Last Updated on August 26, 2023
In the world of finance, geopolitical risk refers to the potential impact of geopolitical events on the economy and financial markets. Geopolitical events include wars, elections, political unrest, policy changes, trade disputes, terrorism, and other types of conflict or instability. Making our trading strategies resilient to such events is an important part of a risk management strategy. What is a geopolitical risk trading strategy?
This article describes one geopolitical risk trading strategy designed for these purposes. Since the fall of the Soviet Union, our geopolitical risk strategy on the Russian Ruble / US Dollar pair made +6444%.
Geopolitical risk is usually bad news for both long-term investing and quantitative trading strategies. But can we turn this around and use geopolitical risk to our advantage to offset losses or even make profits during such events?
Please be advised that the trading ideas in this article are for informational purposes only. This article discusses concepts enabling you to create your geopolitical risk trading strategies.
Related reading: – Searching for a library of trading strategies? (We have hundreds)
First, some words on how to trade the USD/RUB pair after the newly implemented sanctions on Russia:
How to trade the USD/RUB
The price of the USD/RUB pair is currently affected by Western sanctions and the Russian state’s regulatory action. As these factors either intensify or resolve over time, this will affect price further. We need to be cognizant of these risks when evaluating the future of this strategy.
One option for traders is to trade CFDs (Contracts For Difference). CFDs of the USD/RUB pair are available from several CFD providers. Be aware that CFD trading comes with its own inherent risks that any trader should know about before trading them.
Geopolitical Risk Strategy and the Russian Ruble
Over the last ten years, many geopolitical risk events have emerged from actions taken by the Russian state. Nowhere has the economic effects of these events been felt as strongly as the Russian economy itself. As we can see, these events have a strong effect on the performance of the USD/RUB currency pair:
With these historical developments in mind, what would have happened if we had a trading strategy in place which was designed to profit from such sudden and unpredictable events? We will soon find out.
USD/RUB (Forex) As Geopolitical Risk Strategy
The USD/RUB currency pair is part of the Foreign Exchange Market (Forex). Forex trading is extremely difficult, with few good trading opportunities and the risk of great losses due to overleverage.
However, while we will be using the USD/RUB currency pair as our trading vehicle, this does not mean we’ll apply a traditional forex trading strategy. This article essentially creates the opposite of a conventional trading strategy that profits from repeating statistical patterns. Instead, we attempt to ignore these patterns and act on significant non-repeatable events.
Ichimoku Cloud Strategy As Geopolitical Risk Strategy
A good geopolitical risk strategy of this type needs to have small drawdowns in times of relative market stability. In such periods, which is where most strategies make profits, this strategy will not be profitable. We need to ensure we are not taking heavy losses in such market environments.
We have identified the Ichimoku Cloud Strategy as effective at reducing drawdowns and versatile enough to work in many assets. Let’s try designing a strategy that fits our purposes using the Ichimoku Cloud.
Geopolitical Risk Trading Strategy Optimization
The Ichimoku Cloud indicator is a comprehensive technical analysis tool that provides information about support and resistance, trend direction, and momentum (all at once).
The original settings for the Ichimoku Cloud variables are based on the Japanese stock market, which was open 6 days a week, roughly 26 days a month, and 52 weeks per year.
The standard settings for the Ichimoku Cloud indicator are as follows:
Tenkan-Sen bars: 6
Kijun-Sen bars: 26
Senkou-Span B bars: 52
Chikou-Span offset: 26
Senkou-Span offset: 26
We experimented with modifying these settings to make the Ichimoku Cloud indicator more suitable for modern Forex markets. Our goal is to build a strategy that is responsive to short-term moves while avoiding market participation when the market is flat.
We tested using multiples of 5 for our variables, as this corresponds with the number of trading days per week for the USD/RUB pair. Here’s what we found:
|Ichimoku||Net profit||No. trades||Win Ratio||Profit Factor||Drawdown||Avg. trade|
As can be seen, changing the indicator settings does not make a world of difference, which is good, as this trading strategy optimization shows that the strategy is relatively robust. Lowering the settings also leads to more trades to average our results, which can be useful.
Continuing, we will use the settings 5/20/35/20/20 (representing 1, 4, and 7 trading weeks), as this configuration seems to offer a good balance of win ratio, number of trades, profit factor, and low drawdown.
Geopolitical Risk Trading Strategy Trading Rules
In order to avoid curve fitting, we make no further changes to the strategy beyond the above optimization and keep the standard trading logic.
When the following conditions are met, we go long (buy) at the open of the next trading day:
- Tenkan-Sen crosses above Kijun-Sen.
- The momentum of the closing price is greater than 0 (which means the Chikou Span is moving upwards).
- The current closing price is above the highest value of Senkou Span A and B (the Ichimoku “cloud”).
When the following conditions are met, we go short (sell) at the open of the next trading day:
- Tenkan-Sen crosses below Kijun-Sen.
- The momentum of the closing price is less than 0 (which means the Chikou Span is moving downwards).
- The current closing price is below the lowest value of Senkou Span A and B (the Ichimoku “cloud”).
Geopolitical Risk Trading Strategy Backtest And Equity Curve
Let’s see how our USD/RUB Ichimoku Strategy has performed. We have backtested this on USD/RUB (by ICE), on a daily timeframe, from September 7, 1994 (the furthest back our data goes) until today:
Our strategy has performed well in most respects. The strategy successfully beats a buy and hold strategy (blue line) by a decent margin.
Geopolitical risk strategy exhibits several traits we value as traders:
- Great Profit Factor. It should preferably be above 1.75, which it is.
- Good Max Drawdown. It should preferably be below 25%, which it is.
- Mediocre Win Ratio (Percent Profitable). We would prefer it to be closer to 50%. The low win ratio does not make the strategy unprofitable but increases the chance of committing behavioral mistakes when trading. The lower the win ratio, the higher risk for many losers in a row, which makes many traders abandon a strategy.
- The average gain per trade is very high at +5.49%.
If you are considering adopting this strategy in some form for live trading, we strongly encourage you to do out-of-sample backtesting. The best way to do this is to conduct an incubation period of at least 12 months.
If we compare the results to historical events, we also see a pattern emerging:
As we can see, the strategy performs well during and after significant geopolitical risk events.
Geopolitical Risk Trading Strategy As Long Only Strategy
Our strategy currently takes both long and short trades. What happens if we allow our strategy to only take long trades? Let’s have a look:
Doing this seems to improve many aspects of our strategy. However, our Profit Factor is suspiciously high, as a PF of above 4 can be a warning sign of curve fitting. Our total number of trades is also halved, reducing the validity of our backtest.
On the other hand, why would we consider adding short trades to a strategy which is essentially betting on continued trouble for the Russian Ruble? There are several reasons why we prefer our strategy to include short trades in this case:
- It increases our total number of trades, making our results more statistically reliable.
- It differentiates our strategy from the results of buy and hold.
- It increases our bottom line profits.
- Most importantly, it ensures that our geopolitical risk strategy is configured to react to future events that might impact the Russian Ruble positively or the US dollar negatively.
Allowing for short trades comes with some costs, including reduced Profit Factor, increased Max Drawdown, and lower average gain per trade, but all in all seems to be worth it in this case, considering the above points.
As before, make sure to perform an Incubation Period before using any of these ideas in live trading.
Geopolitical Risk Trading Strategies in a Trading Strategy Portfolio
From a statistical point of view, our backtesting results have a good chance of being essentially random. But while geopolitical risk events are unpredictable, and in this sense “random”, they have two traits that help make them tradeable:
- They occur sporadically and unpredictably, but given enough time, they are bound to happen.
- When they happen, the price of assets move strongly, which can be used by a trading strategy configured to identify such moves.
The USD/RUB Ichimoku Strategy essentially places a bet that geopolitical risk events will continue occurring in the future and that these will affect the USD/RUB pair.
Will geopolitical risk events continue occurring in Russia, which the Russian Ruble (and economy and people) have to take the consequences of?
Analyzing this question is beyond the scope of quantitative trading, and we leave it up to you to establish the likelihood for yourself, using whatever methods you find appropriate.
The role of geopolitical risk strategies is never to be your main vehicle for quantitative trading. Their role is to hedge against the consequences of geopolitical risk events occurring. As such, if we decide to use such strategies, we should only ever consider devoting a small amount of our capital on them as part of a portfolio of strategies. We might also consider such strategies as a tail risk trading strategy.
The end goal for all geopolitical risk strategies is to reduce our losses during market volatility while pulling down our profits as little as possible when it is “business as usual”. The USD/RUB Ichimoku Strategy seems to work as intended to create a geopolitical risk trading strategy.