Where does FX sit in a Systematic Trading Portfolio?

You rarely meet a rich forex trader. I’ve met plenty of rich traders who trade quant factors or stat arb. Plenty of market makers, futures spreaders and volatility traders that do nicely. But I don’t think I’ve ever met a rich forex trader.

Jeez man – what a downer!

Don’t run away, we’re gonna turn this around into something positive… bear with us!

This post is a BONUS LESSON taken directly from Zero to Robot Master Bootcamp. In this Bootcamp, we teach traders how to research, build and trade a portfolio of 3 strategies including an Intraday FX Strategy, a Risk Premia Strategy and a Volatility Basis Strategy. If you’re interested in adding strategies to your portfolio or are just keen to start on the path to becoming a successful and sustainable systematic trader, you can check out full details of the Bootcamp here.

Let’s look at our map of the trading landscape and briefly discuss why that is.

This map shows the effects we can take advantage of in the financial markets to make money, and the strategies we can use to exploit those effects.

On the left, we have risk premia (which we explore in Embrace the Mayhem Initation, Week 0 of Bootcamp) .

By taking on certain short term risks, such as the risk of sudden large losses in the equity markets, we tend to get rewarded over time. In other words, you tend to make money buying and holding stocks and bonds. You also tend to make money taking on certain illiquid investments and selling insurance. 

Risk premia is the easiest game in town – if you can calibrate your risk/reward expectations sensibly.

Unfortunately, there is no clear risk premium associated with the FX market as a whole. The expected value of a trade in an FX pair is essentially zero. And that’s certainly true of the market as a whole.

There is no broad FX risk premium we can collect. No easy tailwind.

So we need to make all our returns trading actively. This makes things a fair bit harder – but not impossible.

Where to hunt for alpha

In our map, we divide exploitable market effects into Factor styles in light green at the bottom left and Other inefficiencies in dark green on the top right.

Factor styles are pervasive broad cross-sectional effects which tend to be seen across and within most asset classes, including FX. They include short term mean reversion, momentum, carry, value and low volatility. If there are any “easy wins” in FX it is smart for us to start looking for them here.

The things we’re calling “Other inefficiencies” include your more unique alpha effects, including seasonality, cointegration effects and conditional over and under-reaction by traders to events. This can be a fertile place to look in less efficient markets like the equity and commodity futures markets. It’s harder (but not impossible) in the FX markets, which are ruthlessly efficient. But there are some edges we’ll look to exploit there.   

Throughout Bootcamp, we’ll be sharing a number of these alphas that we’ve found and are currently actively trading.

The intent is that you will use these to make money, but even more importantly we want to show you how we discovered them, how we tested them, and how we implemented them. No doubt these alphas will disappear at some point, but if you know how to discover and exploit others, you’ll never be short of replacements. And there are literally dozens of ideas out there that you can test if you have the tools and know-how to do so.

Main points

  • There is no risk premium inherent in the FX markets – which means we are missing the tailwinds that we like to trade with.
  • We are therefore forced to generate returns through active trading in an efficient market.
  • This is difficult, but not impossible. And there is no shortage of good ideas to pursue.
  • We’ll show you a number of the alphas we trade.
  • More importantly, we’ll show you how we discovered, tested and implemented these alphas.
  • It’s hard to get rich just trading FX.
  • Therefore, it’s very smart to view FX as one part of your trading operation, not the whole thing…

In the next lessons, we’ll run through a quick history of the currency markets and currency trading. And we’ll talk about some other characteristics of the FX market that you simply must know before you wade into these waters.

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