Advanced Forex Strategies Part 1 – Tug of War

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The concepts of TOW are basically from Cross Hedging, Pair Trading, and Double Opposition Entries which use quantitative analysis to develop a profitable trading strategy. TOW is one of the Forex Hedge Fund Strategies that yields the best of results employing an automated system of opening and closing positions based on current market trends and flows. The system is a form of trading that involves making price comparisons between two or more markets in order to capture temporary price disparities that occur when markets move out of their “normal” or intrinsic price alignment. This strategy typically uses statistical measures to determine when two highly correlated markets have moved to a price differential point beyond their historical “average price difference” and may be signaling a trading opportunity. Once the two markets are determined to be statistically “out of alignment”, a long position is taken in the market considered to be undervalued while a short position is simultaneously taken in the market considered to be overvalued relative to the first market. This strategy combs through price ratios and mathematical relationships between currency pairs that are highly correlated enough to create a hedged position as long as the prices move in the same direction. A good example is cross hedging the Euro and British Pound. Even though these two currencies are not identical, their price movements are similar enough to use for hedging purposes. TOW has the potential to achieve profits through simple and relatively low-risk positions.

TOW’s signals are usually given by proprietary spread/arbitrage trading systems that can utilize multiple time-frames including intra-day, daily and weekly price bars. Stop loss orders and targets can be executed intra-day on a 24 hour a day basis. A closer inspection of price spread comparison charts should indicate the existence of short to medium-term price trends that fluctuate around either side of their historical average price relationship-which may also be trending on a longer term basis.

Trades can be based on an expected price move toward a calculated average price relationship (mean reversion), or trades may be taken in expectation of a potential move away from a calculated mean price and toward an extreme price relationship level (mean aversion).

TOW is market-neutral, meaning the direction of the overall market does not affect its win or loss. The goal is to match two currencies that are highly correlated, trading one long and the other short when the pairs’ price ratio diverges “x” number of standard deviation – “x” is optimized using historical data. If the currency pair reverts to it mean trend, a profit is made on one or both of the positions.

Damon Catania
Forex DayTrading Systems

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