Algorithmic Trading: Winning Strategies and Their Rationale

CHAPTER 5

Mean Reversion of Currencies and Futures

Conventional wisdom tells us that currencies and futures are the domain of momentum traders, and conventional wisdom is right about this. Indeed, most CTAs (Commodities Trading Advisors) are momentum based. It is also true that most currency or future pairs would not cointegrate, and most portfolios of currencies or futures do not exhibit cross-sectional mean reversion. So opportunities for mean reversion strategies in currencies and futures are limited, but not nonexistent. This chapter will guide the reader toward those situations where mean reversion is the exception rather than the rule, such as the trading of futures calendar spreads. In particular, we will discuss a trading strategy for one unique futures intermarket spread: the volatility future versus the stock index future.

In the course of exploring mean reversion in futures, we will also discuss a simple mathematical model of futures prices that will illuminate concepts such as spot versus roll returns and backwardation versus contango. Understanding this model will also help suggest new futures trading strategies without resorting to ad hoc technical indicators.

Trading currencies has certain nuances that are foreign to stock traders. Care must be taken when testing for cointegration of currencies or when computing the returns of a portfolio of currencies by making sure that a point move in one currency pair has the same dollar value as a point move in another currency ...