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Handbook of Exchange Rates by Lucio Sarno, Ian Marsh, Jessica James

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20.5 Trading Models

20.5.1 Overview

In this section, we describe a new class of trading models. At Olsen, we use this type of trading model in a portfolio of more than 20 currency pairs. The positions of the trading models are countertrend, meaning that a price move down triggers a buy; a price up move, a sell. These models provide liquidity to the market. Typically, prices move down when there is a lack of buyers, and they move up when there are not enough sellers. By being countertrend, we help balance demand and supply.

A trading model is made of basic agents: the so-called coastline traders that are described in some detail below. The strength of our models is the fact that these agents are identical across currency pairs. The only difference is the price scale λ at which they operate, which adapts to the changing volatility regimes.

20.5.2 Coastline Trader

A coastline trader is a process that exploits profit opportunities contained in the long coastline of prices. As seen above, the coastline is made of the price moves up and down at a given price scale λ. As we shall see, trading the coastline generates profits that is used to improve the price average and speed up the closure of the position. On the price scale λ, the state of the process is defined by its exposure eτ, price average aτ, and the length of overshoot lτ, where τ > 0 is the age of the process expressed as the number of events. An event is the occurrence of a price move of size λ. We now describe the state variables ...

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