Computer models simply don’t understand the underlying fundamentals driving the currency markets as European markets concern themselves with the possibility of global contagion.
Ikos, which runs one of the largest forex funds, the Ikos FX Fund, has managed meager 1.4% returns in 2011. In October, the fund manager reported losing 4% in a single month. The Wall Street Journal reported that as many as 60-75% of all forex funds use algorithmic models to place trades in the foreign exchange market.
FX Concepts, one of the world’s premier foreign exchange funds, is down some 14% this year after computer models led the firm in the wrong direction leading up to Greek sovereign debt concerns. The fund may have laid off as many as three employees due to fund losses, an indication that the tide may have turned for computer models in forex trading.
Technical Analysis Fades
Earlier this year the Federal Reserve Bank of St. Louis published a paper on technical analysis in the foreign exchange market. The study found that technical analysis is becoming less profitable, even though the study continues to become more popular with retail foreign exchange traders.
The Fed had this to say about technical trading rules:
“TTRs were able to earn genuine risk-adjusted excess returns in foreign exchange markets at least from the mid-1970s until about 1990.”
Later, the paper says:
“…and that rule profitability has been declining since the late 1980s.”
According to the research, the failure of technical analysis in the markets is due primarily to liquidity. The paper studies the potential returns in currency trading, finding that the most successful technical trading strategies are found not in major currency pairs, but in the exotic and emerging market currencies.
Return to Fundamentals?
It seems unlikely that fundamentals will retake the market to be a leading driver of volumes. Faster trading speeds and hedging bring more active markets. More active markets, especially more liquid markets, can price almost any happening into currency rates in mere seconds. Fast-acting computer models are finding new opportunities to exploit the statistically risk-free earnings potential in a multitude of markets. It is hardly uncommon for algorithmic trading firms to hedging foreign exchange risk in equity holdings, bridging the gap between stock and currency trading.
The study ultimately concludes that investors who use technical trading and algorithmic models can generate consistent profits, but the capacity to do so requires continuous innovation and more sophisticated modeling systems.
Photo by: Phil_G