If you analyse the issue of the trending/ranging cross using the cointegration pair trading technique it’s easy to see what’s going on. Standard pair trading (Engle-Granger, linear regression, no y-intercept) fits the equation, y = beta*x,
e.g. with y = EUR-USD, x = GBP-USD, we use linear regression to fit, EU = beta*GU.
Or we can rearrange this to get, beta = EU/GU = EUR-GBP. So from the outset we expect the beta from the linear regression to be similar to EUR-GBP.
Let’s do the calculation… Here I use minute data, and do a linear regression over the past 1440 bars (~1 week). I’ve plotted EUR-GBP (blue), the value of beta from the regression (green), and for comparison the SMA of EUR-GBP over the past 1440 bars as well.
Standard cointegration pair trading says to trade when the spread, S = y - beta*x, widens. We can rewrite this equation as S/x = y/x - beta, or using currency notation, S/GU = EUR-GBP - beta.
Therefore we trade when the current EUR-GBP is a long way from the current beta. But the plot shows that beta is a proxy for the SMA of EUR-GBP. So the signals from cointegration pair trading are equivalent to just looking at a long run SMA of the cross-rate and trading when there is a deviation. When the cross trends, the strategy will break down because you’re always waiting for the cross to return to it’s long-term SMA.
This is why I don’t have great hope for pair trading in FX. Just trade a long-term SMA of the cross and be done with it. But if we jazz things up with multivariate cointegration then things could get interesting.