This article highlights how autocorrelation and linearity for end-of-day prices can benefit your trading strategy. We’ll focus on trading and investing in the Euro ETF (symbol: FXE) with a discount trading indicator. Finally, we’ll work our way to backtest the results of the discounting strategy.

The following is a scatterplot depicting the relationship between the previous day’s Net-Asset-Value (NAV) prices for daily median prices for FXE.
Figure 1

You’ll notice there is a good linear relationship, giving a leg up for those who know how to harness the strength in NAV price information for the Euro ETF (FXE).

The following chart corresponds to the same time horizon as the scatterplot, with daily close prices of FXE:

Figure 2
Notice, there isn’t a strong indication of a trend for the entire period since 2006. This is another reason why the sentiment discount trading strategy works so well. Generally, there shouldn’t be any strong trend on the underlying instrument—up or down—for the strategy to work well.

Since we’ve asserted linearity and autocorrelation in daily median prices, a discounting strategy is a reasonable one for us to expect to be profitable. The main goal of this strategy is to capture any Δ (deltas) that are fraying away from the predicted average.

In other words, seeing the linear relationship in the above scatterplot, what we want to do is sell any future points on the graph that are above the linear estimate, and buy any price points that would fall below the line estimate.

This is possible by building a custom indicator. For this example, we’ll turn to Ninja Trader 7 trading software.The biggest obstacle for building our custom indicator, the closed-end-fund discount (CEFD) indicator, is importing the NAV prices, just because the software doesn’t download NAV prices by default. Do not be intimated by this, the formula is fairly easy, and there is a setup wizard in the software package. After downloading Ninja Trader 7, you will go to Tools->New NinjaScript->Indicator as follows:

Figure 3
You’ll want to create an indicator that values the daily CEFD, which is expressed as the previous day’s median price, divided by the previous day’s NAV price. The formal equation for the indicator is as follows:
Here are the results from the backtested strategy done on EURUSD results since 2006:

Figure 4
What are some other good reasons to trade the Euro ETF?

  • Practical trade execution and low-cost.
  • Lower volatility and lower risk of loss.
  • FXE is an optionable stock ETF.
This is all well and good, but there’s a very good reason why our focus is FOREX. So, here are a couple reasons not to trade the ETF versus FOREX markets:

  • Less liquidity
  • Limited trading hours
  • Limited trading, due to EOD prices.
We would much rather apply this strategy directly into the major EURUSD cross pair. However, because most of the informational value is in the NAV price relationship to the market prices, we would lose considerable value in the strategy. Spot FOREX does not have a daily NAV price to compare with, only average prices and forward prices.

The result of our backtest of the trading strategy when applied to the spot FOREX prices of the EURUSD looks like this:

Figure 5
With there being autocorrelation and a linear relationship of the Previous day’s nav prices and current median prices, we’re able to construct a sentiment discounting strategy on the Euro ETF (symbol: FXE), via a custom-built CEFD indicator in Ninja Trader 7 with a little help from the software, we’re able to generate a detailed proof of backtest results from 2006 to the present day. When considering other features of trading ETFs; such as, limited risk, and options, it’s safe to say that trading the Euro ETF (FXE) holds some major benefits for traders. Finally, traders should experience profitable trading periods with autocorrelated asset prices, such as FXE, especially during non-trending markets.
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