QuoteDislikedIf NZD is depreciating while EU is going up you have the dollar that is simultaneously going up and down in different markets. I don't know whether the law of one price applies in these cases, I'm just going off of my own observations of how the market tends to close these gaps eventually. It's almost as if the individual currencies are only elastic to a certain point, eventually the different markets move in such a way as to bring prices back to a kind of parity. It could be that it's all nonsense, but I think it at least deserves some thought...
Is there a compelling reason why these currencies should bounce back other than that you have observed that they have done this in the past? If there is no compelling reason, then the relationship is temporally limited. As stated in my previous post, I investigated this type of thing before and wasted a lot of time on it - you're simply dealing with multiple temporally correlated exposures - no mystery whatsoever if you understand the math. At some point the illusion of co integration will disintegrate and if you're actually trading this thing in anticipation of a return to a historical mean it will blow up. Adding to the trade to reduce overall carry cost in the hopes of reversion will just make the demise go that much faster. If you can do this while honoring a stop, you might be able to milk the temporal correlation while it is in this spot, and until you get an unwinding of the correlation, probably due to macro serial correlation brought on by hyper volatility. The market does this every 3-6 months or so with surprising regularity.
As a practical matter, if you're bent on doing this thing please don't increase your trade size when it is making money. There will be an inevitable unwinding of this temporal correlation when your account takes the big hit. If you keep constant position sizing it will minimize the impact of the unwind. If you size up then the effect of the unwind will be magnified and be very painful.
This all goes back to Craig's point #4 (don't underestimate the significance of this pithy sentence):
QuoteDisliked4. Correlation is a weaker relationship than co-integration, co-integrated forex markets are...elusive.