Trend is your friend

Raise your hand if you’ve ever heard that expression before? Well, now there’s proof that this well-worn phrase is more than just a pointless platitude: “Royal Bank of Scotland Group indexes that track the performance of four of the most popular currency strategies show that the so-called trend style was the best-performing method, returning 7.3 percent this year through August.”

“Trend-Style” trading is also known as trend-following, and is just as it sounds. Traders identify one-way patterns in specific currency pair(s), and attempt to ride them for as long as possible. Given all of the big movements in currency markets this year, it’s no wonder that trend-following is the most popular. If you look at the 52 week trading ranges for the six most popular USD currency pairs, you can see that highs and lows are often as far as 20% apart. The EUR/USD pair, for example, fell 20% over a mere 7 months. Anyone who sold in December 2009 and bought to cover in June 2010 would have earned an annualized return of 35% without leverage! Even if you had captured only a couple months of depreciation would have yielded impressive returns. In addition, you could have traded the Euro back up from June until August and reaped a 60% annualized return. Best of all, both of these trends (down, then up) unfolded very smoothly, with only minor corrections along the way.

I’m sure serious technical analysts are rolling their eyes at the chart above, but the point stands that trend-following has never been easier and rarely more profitable than it is now. One fund manager summarized, “Trend-following investors are capturing the momentum in several big currency moves. You have so much uncertainty in the world now with regard to inflation or deflation, which typically makes currency markets and interest rates move. That is good for trend followers as it causes volatility, which typically creates good profits.” In other words, there is a tremendous amount happening in forex markets at the moment, and this is reflected in protracted, deep moves in currency pairs, which can change direction without notice and yet continue moving the opposite way for just as long. If you think this sounds obvious, look at historical data (5-10 years) for the majority of currency pairs: while trends have always been abundant, it was only recently that they began to last longer and became more pronounced.

The other three strategies surveyed by the Royal Scotland Group (“RSG”) were the Carry Trade, Value Trade, and Volatility Trade. Unfortunately, data was only offered for the carry trade strategy (confusingly referred to by RSG as the volatility strategy), which is down 5.9% in the year-to-date. The carry trade strategy involves selling a currency with a low yield and favor of one with a high yield, and profiting from the interest rate spread. In order for this strategy to be profitable, however, the long currency must either appreciate or remain constant. Thus, when volatility is high – as it has been over the last 2-3 years – this is a losing strategy.

We can only guess that a true volatility strategy probably would have been the second most profitable strategy. This strategy can be implemented through the use of long and short spot positions, as well as through trading in options and other derivatives. As I said, there is no shortage of volatility at the moment: “Since the collapse of Lehman Brothers in 2008, the dollar has seen record volatility against the euro…including six moves of at least 10%.” For traders that profit from volatility, the current uncertainty has created a windfall situation.

However, it has made value trading – based on fundamentals and the notion of Purchasing Power Parity (PPP) – risky and unpopular: “The volatility also has made what would appear to be a straightforward bet against the dollar fraught with risk. Three factors tend to move currencies: the pace of growth, debt levels and interest rates. By those standards, the dollar should be falling against the currencies of emerging-market and commodity-producing nations.” Not only is this not the case (a decline in risk appetite has turned the Dollar into a safe-haven), but even betting on a protracted Dollar decline is itself risky because of surging volatility. One way around this is to trade a Dollar Index (by way of an ETF, for example) which is inherently less volatile (half as volatile, to be exact) than individual currency pairs.

That’s not to say that value trading isn’t profitable over the long-term. “Empirical evidence suggests that currencies…show a tendency to revert back toward PPP in the longer run.” Given current volatility/uncertainty, however, this strategy is unlikely to be profitable in the short run. Fortunately, uncertainty doesn’t negate opportunity, and traders should plot strategy accordingly.