zone Quantitative Easing | Has our Mandelbrot algo routine caught the tip of the GBPUSD pennant?

Rumours have emerged of a Trillion Euro Quantitative Easing (QE) package that is to be made available to fight both deflation and unemployment in the Euro zone, and in the EU in general. Such a development would place considerable strain on the ability of the Single Currency to remain as resilient as it has been against its major counterparts around the world.

However, our sources in Brussels, home of the EU Commission, tell us that this package has become mired in the infighting that can often become apparent between that same Commission and the European Central Bank (ECB).

The politicians are bracing for a kicking from the electorates in the various EU member states in the upcoming European elections and would, therefore, welcome a development like QE as it might give them some support with the voters.

Our source tells us that the relations between Brussels and Frankfurt, where the ECB is based, have become so strained that the Central Bank could hold off implementing the package until after the elections for the very reason that it might actually be of assistance to the incumbent politicos.

Our source also says “…the good old Bundesbank would not be that happy with QE, despite what Weidmann [Jens, Bundesbank president] (sort of) said last week - they may give it a very slight nod but would not be up for it long term - they hate inflation!” 

Has our Mandelbrot algo routine caught the tip of the GBPUSD pennant?

Yesterday we drew attention to the fact that a classic Technical Analysis pendant pattern had formed in the GBPUSD pair, and remarked that sometimes identifying the tip of the pennant, which can often mark the start a further rise in price, is “not a perfect science”.

Later in the morning a strong UK manufacturing report produced a surge in the pair, which seems to have the potential to bring it into completely new price territory to the upside.

We had initiated our Mandelbrot routine on the GBPUSD instrument and, using its proprietary algorithm, it entered a position, at the level shown in the chart. This trade is already in profit to the tune of 1% of equity.

Has Mandelbrot located the tip of the pennant? Time will tell.