Palo Alto FX Trader Looks for Volatility

Daniel Lucas of Merk Investments is leading the foreign exchange charge in the buyside firms offices in the heart of Silicon Valley.

Palo Alto is a long way from Trier, the oldest city in Germany, on the border of Luxembourg. But the center of todays social media revolution and Web 2.0 innovation is where Daniel Lucas, the 31-year-old vice president of quant trading and research for Merk Investments, finds himself trading in foreign exchange markets for the buyside firm. As the sole trader on the equities currency desk, Lucas keeps the hours of a farmer to trade in markets that have opened earlier in New York and Europe.

Each morning, Lucas leaves his home in Berkeley to navigate Northern Californias notorious traffic – on Fridays he brings Penny, his lazy beagle mix who sleeps under his desk – so that he can get to work by 5:15 am. I try to consume as much research in the morning as possible. We get research reports from the sellside, and we have our own system set up to quickly pour over the most important headlines, and then at 5:30 I actually start running my quantitative models, he said. After looking at cash flow from the previous night, Lucas is ready to make his first set of trades by 6 am, when the markets open in New York at 9:30 am.

Although Merk Investments manages an Asian Currency Fund and an Asian fixed income securities desk, Lucas trades $1 billion notional U.S. dollars in G10 currencies per month for the two systematic funds he manages: the Merk Absolute Currency Return Fund and the Merk Currency Enhanced U.S. Equity Fund. (Axel Merk started Merk Investments with the Merk Fund in Switzerland in 1994 and moved his firm to California in 2001.)

The most liquid time in the FX market is also when everybody is up and running on their desks: my early morning or opening in New York, and sort of early afternoon in Europe, he told Traders. In terms of liquidity, that is pretty much the golden hour, the first few hours of my workday.

And he has to keep a keen eye on international news. When Traders spoke with Lucas in August, Canada had just released a disappointing jobs report and the news had a negative impact on the Canadian dollar, but he was short on the currency at the time. The beginning of the year actually was a period when the Canadian dollar depreciated and we picked it up early in our models, and it worked pretty well until it snapped back on some technical trading, he said.

As for trading currencies across the pond, Merk Investments is neutral on the euro as the continent deals with the late summer events in the Ukraine and Vladimir Putins aggressive actions in the region. (Our interview took place before Scotlands referendum on independence from Great Britain made headlines in mid-September.) According to Lucas, Merk Investments has two different strategies pertaining to the euro: one strategic and the other tactical.

We have on the one side the funds that are more macro-managed, more discretionary-managed, and slower-moving. The flagship fund is the Hard Currency Fund, and the idea is that we invest in anything we consider having a better and more stable central bank policy than the U.S., he said, adding, And the euro is one of the things that is still at least long-term bullish on it.

On the tactical side, the trades that Lucas said he has managed more recently, the euro is under selling pressure. The market anticipated the euro to decrease and it held up pretty well, especially against the dollar, he said.

We always use the phrase its the cleanest of the dirtiest shirts.

The FX Arena

Lucas clearly enjoys the challenges and nuances of the foreign exchange markets. FX is an interesting market because you are able to play out your macro ideas in a fairly efficient way, he said. Its pretty easy to invest short in the FX market as opposed to shorting any other instruments. If you want to short equities, you have to go out to the desk, actually source securities and pay up, but with FX, going long/short is easy.

FX is also more efficient in terms of transaction costs, Lucas finds. While not a gray-haired veteran, Lucas said that FX trading in the older days was more favorable to the sellside brokers who provided the research needed to make the trades. With electronic trading taking over more and more, the sellside must be under a lot of pressure. The platform that we trade on prices up to 100th of a pip, Lucas said, referring to price interest point, the small measure of change in a currency pair in the FX market. When Lucas puts out a trade, he finds that banks compete on that level, which is basically a fraction of one pip on a trade.

For the sellside, I imagine that it must get tougher and tougher. But electronic trading is becoming more prevalent.

According to Lucas, Merk Investments considers its Merk Absolute Currency Return Fund to be a best ideas fund that is a hybrid of quantitative and macro ideas that play into the fund. Meanwhile, Lucas calls the Merk Absolute Currency Fund basically a passive fund in equities.

So far, its doing well. In 2013, Merks hybrid quant-and-macro-modeling trading approach beat out the competition and was lauded on the front page of The Wall Street Journal at the start of this year. The Journalpicked the four managers in different asset classes that beat the market for the year, and Merks Absolute Currency Return Fund won in its category.

If you look at the FX space last year, investment managers who have a similar approach to what we do were basically driving returns from FX exposure, Lucas said. I dont want to name names, but there was a big FX player on the market that went belly-up. He wasnt the only one. In the beginning of the year, some of my sellside brokers said they once covered 12 investment managers that were similar to us, but now they cover only two.

Lucas credits his funds performance with a close eye to recent research and avoiding stale models in a changing world. If a nations central bank makes an announcement, like Federal Reserve Chair Janet Yellens comments earlier this year on interest rates, the models have to be able to react to the news, he said. You cant just look at the FX market the way it was five years ago. We have to incorporate the fact that the central bank is playing such a big role in the markets. We did it by doing very diligent research, and then coming up with a systematic way of capturing that data and inputting as a trading signal on the non-directional side.

One of the biggest challenges in the current FX market is the familiar complaint of a lack of real volatility. Far from nerve-wracking ups and downs, the fund has moved sideways lately due to the lack of movement in the market. Lucas points to the CVIX, the currency and volatility index collated by Deutsche Bank. Last fall it was close to 10 percent, but it fell to its near-record low of 5.26 percent on June 30. A second theme in the currency market right now is nobody really has one conviction trade, Lucas said. For a long while last year, it was people trading on the euro, people trading on the yen, which we did, too. But this year there is sort of a lack of this theme of one currency that people pile into.

This makes it challenging for Lucas to pick up on any kind of direction for a currency, he explained. One of the underlying themes of our model is we pick up on risk sentiment, which means that we are trying to extract alpha from the market by observing the option market. We have a systematic way of capturing any kind of tail events in that, and that usually happens as people express their opinion or have some kind of big macro view on a currency. It moves to option market and then it moves to spot market, and that just hasnt happened.

In the past few years, the central banks have become much more transparent in their communication to the press and the markets. You saw it at the beginning of the year when Janet Yellen actually had a slip-up in her language. She said something along the line that rates stayed low for a considerable amount of time and the market started selling off, he said.

After that, Lucas believes that Yellen is trying to be as boring as possible.

Palo Alto Life

Despite working for a buyside firm in a location known for being crowded with social media techies and high-end quantitative mathematicians, a trader like Lucas doesnt feel out of place in Silicon Valley. In fact, although the majority of Merks FX traders are based in New York, there are plenty of traders in the firms San Francisco office even though Lucas is the sole trader at his desk. He told Traders that Merk plans to hire an associate for his desk to replace the Berkeley student who interned there this summer.

While attending university in Stuttgart, Germanys automotive engineering capital, he did an exchange year at California Polytechnic State University in 2006 and later went on to graduate from the Masters of Financial Engineering program at the University of California-Berkeleys Haas School of Business. Lucas said most of his classmates went on to become quantitative traders for sellside firms, but he noticed that his graduating class of 2012 was the first one where several graduates from the quant school were hired by Facebook.

Although he visits Manhattan a few times a year, Lucas doesnt miss what he calls the down-to-business vibe of working on Wall Street. Even with his hyper-early hours, he gets to leave work around 3 pm and play the occasional round of golf or spend time with his new bride Jenna, whom he met at Cal Poly six years ago. Lucas says that while Palo Alto and Silicon Valley will never oust New York from its leadership perch in the financial world, he expects his adopted home to be a hub for innovation in trading technology. As he put it, The byproduct of Silicon Valley is that you are exposed to this innovative culture.

And this means that people his age are not looking to Manhattans financial district to chase their dreams. People are starting to get over New York a little bit. In our graduating class we had a few more people than usual on the asset management side. Thats a recurring trend.