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.