Introduction

First, let’s take a look at the carry trade. In short, the carry trade is used when an investor or speculator is attempting to capture the price appreciation or depreciation in a currency while also profiting on the interest differential. Using this strategy, a trader is essentially selling a currency that is offering a relatively low interest rate while buying a currency that is offering a higher interest rate. This way, the trader is able to profit from the differential of interest rates.

With the introduction of the carry trade , yen currency pairs have become the speculator’s preference. Currency crosses like the GBP/JPY and NZD/JPY have been able to net small intraday or even longer term profits for the currency trader as speculation continues to support the bid tone. But how can one enter into a market that is already seemingly overheated? Even if a trader could, what would be a good price, and doesn’t everything that goes up come down? The answer is easier and simpler than most believe. In this article we’ll show you how to use carry trades to profit from overwhelming market momentum.

Definition

A strategy in which an investor sells a certain currency with a relatively low interest rate and uses the funds to purchase a different currency yielding a higher interest rate. A trader using this strategy attempts to capture the difference between the rates – which can often be substantial, depending on the amount of leverage the investor chooses to use.

For example, taking one of the favored pairs in the market right now, let’s take a look at the New Zealand dollar/Japanese yen currency pair. Here, a carry trader would borrow Japanese yen and then convert it into New Zealand dollars. After the conversion, the speculator would then buy a Kiwi bond for the corresponding amount, earning 8%. Therefore, the investor makes a 7.5% return on the interest alone after taking into account the 0.5% that is paid on the yen funds.

Now on the earning side of the trade, the investor is also hoping that the price will appreciate in order to make further gains on the transaction. In this case, anyone that has invested in the NZD/JPY trade has been able to reap plenty of benefits.

Evolution of the carry trade

The first wave of carry trade started in the late 1980s when financial speculators borrowed in yen and invested in European securities. This first phase ended in 1993 after the Japanese bubble collapsed, Japanese investors retreated home and the yen appreciated.

The second round of carry trade began in the summer of 1995 and ended in late 1998 after Russia defaulted, the Long-Term Capital Management hedge fund collapsed, and the Japanese government planned to recapitalize the distressed banking sector. The yen rose 15% against the dollar in a week.

The recent wave of the yen carry trade is built on the Japanese government’s policy of keeping its interest rate and currency low in order to export its way out of recession and deflation. It has continued until (10-17 August) when the yen jumped 10% caused by the default in sub-prime mortgages and the knock-on effects on equity markets worldwide.

Profitability in carry trade

Over the past five years, official interest rates have been lowest in Japan and Switzerland, and the yen and the Swiss franc are the most commonly cited funding currencies (Graph 1). The Australian dollar, the New Zealand dollar and sterling have appreciated steadily and have been cited as popular target currencies, although a number of other currencies are often used as well (eg the Brazilian real and the South African rand). Since 2004, with the normalization of policy rates from historically low levels, the US dollar has moved from being a funding currency to a potential target.

The carry-to-risk ratio is a popular ex ante measure of the attractiveness of carry trades. It adjusts the interest rate differential by the risk of future exchange rate movements, where this risk is proxied by the expected volatility (implied by foreign exchange options) of the relevant currency pair. By this measure, carry trade positions that were short yen and long target currencies such as the Australian dollar were increasingly promising from 2002 to 2005.

Graph: 1

Sources: Bloomberg; JPMorgan Chase; national data; BIS calculations

These positions have remained so on average, despite two bouts of higher volatility which led to significant, albeit temporary, declines in the attractiveness of some target currencies (eg the South African rand).Over the longer term, however, the attractiveness of carry trades relative to other investments is less clear (Burnside et al (2006)).

Risk reversals – or the price difference between two equivalently out of the-money options – potentially provide an alternative market indicator of perceived risks in carry trades. If the risk associated with carry trade returns is not generalized uncertainty about future values of the exchange rates, as the carry-to-risk measure implicitly assumes, but rather directional uncertainty, this will be more effectively captured by risk reversals calculated from out-of-the money options. A strong correlation between the two measures is apparent in Graph 1. In addition, Gagnon and Chaboud (2007) argue that movements in risk reversals tend to post-date large exchange rate movements in periods of high volatility.

The Mechanics of Earning Interest

One of the cornerstones of the carry trade strategy is the ability to earn interest. The income is accrued every day for long carry trades with triple rollover given on Wednesday to account for Saturday and Sunday rolls. Roughly speaking, the daily interest is calculated in the following way:

(Interest Rate of the Currency that you are Long – Interest Rate of the Currency that you are Short) x Notional of Your Position

———————————————————————–

No of Days in a Year

For example one lot of NZD/JPY that has a notional of 100,000, we compute interest the following way:

(.8 – 0.005) x 100,000 = approximately $20 a day

365

It is important to realize that this amount can only be earned by traders who are long NZD/JPY. For those who are fading the carry, interest will need to be paid every day.

Flags and Pennants in carry trade

At present in this currency rising trend, how can a trader really capture market profits in the bull market? One such formation that has proved to be a great setup may be the all too familiar, flag and pennant formations. This has been especially useful in carry currency crosses such as British pound/Japanese yen and New Zealand dollar/Japanese yen. Both formations are used in similar capacities; they are great short-term tools that can be applied to capture nothing but continuations in the foreign exchange market. They are both even more applicable when the market, especially in the case of carry trade currencies, has been trading higher and higher in every session.

To get a better sense of how this works, let’s quickly review the differences between a flag and a pennant:

• A flag formation is a charting pattern that is indicative of consolidation following an upward surge in price. The name is attributed to the fact that it resembles an actual flag with a downward-sloping body (due to price consolidation) and a visually evident post. Targets are also very reliable in flag formations. Traders who use this technical pattern will reference the distance from the bottom of the post (significant support level) to the top. Subsequently, when the price breaks the upper trend line of the flag, the distance of the post will more often than not be equivalent to the next level of resistance.

• A pennant formation is similar to the flag formation – it differs only in the form of consolidation. Instead of a body of consolidation that moves in the opposite direction of the post (as in the case of a flag), the pennant’s body is simply a symmetrical triangle. Although pennants have been known to slope downward as well, the textbook formation has also been noted as a symmetrical triangle, hence the name.

Similar setups are seen in the cross currency pairs, giving the trader plenty of opportunities in the currency market, with or without dollar exposure. Taking another market favorite, the British pound/Japanese yen, let’s take a look at how this method can be applied to the chart.

In the short-term 60-minute chart in Graph 2, a typically long flag formation is coming around in the GBP/JPY currency pair. In order to establish the formation initially, it is recommended that the chartist draw the topside trend line first. This rule is a must as an initial drawing of the bottom trend line may lead to varying interpretations. Once the initial downward-sloping trend line is drawn, the bottom is a simple duplicate. Here, the trader will make sure to note a touch by the session bodies rather than the wicks in verifying the formation as true. This is to isolate only true price action and not volatility or common “noise” that may occur in the short term.

Step by Step procedure for carry traders:

Now let’s take a look at a step by step process that will allow traders to enter on the carry trade momentum in the market. Figure 3 shows a great opportunity in the New Zealand dollar/Japanese yen cross pair. Following the complete downturn that occurred July 9 – July11, 2007, a visual burst can be seen by chartists as bidders take the currency higher over the next 48 hours, establishing a temporary top at Point A.

Source: FX Trek Intellicharts Figure 3: Following A Sharp Decline, NZDJPY Vaults Higher Off Of Support

1. After consolidation, draw the topside trend line first, completing the formation with the duplicate bottom trend line giving the chartist the flag boundaries.

2. On a sign of a trend line break, measure the distance from the bottom of the post to the top. In this instance, the bottom support of the post is 93.81 with the top at 95.74. This gives the trader a potential for 193 pips on the trade after a break of the top trend line.

3. Once there is a confirmed break of the trend line, place the entry that is at the session close or lower of the finished candle. In this case, the break occurs approximately at 95.40 with the entry being placed at that session’s close of 95.46 (Point C). Subsequently, a corresponding stop is placed five pips below the session low of 95.37. Ultimately, the position is well within normal risk parameters as it is risking 14 pips to make 193 pips.

4. Set initial and full targets. With the full move estimated at 193 pips, we get a partial distance of 96 pips (193 pips / 2). As a result, the initial target is set for 96.42 (Point B).

5. Set contingent trailing stops. Once the initial target is achieved, the overall position should be reduced by half with the rest being protected by a trailing stop set at the entry price (or break-even). This will allow for further gains while protecting against adverse moves against whatever is left. Longer term strategies will hold to the entry price as the ultimate stop, promoting a worst-case scenario of break-even.

Best Way to Trade Carry

With the pros and cons of carry trading in mind, the best way to trade carry is through a basket. When it comes to carry trades, at any point in time, one central bank may be holding interest rates steady while another may be increasing or decreasing them. With a basket that consists of the three highest and the three lowest yielding currencies, any one currency pair only represents a portion of the whole portfolio; therefore, even if there is carry trade liquidation in one currency pair, the losses are controlled by owning a basket. This is actually the preferred way of trading carry for investment banks and hedge funds. This strategy may be a bit tricky for individuals because trading a basket would naturally require greater capital, but it can be done with smaller lot sizes. The key with a basket is to dynamically change the portfolio allocations based upon the interest rate curve and monetary policies of the central banks.

Conclusion

The carry trade is a long-term strategy that is far more suitable for investors than traders because investors will revel in the fact that they will only need to check price quotes a few times a week rather than a few times a day. True carry traders, including the leading banks on , will hold their positions for months (if not years) at a time. The cornerstone of the carry trade strategy is to get paid while you wait, so waiting is actually a good thing.

Partly due to the demand for carry trades, trends in the currency market are strong and directional. This is important for short-term traders as well because, in a currency pair where the interest rate differential is very significant, it may be far more profitable to look for opportunities to buy on dips in the direction of the carry than to try to fade it. For those who insist on fading AUD/JPY strength for example, they should be wary of holding short positions for too long because with each passing day, more interest will need to be paid. The best way for shorter term traders to look at interest is that earning it helps to reduce your average price while paying interest increases it. For an intraday trade, the carry will not matter, but for a three-, four- or five-day trade, the direction of carry becomes far more meaningful.

There is a reason for this. You will always lose money trading options without expert advice.  

I am going to teach you how to trade options and win. There are tons of financial websites out there which will tell you about options, but here, I just want to give you some hard and fast tips that we used on the trading floor at Lehman Brothers.

When you buy an option, you are basically buying a seat at the table. You’re making a reservation for 100 shares of stock, and paying a little bit for the privilege. You can either trade on the short side, or the long side, calls and puts respectively. It’s that simple.

When you delve into the options markets, you are up against an army of brilliant traders in offices in Manhattan earning about $1 million a year. Every time you look at the options board, remember who’s setting the prices. There are no safety nets with options, there are very few opportunities to ride them down and hope they come back. Even if you’re trading GE options, which is the most liquid stock on the board, it does not matter.

Options decay faster than a set of teeth bathing in a bottle of Coca-Cola. The underlying company is irrelevant for the actual trade, but a thorough understanding of the company is very important. However, blue-chip companies or not, options have zero relationship to the actual company, only a relationship to the nature of the equity’s performance in the market.

Don’t ever forget this.

I have a rule that has saved me millions trading on Wall Street, and it’s one you should always, without fail, live by. If you’re in a trade that goes against you, get out! Do not take any chances with options. Pay the commission, accept your mistake and get out.

Always live to fight another day. So many people are too proud to be wrong. They start buying more, or buying shares to hedge, or get into ETFs to counter-act their bad options trade. And suddenly a simple position becomes a convoluted hedge for an incorrect decision. Please do not fall into this trap. We all make mistakes, even the best in the business. But what separates us is our ability to get out the second it goes against us.

1. Never chase a rally.

Try to buy calls on days when the stock is down and puts on days when the stock is up. Or simply, buy calls at a time of maximum fear in the stock, and puts at a time of maximum greed.

2. Be guided by technicals, not the media.

If you’re long an option, always exit your position on the news or, even better, just before an expected new event like an earnings report. The day after the earnings report, the price of the option will collapse and often times, even if the stock moves in your favor, you may not make money.

3. Buy or sell puts or calls in the middle of the day.

In the morning, option traders that make the markets for Fidelity, Schwabb or any brokerage firm, keep their spreads wider because they don’t want to get picked off. They want to feel the market come together. Near the close of the trading day you’re also at a disadvantage. If you need to exit a substantial options position, you’re better off not waiting until the close.

The options market maker knows there are people that need liquidity at the end of the day and their markets are not as efficient at those times. At the end of the day, option market makers are wary of getting beaten by savvy traders with inside knowledge.. That’s why they make smaller markets at the end of the day.

4. There’s less decay if you buy “in the money.”

Buy “in the money” puts instead of shorting the stock if the borrow is difficult on the stock. This will also limit the decay factor.

5. Limit orders limit profits.

If you believe in the trade, and it’s time sensitive, don’t mess around with limit orders. Trying to undercut the trader’s market, hoping to buy at a lower price, you’ll end up chasing it like a Bedouin riding toward a mirage. Also, options market makers love making chiselers pay more.

6. Check out the “Open Interest” on the option.

This is what I call the Roach Motel Factor. Beware of buying options where there is little open interest. The less open interest there is in an option contract the more power the market maker has in dictating the price. Generally, the less open interest, the wider the market and the more difficult to get out. It’s like paying a $500 dollar toll to go over the George Washington Bridge to get into Manhattan. Five hundred in, five hundred out is no fun.

7. Understand the volatility price level you are paying for an option.

Before the credit crisis, on the trading desk at Lehman we were buying puts on Washington Mutual (WM). In the spring of 2007 WM was trading like a rock north of $40. The November $30 puts, a full six months out, were ridiculously cheap, something like 60 cents. Today the same trade would cost north of $2.50. The richness or cheapness of what your paying for an option is measured by the vol you are paying. The 40 cent puts we bought were trading at something like a 0.18 vol, today at $2.50 that would represent over 0.70 vol.

8. Know your deltas to the penny!

Every option acts a certain amount like the underlying stock. An option “in the money” will trade with a high delta and an option way “out of the money,” like our Washington Mutual example above, will trade with a low delta.

Let’s say you own 100 of those November 2007 $30 strike puts on Washington Mutual (WM). That means below $30 you are short 10,000 shares of WM. But say it’s May 2007 and the stock is $42. You’re not short 10,000 shares. Most likely the delta on this $30 strike option with the stock at $42 would be 0.15-ish. So 10,000 x 0.15 = 1,500 shares. With the stock at $42, your 100 put contracts will act like a short stock position of 1500 shares. In this example, the lower the stock moves, the higher the delta.

9. Check the borrow on a stock before you buy the option.

If there is no borrow, the option market maker will have a very difficult time hedging his book. Therefore he will keep his spreads very wide. On the trading floor, we used to call this the untradeable market. As a market maker, he’s obligated by the options board to make the market, but if the borrow becomes very difficult, the options market maker will make it senseless to buy or sell the options.

Borrow on a stock can go away and become a hard borrow if a lot of hedge funds and investors have a negative view on the company, and the many outstanding shares are already borrowed.

10. If possible check out the CDS on the underlying company’s debt.

Some of the sharpest knives in the drawer are big players in the credit markets. If the company has a lot of debt this is a must. Often times the CDS spreads will give you an indication as to what direction the company may be heading. In many ways CDS and options are similar. You don’t have to become an expert in CDS to trade options, but it’s nice to know if the CDS is 600 wider in the past three days. That may indicate a good time to buy that put.

The advice in this article is for day trading options. I have not covered hedges or long range out-of-the money trades.

Hope this all helps, and please feel free to leave a comment or any questions!

Dynamic Hedging is the definitive source on derivatives risk. It provides a real-world methodology for managing portfolios containing any nonlinear security. It presents risks from the vantage point of the option market maker and arbitrage operator. The only book about derivatives risk written by an experienced trader with theoretical training, it remolds option theory to fit the practitioner’s environment. As a larger share of market exposure cannot be properly captured by mathematical models, noted option arbitrageur Nassim Taleb uniquely covers both on-model and off-model derivatives risks. The author discusses, in plain English, vital issues, including: The generalized option, which encompasses all instruments with convex payoff, including a trader’s potential bonus. The techniques for trading exotic options, including binary, barrier, multiasset, and Asian options, as well as methods to take into account the wrinkles of actual, non-bellshaped distributions. M (more…)