Title (above)

In this article we discuss how to triple Sharpe ratio in Forex trading, specifically for USDJPY exchange rate, using simple strategies, such as Ichimoku Kinko Hyo indicator and negatively correlated currency pairs.

Introduction

USDJPY exchange rate has been increasing on average from 2020 to 2024. For example, on November 2nd of 2020 the USDJPY exchange rate was 104.58 yen per dollar and on November 1 of 2024 the USDJPY exchange rate was 151.98, which is a 45.32% increase over four years. 

However, running a backtest on a strategy that invests $1,000,000 in USDJPY on 11/01/2020 and ends on 08/05/2024 (the current backtest end date) gives a Sharpe ratio of 0.374 and return of 27.67%, which is much lower than the Sharpe ratio of 0.559 and return of 64.31% for the same ‘buy and hold’ strategy on S&P500 over the same time period. The reason for the low Sharpe ratio is that USDJPY has a high volatility. For example, USDJPY rate was 161.62 on 07/04/2024 and dropped down to 140.79 on 09/16/2024.

Method

To increase the Sharpe ratio we can isolate the intervals where USDJPY is increasing and liquidate the position when it is decreasing. 

A very reliable indicator, which is often used in Forex trading, is the Ichimoku Kinko Hyo Indicator.

In particular, if Ichimoku Tenkan crosses above Ichimoku Kijun, it is considered a ‘buy’ signal, while if Ichimoku Tenkan crosses below Ichimoku Kijun, it is considered a ‘sell’ signal.

Since both Tenkan-sen and Kijun-sen are dependent on multiple periods, they are delayed in time indicators and therefore should be used only in the same direction as the average direction of price changes. 

For example, using ‘Tenkan above Kijun’ crossover to buy and then ‘Tenkan below Kijun’ crossover to liquidate the position would work well if the price is increasing on average (so that the buy price is likely to be below sell price); however, due to the time delay in the indicators, the same strategy would be less likely to work if the price is decreasing on average.

Results

To increase the Sharpe ratio, we buy USDJPY if Ichimoku Tenkan crosses above Ichimoku Kijun, and liquidate the position when  Ichimoku Tenkan crosses below Ichimoku Kijun.

We run a backtest starting 11/01/2020. It shows that the strategy works 89% of the time (this is the Win Rate), increases the Sharpe ratio to 0.906 and the return to 43.16%.

To increase the Sharpe ratio further, we buy EURUSD when we liquidate USDJPY position and liquidate EURUSD position when we buy USDJPY. Thus the strategy holds USDJPY when Tenkan is above Kijun and otherwise holds EURUSD. Since the currency pair USDJPY, EURUSD is negatively correlated, with the correlation coefficient -0.7788 for 11/02/2020 to 11/01/2024 time period, the strategy works 76% of the time. The Sharpe ratio is increased to 1.032 and the total return is 60.64%.

Discussion

When writing this strategy, we tried to include Ichimoku Senkou Span A and  Ichimoku Senkou Span B indicators, as it gives a stronger ‘buy’ signal if Tenkan is above Kijun, which is above Senkou A, which is above Senkou B. However, this significantly decreased the number of trades and as the result, significantly decreased the profits. Therefore, the strategy only compares Tenkan and Kijun indicators.

While buying and holding S&P500 makes a higher profit, it is worth noting that the drawdown for the USDJPY strategy is 5.8%, which is much lower than 24.6% drawdown for the strategy that buys and holds S&P500 over the same time period.

Conclusion

Forex trading is notoriously high risk due to high volatility of the exchange rates. The simple trading strategy explained here allows to increase Sharpe ratio by a factor of three and get the profits close to those from S&P500. The only assumption underlying the strategy explained here is that on average the ‘USDJPY’ exchange rate is rising. In this case the strategy has a high Win Rate.

References

For a complete explanation of Ichimoku Kinko Hyo Indicator see the Investopedia article: