TOW concepts basically come from Cross Hedging, Pair Trading, and Double Opposition Entries, which use quantitative analysis to develop a profitable trading strategy. TOW is one of the Forex hedge fund strategies that produces the best results through an automated system of opening and closing positions based on current market trends and flows. The system is a form of trading that involves making price comparisons between two or more markets to capture temporary price disparities that occur when markets move out of their “normal” or intrinsic price alignment. This strategy generally uses statistical measurements to determine when two highly correlated markets have moved a point of price difference beyond their historical “average price difference” and may be signaling a trading opportunity. Once the two markets are determined to be statistically “misaligned”, a long position is taken in the market that is considered undervalued, while simultaneously a short position is taken in the market that is considered overvalued relative to the first market. This strategy looks at price relationships and mathematical relationships between currency pairs that are sufficiently correlated to create a hedged position whenever prices move in the same direction. A good example is the cross hedging of the euro and the British pound. Although these two currencies are not identical, their price movements are similar enough to be used for hedging purposes. TOW has the potential to profit through simple and relatively low-risk positions.
TOW signals are generally given by proprietary arbitrage / spread trading systems that can use multiple time frames, including intraday, daily, and weekly price bars. Stop loss orders and targets can be executed during the day 24 hours a day. A closer inspection of the price spread comparison charts should indicate the existence of short- and medium-term price trends that fluctuate on both sides of your historical average price ratio, which may also have a longer-term trend.
Trades can be based on an expected price movement towards a calculated average price ratio (mean reversal), or trades can be performed with the expectation of a possible movement from a calculated mean price towards an extreme price ratio level (aversion half).
TOW is market neutral, which means that the general market direction does not affect your profit or loss. The goal is to match two currencies that are highly correlated, trading one long and the other short when the price relationship of the pairs diverges “x” standard deviation number – “x” is optimized using historical data. If the currency pair returns to its average trend, a profit is made on one or both positions.