Lessons from the Evolution of Foreign Exchange Trading Strategies
Christopher J. Neely
Federal Reserve Bank of St. Louis - Research Division
Paul A. Weller
University of Iowa - Department of Finance
April 9, 2013
Federal Reserve Bank of St. Louis Working Paper No. 2011-021D
The adaptive markets hypothesis posits that trading strategies evolve as traders adapt their behavior to changing circumstances. This paper studies the evolution of trading strategies for a hypothetical trader who chooses portfolios from foreign exchange (forex) technical rules in major and emerging markets, the carry trade, and U.S. equities. The results show that a backtesting procedure to choose optimal portfolios improves upon the performance of nonadaptive rules. We also find that forex trading alone dramatically outperforms the S&P 500, with much larger Sharpe ratios over the whole sample, but there is little gain to coordinating forex and equity strategies, which explains why practitioners consider these tools separately. Forex trading returns dip significantly in the 1990s but recover by the end of the decade and have been markedly superior to an equity position since 1998. Overall, trading rule returns still existin forex markets — with substantial stability in the types of rules — though they have migrated to emerging markets to a considerable degree.
Number of Pages in PDF File: 46
Keywords: Exchange rate, Technical analysis, Technical trading, Carry trade, Efficient markets hypothesis, Adaptive markets hypothesis
JEL Classification: F31, G14, G11, G15working papers series
Date posted: September 24, 2011 ; Last revised: April 11, 2013
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