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Intermarket Analysis

Intermarket Analysis

Intermarket Analysis investigates the relationships between different financial markets. The following intermarket analysis focuses on four major asset classes: bonds, currencies, equities, and commodities.

CONTENTS

The Unification of Global Financial Markets
Intermarket Analysis by John Murphy
The Complicated Role of the US Dollar
US Dollar and Gold Price Adverse Relation
Crude Oil Relationships
EUR/USD Relationships & USDJPY Correlation to Equity Prices
Treasury Bills Correlation to the Forex and Equity Markets
Industrial Metals Correlation to Equity Prices
This Research is Based on 15.5 Years of Daily Market Data
Intermarket Analysis Conclusions

The Unification of Global Financial Markets

World financial markets operate as a common area for world investors, a common area incorporating different combinations of Risk/Return, for example:

Government Bonds: Low Risk / Low Return
Corporate Bonds: Medium Risk / Medium Return
Hedge Funds: Medium Risk / Medium Return
Equity Markets: High Risk / High Return

After the crisis of 2007, the interconnections between these different combinations of Risk/Return have grown stronger. What happens in one financial market affects directly what happens in all other markets.

The Goals of Intermarket Analysis

Modern analysts use sophisticated frameworks, which are able to incorporate the major market interconnections. This is crucial for the following reasons:

(i) Explaining price action, when other methods fail

(ii) Obtaining early insight into strong long-term trends

(iii) Performing more accurate forecasting on individual assets (short-term and mid-term)

(iv) Reducing the cross-market portfolio risk, which emerges from the existence of all these interconnections (very important process for institutional investors)

Defining a Cross-Market Correlation

The term correlation will be widely used in this analysis. A correlation between two asset classes expresses an average relationship between two different markets, backed by historical data. The correlation coefficient takes values between -1.0 and +1.0, where:

+1.0 is the perfect cross-market correlation (identical direction between two assets or asset classes)
-1.0 is the perfect negative cross-market correlation (identical opposite direction between two assets or asset classes)

Forex Institutional Trading

Forex Institutional Trading, Order Flows, and Stop-Hunts

If you are a retail trader, understanding the role of Institutional Trading is the same as a little Penguin knows when and where the white sharks go for hunting. This little information can save its life numerous of times.

Profiling Institutional Traders

Institutional traders are large players managing great sums of trading capital. They include Investment Banks, Hedge Funds, Mutual Funds, Investment Firms, and some large Commercial Corporations. Institutional traders can manage their own funds but also their clients’ funds. The Euromoney Survey can provide a good insight regarding the top institutional players in the Forex market.

The Euromoney Forex Survey

According to the 2017 Euromoney Foreign Exchange survey, Citigroup continues to hold the top ranking amongst currency trading companies. Note that the market share of the top five (5) global banks has diminished to 41.1% compared to 61.5% in 2009.

Table: Euromoney Fx Ranking (Based on Forex Market Volumes)

Euromoney Fx Ranking

The Essence of Managing Portfolio Risk for Institutional Traders

Institutional traders are very risk-averse and avoid trading ‘naked’ in the market. They give extra weight to concepts such as risk management, portfolio diversification, and cross-asset correlations. They use every available financial instrument they can get in the market (Forwards, Futures, Options, Swaps, etc.). In addition, they care a lot about the transaction cost they pay. Institutional traders do not like placing all their eggs in the same basket. Therefore, they open many different positions in the market. Positions that they plan to hold for long periods of time. On the other hand, retail traders open a few positions and plan to hold them for short periods of time. The following table highlights the different trading philosophy of institutional and retail traders.

Trading the VIX (S&P500 Volatility Index)

Trading the VIX

The VIX or else the "S&P500 Fear Index” is a market thermometer measuring the risk appetite of equity investors. The VIX is a contrarian indicator that can be helpful in identifying extreme market movements and potential reversals.

Introduction to the VIX Index

The Volatility Index or else the VIX Index of the Chicago Board of Exchange (CBOE) indicates the expected volatility of the S&P 500 Index Options. In other words, it predicts the future volatility of the S&P 500 stock index. The Chicago Board of Exchange introduced the VIX Index in 1993 but added a VIX futures contract, not before 2004.

The VIX index measures the level of fear or greed in the stock market. In general, investors trade the VIX for hedging and speculation:

Hedging against the volatility risk of their existing S&P 500 positions, as historically, the VIX Index is negatively correlated to equity prices
Speculation on potential VIX volatility movements

Large institutional investors use the VIX derivatives to hedge their long positions in S&P 500 stocks. This is happening as the market volatility booms when the stock prices tank. Other investors simply use the VIX Index to speculate on high S&P 500 volatility.

What the VIX Really Measures?

As calculated by the CBOE, the VIX presents the market expectations as concerns S&P 500 volatility for the next 30 days.

■ VIX tracks CBOE put (down) and call (up) options of the S&P 500

■ VIX above 30 indicates high volatility and below 20 indicates low volatility

The VIX Formula

This is the generalized CBOE VIX Index formula:

Algorithmic or Mechanical Trading

Introduction to Algorithmic or Mechanical Trading

What is Algorithmic/Mechanical Trading?

Algorithmic, Algo, Mechanical, Systematic, or Rule-Based trading, refers to a trading method where order execution is based exclusively on a pre-defined set of rules and instructions.

 Mechanical-trading rules and instructions include variables such as price, time, and volume

 Mechanical-trading usually refers to a software code (automated-trading), but it can be also based on manual execution

Who Applies Algorithmic Strategies?

Several different market participants apply algorithmic strategies, such as investment firms, hedge funds, high-frequency trading firms, large individual traders, and small retail traders.

In the top of the chain, there are several large hedge funds and investment firms using state-of-the-art technology and hiring a wide team of programmers, mathematicians, and professional traders. They use proprietary systems, programmed to trade tiny inefficiencies between the dynamics of demand and supply. These strategies can focus on a single financial market, or on multiple asset classes. The asset classes involved include shares, ETFs, currencies, and government bonds.

Can Retail Traders Compete?

In the short-term, retail traders are unable to compete against institutional traders holding superior technology and unlimited resources. Retail traders can only develop and apply mechanical systems aiming to trade price swings lasting from a few hours to several days.

Analyzing Forex Market Volumes

Foreign Exchange Market Volumes

Volume is a leading market indicator that can help traders to recognize strong trends and reversals, but also to identify the current market phase and to think ahead of the current price action.

In general, analyzing market volumes can be helpful in:

Evaluating the strength of a price trend
Confirming the breakout of a key support/resistance level
Recognizing the market phases of accumulation/distribution
Indicating signs of potential price reversal
Optimizing the time to enter/exit the market

The Aggregate Forex Market Volumes

All organized exchanges report daily the aggregate number of traded financial assets (contracts, shares, etc.). On the contrary, the Foreign Exchange market is an OTC (Over-the-Exchange) decentralized market and that means measuring the aggregate volumes is a very difficult task. The Bank of International Settlements (BIS) offer some insight regarding Foreign Exchange volumes.

Here are some key points according to BIS Triennial Survey (2016):

The Foreign Exchange market daily volumes average over 5.0 trillion USD
Spot transactions reach 1.7 trillion USD per day (diminishing for the first time since 2001)
FX swaps transactions reach 2.4 trillion USD per day (Forex traders are showing an increasing interest for derivatives contracts)
Outright Forwards reach 0.7 trillion USD per day
Options and Similar products reach 0.25 trillion USD per day
The US dollar remains the dominant vehicle currency, being on one side of 88% of all Forex transactions (Euro 31%)
Five countries (UK, USA, Singapore, Hong Kong, and Japan) contribute 77% of all Foreign Exchange transactions

Source: http://www.bis.org/publ/rpfx16fx.pdf

Forex Market Sessions and Volume

The London Session is traditionally the most active Forex session and the New York session is the second most active. The London/New York session overlap offers the most volume-active Forex trading hours.

■ Volume peaks between 12.00 GMT and 16.00 GMT

Trading Forex by Following the Smart Money

Following the Smart Money -The Six (6) Indicators

Traders who are able to recognize and to follow the movements of the smart money can improve significantly their trading performance.

What is the Smart-Money?

Smart money can be defined as the capital invested by traders with expert knowledge and often with inside information. The smart money can spot trends before others and trades basically against the general market sentiment.

Smart-Money and the Foreign Exchange Market

The Foreign Exchange market is a decentralized (OTC) market and that means there is no track record of the aggregate trading activity. That makes things even more difficult in identifying the smart money movements. However, there are quite a few indicators providing an insight to where the smart money is flowing.

This analysis includes the following indicators:

(1) Following the Long-Term Circles of Unemployment, Inflation, and Growth

(2) COT Analysis (Commitment of traders)

(3) The US-Dollar Index (USDX)

(4) The CBOE Volatility Indexes (VIX & Skew Index)

(5) The Treasury Bills Correlations

(6) Contrarian-News Approach