In my previous articles on grid trading I have covered topics such as:

• The origins of grid trading
• Discretionary grid trading using the methods described in Bird Watching in Lion Country (BWILC)

In this article I was to look at Grid Trading using Correlated Pairs.

Correlation Based Grid Trading

In my previous articles , we looked at trading a single currency pair with a grid. For example, BWILC uses grids to trade the primary fundamental trend. In both this approach, hedging trades are done on the same pair. In the original approach to grid trading, described in the first article, the hedging trades we done on a correlated pair. For example the long side of the grid might be on the EUR/USD and the short side of the grid might be done on the USD/CHF.

The way it works is when the EUR/USD moves in your favor you take profits. All the while you will be building up drawdown on any open USD/CHF positions you may have open. Eventually, the USD strengthens and then moves in favor of your USD/CHF short positions and you start taking profits on your USD/CHF positions while building up drawdown on any open EUR/USD long positions. Eventually the USD will move back in favor of you long positions and you repeat the process.

The primary motivation for using a correlated pair in the original system was that Oanda did not support hedging orders on the same pair. So if you had a long EUR/USD position, you could not hold a short EUR/USD position as well. On the Oanda platform, when grid trading was first popularized, if you wanted to have hedging positions in the opposite direction of your long EUR/USD you had to either:

• use a separate sub-account with your short EUR/USD position in it; or
• use a highly correlated pair (such as the USD/CHF) for the opposite side

If you have your hedging positions in another sub-account, then the drawdown would not be offset by your profitable positions and you are at greater risk of a margin call. Therefore the inventor of the system preferred to use the later method.

By trading the pairs in this way however, what you are effectively building up is a synthetic EUR/CHF position and not a hedged EUR/USD position.

If the EUR/CHF is ranging at the time the trades are underway, the hedge is relatively reliable. However, if the EUR/CHF trends and the correlation between the EUR/USD and USD/CHF breaks down, the hedge becomes unreliable and you are left exposed to a potentially nasty drawdown or a fatal margin call.

The other way you come unstuck with this approach is failing to realize that a EUR/USD position has a different base to a USD/CHF position, so the pip sizes are different. Therefore, to have a perfect hedge, you cannot simply take a single lot on both positions, you have to take out a smaller number of lots on the USD/CHF to have an equally hedged position. Ironically, the value of this difference in pip size equals the EUR/CHF.

On the upside, there are two primary advantages to trade this strategy:

• the EUR/CHF has a tendency to range, because the Swiss economy is highly linked to the Eurozone economy . The tendency to range makes it great to exploit in grid trading; and
• The other advantage of this strategy of course is if you arrange your orders on the grid in the right direction you can benefit from carry trading related interest

These benefits of course could be gained from trading the EUR/CHF directly. Probably the only benefits for trading the synthetic pair over the cross would be:

• Pairs like EUR/USD and USD/CHF range by as much as 100 pips in a day, whereas the EUR/CHF only ranges 40 pips in a day. This extra volatility means there is more opportunity for a grid trading system to profit. (thank you to Colin for pointing this out here);
• Unexplained price spikes and requotes are probably more common on the crosses like the EUR/CHF;
• Some crosses may have higher spreads than the product of the underlying pairs (although this is not the case for the EUR/CHF);
• You can trade cross rates that might not be available on your brokers platform by building up synthetic pairs; and
• It is useful for brokers who do not support hedging.

The other benefit of correlation based hedging is the psychology of the strategy. When you are trading grid based strategies you expect to be left holding some positions in draw down. It is just part and parcel of the approach. Compared to the regular approach to trading, where you are likely to drop positions at the first sign of trouble, with grid trading you are more likely to weather a poorly performing grid position until it comes good.

On of the things that disappointed me about correlation based grid trading is it does not seek to exploit some of the more advanced statistical arbitrage edges that pairs traders in the stock and futures market have been exploiting since the late 80s. I think if an area is worth exploring on how to further improve the edge of correlation grid trading.

Correlation Based Trading Systems

The buzz around grid trading has created a market place full of free and not-so-free grid traders, including:

• Freedom Rocks;
• Forex For Smarties;
• True North;
• Trade Goose;
• HedgeEA; and
• Groodge

Freedom Rocks (FR)

I personally know very little about how FR actually works or really how successful it is (I am not a member, so I don’t know the real inside story). On the surface FR seems to uses a combination of four elements:

• Multilevel or network marketing scheme to try and get the system taken up
• Financial advice services to help you get debt free (i.e. the sales spiel goes something like – “we will get you debt and financially free”)
• A hedged position to earn interest from the carry (i.e. the sales line goes something like “see we pay you more interest than the banks”)
• A grid trading expert advisor to earn income from volatility opportunities

I find the use of a network marketing scheme by FR suspicious. Actually I find any multilevel marketing scheme suspicious (everytime someone tries to sell me Amway I run for the hills). I can see why they are doing it. It is all about FR playing the role of an introducing broker (IB). By getting the members to sell FR to as many non-trader Mums and Dads as possible they stand to make substantial gains from the small fee they pickup from the spread on each trade. Then when you add that to a business of selling seminars, the owners of FR stand to make money no mater how bad their grid trader performs or how badly the carry trade is in drawdown.

Now whether on not FR is a bad egg or not, I do not know. All I can say is if you are interested in FR, please approach it with a skeptical mind. And for god sake don’t give them any money until you have done enough research to convince yourself that it is worth trying.

Forex For Smarties (FFS)

FFS seems to try and replicate he trading element of FR without the network marketing element. They charge about $99 per month for access to their system. I don’t know if the FR and FFS trading systems are the same. However, on the FFS website they describe their strategy as follows:

1. You buy unequal quantities of one or two major currency pairs and buy unequal quantities of another one or two major currency pairs which usually move in the opposite direction. This is a form of “Hedge” trading. It gives you a partially hedged position in the market. Ideally, gains on one side would cancel losses on the other and leave you with a flat position (no risk and no profit). In practice, movements will produce alternate overall gains and losses, usually within an acceptable range of risk. You can hold long term with reduced risk because of the hedging. You earn interest daily on the held position which can yield up to 30% per year of your full account balance. This is a form of “Carry” trading;
2. While holding, you place buy “limit” orders below, and sell “limit” orders above, your entry price on each traded currency. Hence, you buy low and sell high. This is a form of “Grid” trading. Depending on your choice of settings and market movements, these trades can produce substantially more than 30% per year; and
3. When your entire position is in a reasonable overall profit (say 10% of your total account balance), you may close out all trades, which will transfer your unrealised profit into cash in your account balance. You could do this to compound your earnings and increase your trade sizes and interest, or to withdraw profit without reducing your safety margin.

The success of subscribers with this method is open to question. If you read their forums you can see in late 2007 a number of members started to complain about big losses. Then all of a sudden management didn’t seem to respond to requests any more. The website seems to still exist, but I don’t think anyone is home. Given the lack of activity I did’t waste any time here.

True North

True North is an excel based hedging calculator which can be purchased for USD $199 and it allows you to calculate how big a hedging position is required. It also allows you to calculate 3 way and 4 way hedges as well. True North does not seem to come with a grid trading component, so it probably doesn’t fit into this article, but I have included it anyway.

If you read their website, they spruke that enormous returns can be made with their spreasheet and they provide an example of a statement over a three day period where they make astronomical returns. I find this just plain dodgy. Making a killing on one trade is one thing, but to do it consistently is another. I would steer clear of this until they are more forthcoming about the consistency of their results.

Trade Goose

I mentioned above that I was disappointed that most correlation based grid trading systems failed to exploit similar edges to pairs based trading systems used in the futures and equities markets. Trade Goose is a system that seems to do this and for this they demand a premium price of around $159 per month. They don’t provide many details about how their system works, other than:

Trade Goose utilizes an intense algorithm to analyze price behavior and correlation coefficients between pairs. These algorithms were created using computer modeling, cycling millions of iterations, looking for the strongest probabilities. Trade Goose focuses on price action with little reliance on lagging indicators. Extreme movement in divergence of correlation provide the profit opportunities. Trade Goose enters and exits trades often, as it focuses on short term moves. In addition, Trade Goose leverages a self adjusting grid to manage drawdown as it sheds old or losing positions. Therefore, periodic losses are a key part of the risk management strategy and are to be expected.

On their website they claim a weekly return of 2.5 to 3.5% is possible, but I have also seen this system is open to a reasonable degree of risk. For example, on forex-tsd forums the creators of trade goose in their demo account regularly have drawdowns higher than 25% and on one occasion they recorded a massive 65% drawdown. On their live account their is an example of almost a 50% loss.

I would say this system is still evolving. I would steer clear of it for a while until we start seeing others reporting positive results with maximum drawdowns less than 20%.

HedgeEA and Groodge

HedgeEA and Groodge are open source grid traders available on forexforums.org. HedgeEA tries to build an optimally hedged grid on the EUR/CHF in order to benefit from the carry income. Groodge on the other hand searches between multiple pairs to find the highest active correlation to place the grid on for the next cycle of trades. Once the cycle is complete, Groodge looks for another pair of currency pairs to place the grid on.

I have not had time to evaluate either of these at the moment. I may come back and have a look at these later.

Closing Thoughts

After having a look at correlation based grid trading, I would say approach these systems with caution. If there is an edge with these systems it is in using grid trading in a market that “typically” ranges. However, the big downside is that correlations break down all the time and you will be left holding the nasty end of a big draw down or get margined out at worst. If you want to fool around with grid trading I would start with the free HedgeEA and Groodge (described above) and see for yourself. I wouldn’t be shelling out any cash at this stage for one of the above commercial systems until you have had more experience.

This entry was posted on Monday, August 18th, 2008 at 10:52 pm and is filed under Grid Trading, Product Reviews. You can follow any responses to this entry through the RSS 2.0 feed. You can skip to the end and leave a response. Pinging is currently not allowed.