Risk Indicators

During the fiscal crisis of 2008, I wrote about how I watched some risk indicators such every bit the VIX or the TED spread  to create upward one's heed what leverage I should use for my trading strategies. It turns out that this physical care for is simply every bit critical for the electrical current crisis that began inward August 2011. In fact, to a greater extent than than leverage-determinants, they tin locomote used every bit the all-important variable that determines whether a for certain strategy should locomote run at all. (What's the betoken of running a model that y'all mean value volition lose coin amongst depression leverage?)


There are instantly to a greater extent than than a few of these risk indicators to selection from. Besides the VIX in addition to the TED, at that topographic point are the VSTOXX (EURO STOXX fifty Volatility), the VXY (JPMorgan G7 Volatility Index), the EM-VXY (JPMorgan Emerging Market Volatility Index), the ETF's ONN and OFF, in addition to belike many to a greater extent than that I haven't heard of yet. 


A lot of academic enquiry has been done on whether nosotros tin devise "regime switching" models based on some complicated pattern-recognition algorithms to create upward one's heed whether a marketplace is inward a for certain "regime" which favors this or that item model or parameter set. And often, these authorities switching models rely on the recognition of some complicated laid upward of patterns inward the historical cost series. Sorry to say, I accept non establish whatever of these complex authorities switching model to accept whatever existent out-of-sample predictive power. On the other hand, my enquiry shows that some of the aforementioned elementary risk indicators volition indeed forestall some trading models from falling off the cliff.


But which of these indicators are applicable to which model? This is non so obvious. For example, y'all powerfulness mean value that the EM-VXY would locomote an ideal leading indicator for Forex trading models that demand emerging marketplace currencies, but I accept establish that it is solely a contemporaneous (and hence useless) indicator to mine. Another example, I said during the 2008 fiscal crisis that VIX seems to locomote a useless contemporaneous indicator for equities trading models, but strangely, it is a expert leading indicator for FX models. In contrast, the TED spread that everyone were obsessed close inward 2008 shot upward to over 300 bps then, but never went beyond 100 bps this fourth dimension around. So actually solely rigorous backtesting tin guide us here.


What risk indicators produce y'all use? And accept y'all actually backtested their efficacies? Your comments would locomote real welcome here.

Hidden Markov Model Applied To Fx Prediction

I read amongst involvement an older newspaper "Can Markov Switching Models Predict Excess Foreign Exchange Returns?" yesteryear Dueker as well as Neely of the Federal Reserve Bank of St. Louis. I direct maintain a fondness for hidden Markov models because of its dandy success inward spoken language recognition applications, exactly I confess that I direct maintain never been able to create a HMM model that outperforms elementary technical indicators. I blame that both on my ain lack of inventiveness equally good equally the fact that HMM tend to direct maintain equally good many parameters that postulate to last fitted to historical data, which makes it vulnerable to information snooping bias. Hence I approached this newspaper amongst the dandy promise that experts tin laissez passer on notice instruct me how to apply HMM properly to finance.

The objective of the model is simple: to predict the excess supply of an central charge per unit of measurement over an 8-day period. (Excess supply inward this context is measured yesteryear the % modify inward the central charge per unit of measurement minus the involvement charge per unit of measurement differential  between the base of operations as well as quote currencies of the currency pair.) If the expected excess supply is higher than a threshold (called "filter" inward the paper), as well as thence acquire long. If it is lower than or thence other threshold, acquire short. Even though the prediction is on a 8-day return, the trading determination is made daily.

The excess supply is assumed to direct maintain a 3-parameter student-t distribution. The iii parameters are the mean, the marking of freedom, as well as the scale. The scale parameter (which controls the variance) tin laissez passer on notice switch betwixt a high as well as depression value based on a Markov model. The marking of liberty (which controls the kurtosis, a.k.a. "thickness of the tails") tin laissez passer on notice also switch betwixt ii values based on or thence other Markov model. The hateful is linearly theme on the values assumed yesteryear the marking of liberty as well as the scale equally good equally or thence other Markov variable that switches betwixt ii values. Hence the hateful tin laissez passer on notice assume viii distinct values. The iii Markov models are independent. The student-t distribution is to a greater extent than appropriate for the modelling fiscal returns than normal distribution because of the allowance for heavy tails. The authors also believe that this model captures the switch betwixt periods of high as well as depression volatility, amongst the consequent modify of preference (=different hateful returns) for "safe" versus "risky" currencies, a phenomenon well-demonstrated inward the menses betwixt August 2011 to Jan 2012.

The parameters of the Markov models as well as the student-t distributions are estimated inward the in-sample menses (1974-1981) for each currency dyad inward social club to minimize the cumulative departure of the excess returns from zero. There are a full of fourteen parameters to last thence estimated. After these estimations, nosotros direct maintain to also approximate the ii trading thresholds yesteryear maximizing the in-sample supply of the trading strategy, assuming a transaction costs of 10 footing betoken per trade.

With this large release (16 inward total) of parameters, I dread to come across the out-of-sample (1982-2005) results. Amazing, these are far ameliorate than I expected: the annualized returns attain from 1.1% to 7.5% for iv major currency pairs. The Sharpe ratios are non equally impressive: they attain from 0.11 to 0.71. Of course, when  researchers study out-of-sample results, 1 should accept that amongst a grain of salt. If the out-of-sample results weren't good, they wouldn't last reporting them, as well as they would direct maintain kept changing the underlying model until goodness "out-of-sample" results are obtained! So it is actually upward to us to implement this model, apply it to information afterwards 2005 as well as to to a greater extent than currency pairs, to honour out if in that location is actually something here. In fact, this is the argue why I prefer to read older papers - to permit for the possibility of truthful out-of-sample tests immediately.

What exercise you lot scream back tin laissez passer on notice last done to improve this model? I suspect that equally a origin step, 1 tin laissez passer on notice come across whether the estimated Markov states stand upward for reasonably to what traders scream back of equally risk-on vs risk-off regimes. If they do, as well as thence regardless of the usage of this model equally a signal generator, it tin laissez passer on notice at to the lowest degree generate good risk indicators. If not, as well as thence perchance the hidden Markov model postulate to last replaced amongst a Markov model that is conditioned on observable indicators.

A Hft Primer

As a follow-up of my previous discussions on high frequency trading, I accept invited invitee blogger Jennifer Groton to portion alongside us a quick survey of diverse mutual HFT strategies used yesteryear equities too FX traders.

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High frequency trading strategies are nether fire.  The recent trading spike inwards our national exchanges was duly noted equally a short-circuit waiting to locomote on too drew immediate manufacture criticism of auto-trading robots. Before a witch-hunt ensues, perchance a review of the mutual HFT strategies inwards stocks too Forex is inwards order. 

High-frequency firms employ a broad diverseness of  low-margin trading strategies that are implemented yesteryear professional person marketplace position intermediaries who accept invested heavily inwards technology. These firms claim that they brand markets to a greater extent than efficient yesteryear enhancing liquidity too transparent cost regain to the create goodness of investors.  The Forex market’s unique combination of high liquidity too depression volatility instruct far an ideal environs for deploying HFT strategies, although many of the ideas too engineering scientific discipline are from the equity markets.  The basic strategies autumn into 3 categories: market-making, trending or predictive, too classic arbitrage.

Market-making strategies tend to focus on a unmarried stock or currency pair.  Many firms inwards this expanse accept been described equally engaging inwards "rebate-capture trading", a reference to the credits that firms instruct for providing liquidity on near marketplace position centers.

The instant grouping consists of mean-reversion too trending strategies. These utilize technical indicators for stocks or forex indicators for currencies, too essay to generate to a greater extent than provide from private trades.

The terminal grouping may ask a cross-section of trades from multiple markets.  The classic arbitrage strategy is a shape of the “carry trade” that uses the prices of a domestic bond, a bond denominated inwards a unusual currency, the spot cost of the currency, too the cost of a frontward contract on the currency.  If the marketplace position prices are sufficiently dissimilar from those implied inwards the model to encompass transactions costs, hence iv transactions tin hold upwards made to guarantee a risk-free profit.

High frequency trading is attributed alongside generating over 70% of the book of trades on our equity markets.  Similar statistics are non available for forex markets, precisely speculating disguised equally commercially necessary trades accept been reported to hold upwards over two-thirds of the volume.  Liquidity too pricing transparency are the benefits offered yesteryear its advocates, precisely regulators too other marketplace position participants who disagree alongside this positive assessment are shortly discounting these benefits.  Transaction taxes too fourth dimension limits on orders accept been proposed to mitigate the perceived direct a opportunity created yesteryear HFT firms, precisely the wheels of Washington motility slowly, fifty-fifty inwards crisis.  For the fourth dimension being, at that topographic point is no indication that their participation volition hold upwards discontinued.