

Forex scalping: AUD/JPY under the microscope 
Written by Forex Automaton  
Thursday, 26 March 2009 10:08  
Page 1 of 2 I analyze the correlation structure of AUD/JPY on the time scales between 10 minutes and 10 seconds and see dramatic differences between the real market and the efficient market expectations on the one hand and among the time scales of the real market, on the other. High frequency data are particularly puzzling. Are we looking at the traces left by algo trading in large volumes? The study uses AUD/JPY time series of about 10,000 data points each, obtained from a popular provider (an ECN broker). Naturally, from the efficiency point of view, traders chase quick execution, but from the strategy point of view, what matters is the time scale on which the trader analyzes the market and makes decisions. According to the efficient market hypothesis, markets have no prehistory dependence, therefore the size of the spread and cost of capital are the main factors making the difference between the time scales. Indeed, even if the market is a random walk, with volatility (RMS of price return) growing with time scale as a square root, you do not want to trade on the time scale such that the volatility of price on that time scale is comparable to or less than the spread  just surrendering your entire account to the broker will save you time, with the same effect on your budget. Tighter spreads make smaller time scales possible, but you still don't want to trade a random walk on any time scale, unless you seek legal gambling. With real world being so different from the hypothetical world of efficient market theorists, there is a new dimension to the problem: once some measure of nonrandomness is found, how does it change with time scale? Efficient market theory is of no help since according to it, all such measures are null, therefore there is no field for study. How far is that from truth? The forex "pulser"
In principle time series may acquire structure as a result of market dynamics or imperfections of the dealing system. The structure seen in Fig.1, bottom panel, seems artificial. If this were an analog signal, one could suspect that a pulser signal got caught up via induction or some other way. How tight a spread is needed to trade this "pulser"? Autocorrelations 101 for forex scalpers.Needless to say, time series like this are highly predictable. Here is a little quantitative exercise to calculate how tight a spread is needed to capitalize on such a feature of the autocorrelation. The simplest way to do that would be to
Trading such a time series is profitable if the spread (difference between bid and ask prices) is below a, and if the execution time is instantaneous or at least much smaller than the period of the series. Therefore the rule of a thumb is  if in the autocorrelation of logarithmic returns we see a regular feature of a certain magnitude, the spread (expressed is a fraction of price) must be below square root of that magnitude. Getting back to Fig.1, the feature of magnitude 0.015 to 0.02 (times 10^{6}) requires spread of 0.00012 to 0.00014 as a fraction of price; with the actual AUD/JPY exchange rate about 65, that translates into 0.008 to 0.009  most likely, just one pip. The actual spread on the retail market may be 0.03 or 0.04 (3 or 4 pips), obviously much higher. The spread problem is not the only problem. After all, there are brokers who claim to have zero spread. In the best of all worlds, there is still a problem of synchronizing your trading to the "pulser" (whatever its origin and nature is). A realtime trading system with sufficiently high frequency of operation is needed to analyze the pattern. How stable is the pattern? Perhaps the amplitude gets higher at times? Perhaps the phase varies? Are we looking at a destructive interference of several time histories with varying phases, in the ten thousand point strong sample that made Fig.1? Perhaps each of those constituent series, while stable, is suitable for profitable trading? These are open questions at the moment. Whatever the answers, many forex brokers frown upon forex scalpers! What could cause the effect?At the moment I can only speculate about this. I can discuss three possibilities.
Another feature of the autocorrelation is the familiar "bipolar disorder", a tendency to form quickly alternating rises and falls, more pronounced than in a fully unpredictable time series of the same volatility, shows up as negative deeps surrounding the zerotime lag peak. This feature has been seen in LIBOR and forex, including data from different providers. For LIBOR and stock market data this has been seen on the day scale, for forex  on the hour scale and as we now see, down to 10 s scale, although I would not be surprised to see it on the day scale for forex as well. 