Monday, February 19, 2007

Do the FX Futures Help Us Track Large Traders in the Currency Markets?

You're probably aware that the Chicago Mercantile Exchange trades Euro FX contracts that trackscurrency trading involving the Euro and the dollar. (The CME also has contracts covering many other currency pairs). The price of the contract reflects the value of a Euro in dollar terms, so that when the contract rises in price, it reflects Euro strength and dollar weakness. The symbol for the Euro FX contract is 6E, and the current contract is 6EH7.

What you may not be aware of is that the Euro FX contract has gained respectable volume over time. It is not at all unusual to see 20-40 thousand contracts trade per hour during the busier hours. While this is not as much volume as we're accustomed to seeing in the emini S&P 500 Index (ES), it is sufficient liquidity for most independent traders. During those busier hours, a one-pip spread is the norm (a pip is the equivalent of a tick in the equity index futures and is equal to .0001 dollar.) Further background on the FX markets and the Euro product is available through the CME.

The question, however, is whether volume in the Euro product reflects true underlying demand and supply in the much larger cash market for currencies. After all, the cash market for FX, according to the CME, amounts to 1.9 trillion dollars daily. The FX futures, with their tens of thousands of contracts traded, are but a tiny fraction of this much larger market.

Readers are aware that I use futures volume in the S&P 500 Index to help me understand how large traders are trading. This is valuable in identifying breakout trading opportunities, and it also helps me identify when markets are likely to be range bound. To gauge how much movement we're likely to get during the day, I track how much volume in the ES futures we're getting relative to how much we normally have for that time of day. This is a helpful measure of market opportunity, because it tracks the presence of large traders in the futures, which is well-correlated with the presence of institutional traders.

But can we obtain similar benefits by tracking FX futures volume? One problem in the FX markets that we don't have in equities is that there is no central marketplace for the cash trade. For U.S. stocks, for instance, we can compare the cash trading volume in the NYSE Stock Exchange with the day's futures trading volume in the CME emini S&P contract and observe a positive correlation. Cash currencies, however, trade on multiple platforms and lack a single, central marketplace that reports volume. There is no equivalent of a New York Stock Exchange for cash currency trading.

If, however, we can establish that futures volume in the FX market is connected to price movement, then we can infer participation of large traders in the currency market when futures volume is high relative to its norm. We know that small futures traders don't move the world currency markets. When those markets are moving significantly, large institutional traders--from banks to hedge funds to monetary authorities--are responsible. A high, positive correlation between FX futures volume and movement in the Euro/Dollar relationship would suggest that we might be able to use FX futures volume data similarly to the ways in which I use futures volume in the ES product.

I went back to 1/3/2007 in the 6EH7 contract and examined hourly futures volume from 8:00 AM ET to 15:00 ET. What we see is a great deal of variability in hourly volume within the day--even more than is typical in the equity index futures markets. Volume is highest in the morning hours and noticeably tails off from noon forward. The correlation between hourly volume in the Euro FX emini contract and the high-low price range for that hour is a very high .89. Equally interesting, volume for the hour correlates with the price range for the next hour by about .30. What this means is that, for FX futures as for equity index futures, volume is telling us something about volatility. When there is more volume, there's more movement--and thus more potential opportunity for the trader. Since only large, institutional participants can move the currency markets, this suggests that Euro FX volume is telling us something about the involvement of the "big boys" in that market.

When I limited my look to the period between 8:00 AM ET and noon, a similar, high correlation between volume and price range was evident: .86. Interestingly, however, there was a smaller correlation between volume in the current hour and price range for the next hour: .11. That tells me that volume may be variable within the hour for the FX futures, limiting serial correlations.

I decided to drill down and examine Euro FX futures volume on a 15-minute basis between 8:00 AM ET and noon. Once again, the correlation between volume and price range was very strong: .85. Moreover, we see a substantial correlation between volume in the prior 15-minute period and price movement (range) in the next 15-minute segment: .31. Even on this short time frame, volume informs us not only about current volatility, but also contains information about upcoming opportunity.

My very strong suspicion is that it is not absolute volume that is important, but current volume relative to the average volume for that particular time of day. If we're trading 20,000 contracts at 9:00 AM, that might be average volume or even a bit below. That same volume at noon would be quite high. Knowing typical volume at each time period and how much volume we're currently getting helps us infer likely movement, which is really a function of institutional participation.

Can a currency trader infer the likelihood of a range bound or trending day based on unfolding volume? Can we use futures volume in the Euro FX eminis to validate genuine vs. false breakout moves? Can we combine an analysis of volume with movements toward and away from value areas for an enlightened application of Market Profile (tm) to FX trading? Many fine avenues of analysis are opened by the relationship between volume and price movement.

One conclusion, however, strikes me as inescapable. If I'm an active trader in the Euro currency and need to ascertain likely opportunity in my market, I would be wise to track the Euro futures contract. The volume information from the futures--data not available in the cash market--offers an informational edge that, at least in my equity index trading, has proven invaluable.


AnaTrader said...

Hi Brett

If I'm an active trader in the Euro currency and need to ascertain likely opportunity in my market, I would be wise to track the emini futures contract. The volume information from the futures--data not available in the cash market--offers an informational edge that, at least in my equity index trading, has proven invaluable - Unquote

As a matter of fact, this is what I do ie refer to the price and volume on the emini GBPUSD eg before I enter or exit my position.

It is impossible to get a true volume real time on Forex cash as it is not only traded in many exchanges but it is also trading 24 hours, worldwide.

Brett Steenbarger, Ph.D. said...

Ray Barros is a very successful trader and educator with far more experience in currency trading than I have.

He passed along to me the following comment:

"Thanks for the post. It certainly accords with my own conclusions: that for the GBPUSD and EURUSD, the Futures vol is a reliable indication for their FX counterparts.

I found this to be true only from the London open (EST 3:00) to NY close. In the Asian timezone, the relationship is less correlated - probably because of the much thinner futures vol."

Thanks for the observation, Ray.


John Forman said...

I would definitely concur with Ray's comments. The London/NYC overlap is the dominant volume period for the forex market. After about noon in NY things tend to quiet down a great deal. The US afternoon, for a short-term trader, is generally a time that one doesn't want to be taking positions.

The addition that I would make to the discussion here in regards to both price and volume action during the Europe/US overlap is that it not only encompasses the largest number of participants for any given trading day, it also tends to include more important news and data events. That includes things like rate announcements from the central banks, pretty much all US and Canadian economic data, and some of the UK/Europe stuff as well. This can be a significant contrast to stocks where oftentimes the major price driving events for individual stocks (earnings releases) occur after official market hours.

Here's something else different in forex futures from stock index ones. Institutions play a big part in stock index futures trading - whether for speculation or for hedging. The same is not true for forex. The big players use the spot market for their activity because it is much more efficient and flexible for them. That implies the majority of the volume seen in futures is actually us individual traders. So that begs the question, what does it mean when individual traders are more or less active?

Brett Steenbarger, Ph.D. said...

Hi John,

Thanks for your very informed perspectives. I just posted data on the Trader Performance page of my personal site ( that suggests that large traders (in relative terms) do dominate the Euro FX emini trade. Moreover, volume there does correlate with price movement in both cash and futures. This suggests to me that there is not a total disconnect between who is trading the cash and who is trading emini FX futures.


MikeH said...

Another observation I have is that the FX futures trade "quote" driven while the indexes are "order" driven. The size quoted in the Euro book is nearly always changing, often with the inside market cycling up and dow between 10 and 200 contracts, without trades necessarily taking place. Presumably this is action from banks quoting the spot and futures market (there is an incentive program in place for commercial banks that offers reduced Globex fees). So it seems that the changing quote causes trades, causing volume. The indexes, such as the ES have a deep book of standing orders, and trades have to work through them, including a number of sweep orders that take place. Despite the different style (at least in my opinion), the result appears to be the same - volatility highly correlated to volume.

You can also see this quote driven action on report releases. Normally the Euro book will be between 50 and 300 contracts at prices 5 deep on each side, but at 8:29 EST it will go to only 5 or 10 contracts at each price. On the report release, the quotes change and basically execute anything in their path.

naked said...

Hi Brett,

Also of interest is that price moving events, such as economic reports, might cause large arbitrage opportunities that hedge funds capture. This could potentially increase the amount of volume in the underlying contract dramatically.

That is to say, when economic data is released and the price of the EURUSD pair begin to probe for a new value, then arbitrage traders may step in to arb when the the futures premium deviates from the fair value area.

This could also explain the huge fluctuations in bids and offers throughout the day. If this is true, then arbitrage/program traders are much more opaque in their activity than in the ES because we can see their large bids and offers to arb the futures and cash.

Hope what I just said makes sense! It's past midnight and my vision is beginning to blur. :-)



Brandon Wilhite said...

Thanks for sharing the interesting results.

I know that a lot of day-traders prefer gbp/usd over eur/usd and it is certainly one of the hot currencies right now. Since you are primarily a day-trader, it might be worth a look.

I would be willing to bet that a further study of the volume data would show that the correlation is higher on a relevant news release day vs. a non-release day.

Don't forget the ETF also. Although volume-wise it's probably not significant, one thing I've looked at is arbitrage between the various forex vehicles. I found very very few opportunities, which to me says a lot about the market as a whole. I also think it would be possible to look at the various trading vehicles and even relationships between the various crosses to use as an indicator for the veracity of a given move.


Brett Steenbarger, Ph.D. said...

Thanks Mike H and Naked for the excellent volume observations re: the FX market. It shows how important it is to thoroughly know one's market and its idiosyncracies before you trade it. The computerized autoquoting that goes on in the Euro FX futures keeps the futures price close to the cash and is a major reason, I suspect, that futures volume tracks activity in the underlying spot market.