Lessons from the Evolution of Foreign Exchange Trading Strategies

Abstract

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.

Keywords: Exchange rate, Technical analysis, Technical trading, Carry trade, Efficient markets hypothesis, Adaptive markets hypothesis

JEL Classification: F31, G14, G11, G15