For investments decision making and comparison of different securities, offered on financial markets, an adequate unified basis is absolutely necessary. The income return on an investment also called yield serve as this basis.
Functional connection between term of an investment and earned return (for most securities it equals to interest rate) could be visualized as a chart in “return- timeline” coordinates. Constructed line is called yield curve and it is powerful investment assessment tool which shows not only current market condition but also expectations of rate movements in future. Uprising (also referred as positive) yield curve signals that interest rates for long term instruments are higher than for short term. Descending (negative) curve stands for opposite situation.
A yield curve analysis for long run time period (even from first historical records till latest trade deals) may help to set realistic investment goals. Ideal yield curve demonstrates stable growth coming through successive local peaks. An inverted yield curve, where the shorter-term yields are higher than the longer-term yields, can be a sign of upcoming recession.
For Foreign Exchange market a special technique yield curves intersection was developed in order to help traders in minimization of loss periods and to increase number of profitable deals in total trading volume. It roots in Moving Average price smoothing that is widely used to choose a moment for entrance to the market and is included in all popular analytical software programs. In most cases traders build two MA graphs upon different time frames and enter the market if short-term MA crosses long-term line for long position and vice versa for short position.
Yield curves intersection method is very similar to above mentioned technique but moving averages are calculated for yields, not for prices. If short-term MA line is above long-term line it means that at a current moment market generates more profit than in preceding analytical time period. When market conditions change for the worse the short-term MA line goes under long-term.
So after analysis of all gathered data and relative risk evaluation a trader opens a position only if short-term moving average is higher than long-term. Trading signals, received when short-term MA is lower than long-term, are ignored. On the other hand all trading signals and their results must be considered for yield curve calculation because it’s built on all historically generated signals, not only on those that were accepted for trade’s execution.
This strategy logically makes it possible for traders to pass through long loss making periods on the market. Trading decisions, confirmed by above mentioned method, will comply with the market leading to higher percentage of profitable deals. Frequently investors receive the same or even higher return with lesser movements against a position and with lesser quantity of deals.
Yield curves intersection technique is based on simple assumption that in certain periods the system works more efficient than in another. Quite often it is true. But sometimes situation which a trader may take for a positive phase (or positive market condition) is a result of chain of accidental coincidences, statistically affected the yield curve fitting and influenced decision making process. That’s why notwithstanding all advantages of this risk minimization method its disadvantages also must be remembered:
It should not be used for real time trading, especially for intraday profiting.
Since calculation of the yield curve involves absolutely all signals, generated by trading system, traders have to spend their time on recording transactions that will not bring them actual profit.
The results highly depend on chosen parameters of yield curve fitting. It may happen that intersection of 3-days and 6-days moving averages shows positive phase and potentially high profits while intersection of 4 and 7 days MA’s line will give opposite result and predict significant losses.