Transcription
Hello everyone, and welcome to the Quantpedia Explains trading strategy's video series. Today, we will speak about a primer on grid trading strategy.
Hello everyone, my name is. Today we will discuss a strategy that's called grid trading. Grid trading is a very popular strategy among retail traders, and we will try to analyze the strategy and to understand a little more why the strategy is working, when this strategy is not working, how it is related to other trading strategies, and what are the weak points of this strategy. And what we need to pay attention to when you are trying to build a grid trading strategy or when you try to trade this strategy.
We have two articles on Quantpedia that are related to grid trading strategies. The first one is "A Primer on Grid Trading Strategy," written in December 2021. Here, we explain about the grid trading strategy. So, the basic idea of the strategy is very simple. You need to repeatedly buy at a specified price and then wait for the price to rise above that level and sell the position. Or, on the other hand, we are selling at specified prices and we are waiting, or shorting, and we are waiting for the price to go down and cover.
How does it work? Like in grid trading, usually the trader sets up a reference price, by the midpoint, ending closing price. We set up the grid, or the grid tells us with price references, for which price levels that we will buy and which price levels it will cover. Or, on the other hand, on which price we will short and then cover. How does it look? We have a reference price, or for example, today's closing price. Limit buy orders on price levels that are below the reference price. And once the price, we can imagine a blue wave that it's like the price that we use in this example, around the price of underlying assets, to go down, we start buying. So, we are filled on the first limit, or the second limit order, or limit order. So we buy, buy, and buy, and we hope that the price will start to reverse. And once the price starts to reverse, we will be able to sell on the higher level.
What does it mean is that the grid trading strategy is a reversal strategy. So, it performs well in a price that trends, but it's very, very bad for trending. It works the same on the short side. So, it means we have the limit orders for shorting positions, which are above the reference price. And once the price starts going above the reference price, we start opening shorting positions and we cover once the price reverts and that's going again. As you can see, as I mentioned, the strategy relies on the assumption that the price will also move sideways during the day or during the week. So, it means if the price went only down or up, we would not be able to close the position profitably, and at the end, we will eventually lose an unlimited amount of money. So, it's a very, very risky strategy. It's not performing well, and because you can eventually lose significant amounts.
There are additional parameters that are used in grid trading and applied to the price. And there is one very important thing that I would like to mention here. A lot of the time, grid trading strategies are not reported on a mark-to-market basis. Performance of the strategies is reported only from closed trades. And in this example, in this picture, I will show you why it's extremely dangerous. Usually, hedge funds, or mutual funds, or all of these institutions that are somehow regulated by central authorities or by central banks or some cyclic transformations or anything like that, they must report portfolios on a mark-to-market basis. So, it means even at the end of the day, or end of the week, or at any time period, funds must calculate what is the value of each underlying position in their fund and must report what is the actual value of the portfolio.
Let's say at the end of the day, grid trading strategies sometimes do not do something like that. They report just the performance from the closed trades. So, what does it mean is that instead of reporting positions every day, and instead of showing what is the available volatility of the grid trading strategy, which is the line, the grid trading systems, it's very often report only the closed trades. Because you have a lot of trades, you are buying on two different positions and you are waiting until the price goes up. And after the price is not going up, you are not showing what is the loss on that open position. Of course, when you start to buy in a grid trading, buy, buy, price going down, going down, and you have not closed the position, and you will not report it, you can tell that you are not in loss because you are still waiting for the trade to close. But you should be fair and you should report on a mark-to-market basis at all of the fund reporting, and you should assure that you are in a great road on the position and the volatility of the underlying strategies.
It's very important for a grid trading strategy. It's very important to check whether that grid trading strategy reports on a mark-to-market basis, or at least at the end of the day. Or if you report because of the closed trades, they can hide significant drawdowns and significant losses on your portfolio. The grid trading strategy can have a positive performance in the case there is a sideways trend in the market. But in case there is a strong trend in the market, your performance would be really bad. But the grid trading strategy will try to show you that there are still profits. That's a very dangerous thing, and I really advise you how the reporting looks like.
When we have a second article, that it's interesting because it tells what is the relation between grid trading and delta hedging. Why it's interesting? It shows that there is some merit in grid trading strategies because they are reversal in nature. They are short volatility. Even though they are sometimes very dangerous, there is some underlying edge in this kind of strategies because they gain from selling the underlying volatility. And we will show how is grid trading related to volatility selling and to delta hedging.
Firstly, what is a trading strategy that aims to reduce the directional risk of a short option strategy in ranges? It's so-called delta-neutral position. It's similar trading. So, let's firstly explain option selling or turning the volatility. So, let's imagine that you are an option trader. We will sell one put option and one call option. We are short straddle. So, that's the strategy. But we receive the money in case our options expire at the end of the period plus or minus at the same price at which we sold our options. So, we will receive the premium from the options that we sold. So, in our case, this short straddle position is a short volatility position. What does it mean? It means that in this case, if the volatility is high and the strategy starts or the underlying starts to trend, we will significantly drawdown. So, we will get into this red part of the payoff. In case, let's say the price ends up at the same price that which we sold our options, we receive the premium. That's the short straddle.
In the case of the short straddle, we can try to remove some of the risk of the movement on the underlying by performing delta hedging. What does it mean? We sell a short straddle, so we sell the short call and or put options. And once the underlying starts to move into one or another direction, we will start selling or buying the underlying. Delta hedging is a hedging strategy that tries to remove some risk out of the volatility shorting option strategies. And delta hedging strategy is a long volatility strategy. So, it means we are buying small fragments of the underlying in case the underlying loads up in price, and we are selling short amounts of the underlying in case the underlying goes down. If the volatility strategy is similar to time series momentum or platform strategies, so usually we incur a small loss. Usually, we are buying at a little higher price than selling. But overall loss from delta hedging is smaller than the premium that we receive from sold options. And therefore, the delta hedging increases the Sharpe ratio of short volatility strategies. So, it protects against large directional moves when we are volatility traders.
Now, in grid trading, we buy an asset when the price falls and sell when it rises. So, what does it mean is that this strategy is basically the reverse to delta hedging. If an option trader sold a put option, they can apply a delta hedge. But on the other hand, if you are an investor and you don't want to sell options, you can just apply a grid trading strategy. You will stand on the opposite side of the delta hedger's trade. So, you will buy the assets when the price is falling. So, what does it mean? To put it simply, an investor that holds a short straddle position is short volatility. An investor who applies a delta hedging trading without shorting option positions is long volatility. So, we profit when the price continues to move in one direction. We are hedging our short straddle. And lastly, when we are an investor and we apply the grid trading strategy, in a similar position to the investor who holds the short straddle, but we are doing it without the need to use the options. So, when we do grid trading, we are short volatility positions, profit when the price does not move strongly in one direction. So, by performing grid trading, it's nearly the same as performing short volatility or short option strategies or volatility selling or option selling strategies. We are just not using the options, but we are trading the underlying. So, we are buying and selling the underlying.
What does it mean is the grid trading has some underlying edge, or we must be very cautious because we can lose a lot of money. How we can build some grid trading strategies? So, we analyzed futures on sync currencies, including Australian dollar, British pound, Canadian dollar, Japanese yen, and Swiss franc, as well as 15 cross currency pairs. We used data from 1999 until November 2021. The important is that we used futures and not a spot exchange rate because the price of the futures includes also interest. That's very important. Now, we have countries with high interest rates, such as Australia, which is usually a country that has a very high interest rate, and usually the Australian dollar tends to move significantly more and trend more than countries with low interest rates, such as Japan.
Here we have a figure that shows the equity curves of all of the futures plus all 15 cross currency pairs. Here we have how the prices of the underlying can move. And now the question is, which of these underlying are good for grid trading strategies and which are not good ones? Here, in the last figure, we can show an illustration of two synthetic cross currency pairs. So, in the first one, we are long Australian dollar and short Japanese yen. And we can see that the price is significantly drifting in one direction because we are long a currency with a high interest rate and we are short a currency with a low interest rate. So, we are receiving a significant amount of interest rate spread. And in the second case, we are long British pound and short Swiss franc. In this case, we are holding the cross currency pair of countries with similar interest rates. So, it means that the underlying is significantly volatile and is not trending into each direction.
Now, try to imagine that we will try to use the grid trading strategy on one and also on the second currency pair. What will happen? Is that in the case of British pound and Swiss franc, our grid trading strategy would be relatively profitable. In the case of Australian dollar against the Japanese yen, we will lose all the money. The reason why we lose a lot of the money in this case is because this pair starts to trend in one direction, and the trend will continue for several years, and at the end, we lose all of them.
How does it look like when we apply grid trading for all of the currency pairs and all of the cross currency pairs? As you can see, there are some currency pairs in which we lost all of the money. There are other currency pairs for which we earned some significant return. Now, the question is, what we can do with that? We can identify some of the pairs that are better for grid trading. Yeah, we can do something like that, or we can try to find the pairs that are better.
The first thing that we can try to do is that we can move the reference graph. So, you know, in the first case, we set the reference price at the beginning of the sample, in 1999, and we didn't move the reference price. Of course, we can do something better. So, we can move the reference price and we can change the reference value in time. But in this case, the grid trading strategy sets the reference price to the price from 250 days ago. Now, that's a very simple way how to do it, but of course, there are other ways. So, I just want to show you what will happen. So, if we move the reference price every day, what will happen is that we can still perform on some of the pairs. The trending pairs are losing some money, but not as significant amount as in the case that we were not moving the underlying reference price. So, we improved some of the equity curves of the underlying pairs. What is the most important is no pairs or cross currency pairs in which we lost all of the money. So, that's a good example.
What is even better is to move the reference price and set up the monthly rate. The idea behind these analysis is that because the delta hedging, also the grid trading strategy, is inspired by short volatility strategy, the short volatility strategy in case of selling the options or short straddle strategy, usually the options in the time decay in option prices is the highest in the last 30 days before expiry. Usually, when option traders sell their options, they sell options with a very short time until expiry because that's exactly the time when that amount of premium is lost. When you are selling options, you gain the premium. For us, it means that it's better to reset reference price on a shorter basis. So, we set up the reference on a monthly basis. So, every month, we set up the new reference price and we perform the grid trading strategy. As you can see, the grid trading significantly improved. We no longer have currency pairs that lose, I don't know, 80% or 70% or 50% of underlying. And we still have some interesting pairs.
The very easy way how to finish the analysis is to equilibrate all of the pairs. And in this case, we have a diversified application strategy on all of the underlying pairs. So, we are selling volatility, we perform the grid trading on all of them. Like errors, we receive the performance that's coming from volatility of the underlying pairs. The resultant equity curve doesn't have a high performance, but it has a positive Sharpe ratio. Of course, we can leverage the strategy significantly if you want, because trading based on the currencies, and in currencies, there is a possibility to open a significant amount of leverage. That's the result of our feed analysis. Of course, we can improve the strategy by selecting the pairs that are best because they offer the highest probability of mean-reverting movements, etc., etc. So, there are other ways how to improve the grid trading. But I would like to finish for today at this moment. So, I hope that you liked these two articles. In case you are interested, links to those articles are in the description. I hope that you will join me in the next video. Thank you very much.