Make Money With Carry Trades
February 7, 2007 by Trader Rich
I don't know if I can call my current state of Forex trading a slump but February has been tough going for a couple of reasons. I've been experimenting with a couple of new strategies and unfortunately I always do so on a live account. This may not be the smartest thing to do but what's done is done. I'm currently at -217 for the month. The H-system is at -102 and Lien Schlossberg is at -83. I found out the other day that when I signed up for the service, I signed up using quarterly payments. This means that I have 3 months of their service. I'm going to see what I can do to change this to monthly because what I've seen so far from them is less than impressive. It's still early in the month so I have plenty of time to recover.
One addition to my trading history is the tracking of interest. I've been talking to another trader about carry trades and I've also been reading about an interesting strategy on the Oanda forums. You can read more about it but basically, this trader will buy a pair where the base currency has a higher interest rate, such as the GBP/JPY. The GBP has an interest rate of 5.25% and the JPY is at .25%. The easiest way to try to explain this is with an example:
First day: He'll buy the GBP/JPY at some predetermined time in the evening.
- If target hits 100 pip profit, he will close position
- There is no stop loss
- If 100 pips profit target is not hit, the position remains open
- He is collecting interest equal to GBP, JPY differential
Second day:
- If the current price is below the price he entered but not more than 100 pips below, he sits tight. Remember, this position is collecting interest.
- If the current price is over 100 pips below the price he entered at, he opens another position based on 1 percent of his NAV. So he is scaling in (on a losing position)
- If the current price is above the price he entered, he closes the position at a profit
To continue the example, I'll assume that he either had to scale in or sit tight.
Third day:
This is basically a repeat of second day steps.
- If the current price is below the price he entered but not more than
100 pips below, he sits tight. Remember, this position is collecting
interest. - If the current price is over 100 pips below the price he entered at, he
opens another position based on 1 percent of his NAV. So he is scaling
in (on a losing position) - If the current price is above the price he entered, he closes the position at a profit
This strategy could incur significant drawdowns but he's also collecting a nice amount of interest on money that really isn't his (leverage.)
I hope I'm understanding this. It's not the easiest thing to explain. Read over the thread at Oanda. I'm not saying I'm going to use this but I've never really investigated carry trade strategies and I find it very interesting.
Popularity: 3%
Loading ...
I used to believe there was no free lunch with carry trades and the price was that they were susceptible to sharp downmoves. If correct, this would be an expensive price to pay for the type of investment strategy you mention. Nevertheless, even though I tend to shy away from big carry trades due to a fear of dramatic unwinding of positions, I have researched the evidence and the general consensus seems to be that you can indeed extract a premium from the carry trade over a long term horizon. If you hold the GBP/JPY trade for a year for example, it has to move more than 5% against you for you to lose money.
PS - Deutsche have a fund which you can buy in to at very low cost, which invests in a basket of high yielders, saving you the hassle of monitoring and rebalancing positions. It’s called something like the HarvestFund.
What about scaling in? Can this be compared to Dollar Cost Averaging like investing in Mutual funds. I invest in mutual funds each month. The same amount is used to buy each month and depending on the price, you can buy more or less shares than the previous months. This limits risk and in the 5 years I’ve invested in multiple funds, I’m up in all of them. I guess it would depend on how much you have to scale in each day and whether you have enough capital to do it…. ???
I guess the first question that comes to mind is how far down is the trader willing to let the position go against him?
Does he mention what percentage of the NAV he starts off with…or is it 1% as well?
From what I gather, it’s always 1% of NAV.
I’ve been looking into carry trades as well. Another way to do carry trades is to go long on GBPJPY, and then go short on CHFJPY. The two pairs are correlated so there’s no need to use a Martingale strategy. Instead, your pip profit/loss mostly stays the same while you collect positive swap fees. I’ve been testing this strategy out on a MT4 demo account and it seems to work, but I feel that I have more to gain in the long term if I focus on improving my TA-based trading.
I had a read through, and this post in the middle of the thread seemed to make more sense to me:
The biggest difference with mutual funds and the dollar cost averaging approach is that equity mkts exhibit a strong upward drift over time. I’m not saying the idea doesn’t hold water in fx, but it will be considerably less effective. One could try and estimate an averaging approach before emabarking on the carry strategy, such that you don’t allocate too much capital to begin with, which could put your ‘average’ in too deep a loss if things got out of hand. You want to be able to ride out the storms. Then there is the -ive correlation basket approach that Forex Trader mentions - I think this makes good sense as well, but it is very different as you are moving away from betting on directional moves and towards a pure carry harvesting strategy.
That said, in the UK (and probably in the US?), interest rates on simple deposit accounts are north of 5%, and this is without any currency risk. The only real benefit from the carry trade at this point in the cycle seems to come from leverage and a side bet on currency appreciation. It’s just not as attractive a proposition as it was a few years ago (again, that’s not to say it won’t work).
Mickey, so from your experience, is this a profitable strategy? It doesn’t matter to me as much that it may only get 5% a year or so because that’s why it’s best to have many different strategies…
Caravaggio, I’m trying to understand this so bear with me… If I have $50,000 and put it in a standard money market for a year at 5%, I’ll gain $2500 in interest for the year. If I take this same $50,000 and use a carry trade strategy mentioned by Mickey above, how much could I make on a 20:1 leveraged account?
It’s definitely a profitable strategy. If I were to do carry trades, I would probably attempt several different methods at once to see which worked the best before I settled on just one. The method mentioned in the Oanda thread seems to have the most profit potential, but at the same time it seems much more risky since you would be using a Martingale strategy. The hedging method I mentioned I first learned about on the forex-tsd.com forums. There is actually a hedging EA on the forums for this strategy.
Here’s yet another method of doing carry trades. Instead of hedging a GBPJPY long position by shorting CHFJPY, you could instead hedge with GBP currency futures. That gets a bit more complicated since currency futures are a bit different than retail forex. But the advantage here is that unlike going short on CHFJPY, the futures contract won’t collect negative swap fees.
While a pure carry trade (one currency only) does carry the risk of large drawdowns, the key is prudent money management and depending on your risk tolerance mitigating some of that risk by:
- trading with a single or basket of -ve correlation currencies
- using elements of Grid trading like this guy in the Oanda post
- look for curriencies that are moving sideways rather then trending (on a daily/weekly chart) depending on how long you want to be in the trade
Bottom line is that Forex is a risky instrument and you manage that risk. Most people dont have an apetite for that risk and are therefore happy to earn 3% in a savings account.
The problem with mutual funds besides management costs is leverage. You spend a dollar to invest a dollar. In forex that leverage can be adjusted from a 20:1 to a 400:1 account.
So now if Rich has $50,000 to invest and only uses 1% of his NAV what would his returns be on a pure carry trade:
Account Balance= $50,000
1% NAV = $ 500
$ interest ROI
Leverage bought earned (on 50K)
20:1 10K $ 500 1%
50:1 25K $ 1,250 3%
100:1 50K $ 2,500 5%
200:1 100K $ 5,000 10%
400:1 200K $10,000 20%
Chances of a massive drawdown to force a margin call is theoretically always there, but weigh your risk/reward and the returns seem much better than any mutual fund.
I found a good example on Oanda that uses Chaffcombe’s method for managing carry trades:
For example’s sake, let’s just take a single pair, AUDJPY, a starting balance/NAV of $1000, and leverage to be used 1:10.
Now, assuming a current price of 85.00, we start the week by buying 10,000 units of AUDJPY. We check our trade next week to find the price at 86.00, and our NAV at $1087. To maintain 1:10 exposure, we buy 870 units of AUDJPY. Now our exposure is long 10,870 units of AUDJPY. Next we come and find the price sitting at 87.00, and our NAV at $1,240. To maintain 1:10 exposure, we buy 1,530 units of AUDJPY. Now our exposure is long 12,400 units of AUDJPY. Is it how it is supposed to work?
Now, we come back next week and see the price sitting at 86.00, and our NAV at $1,074. To maintain 1:10 exposure, we sell 1,660 units of AUDJPY. We are now 10,740 units long on AUDJPY. Next week we come to see the price at 85.00, and our NAV at $994. To maintain 1:10 exposure, we sell 800 units of AUDJPY. Now we are long 994 units AUDJPY. We come back to where we started trying to maintain a fixed exposure, but our NAV is in $6 loss.
I too have started looking at these strategies. Obviously, any time you have the carry in your favor, the odds improve, but the drawdowns when the market goes against are definitely massive. While a hedge in another pair can help, that assumes the correlations hold. I do think there’s potential, though, and I’ve got some ideas I want to check out.
I’ve mentioned this before, but for anyone interested in earning interest with zero appetite for drawdowns should study the Fractional Product Inefficiency(FPI) or The Impeccable Hedge (http://kreslik.com/forums/viewtopic.php?t=307)
The beauty of this strategy is that you can trade with a larger margin, not worry about grid trading, correlations or be concerned whether the market is trending or ranging.
The only “problem” is that you don’t profit if any of the currencies have a large favourable move. This is an ideal strategy for anyone with a very low appetite for risk with a need for using very high leverage(400:1)
Seems like this system seems to be flavour of the month right now.
A lot of good points are brought up in the Oanda thread about how changing your position sizing affects the amount of retracement required to get you back into profit during a sustained move against your positions tempered with the impact on your margin requirements.
I summed it all up on one of my blog posts.
I use cost averaging in my day to day trading at the moment, as it’s a key part of my trading strategy. There’s definitely something to gained from using cost averaging, as long as you limit your losses in some predefined way.