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Carry Trade Pulls Back on Higher Risk Aversion

Monday, 10 December 2007 13:53:43 GMT

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Written by Antonio Sousa, Quantitative Strategies Analyst
Exchange rates volatility remains awfully high and as a result of increasing uncertainty traders preferred to stay away from holding positions in high yielders. In fact, last week the DailyFX Dynamic Carry Trade Basket was down by nearly 153 pips. The biggest losses were taken in the long position we held in the Sterling against the U.S. dollar (-205 pips) and in the long position we took in the Australian dollar (-91 pips). On the other hand, the only profitable trade we had was the long position we held in the New Zealand dollar with 117 pips gain. Looking ahead, the outlook for carry trades is bullish. The Federal Reserve is likely to cut the fed funds overnight rate by at least 25 bps when the FOMC holds its meeting during this week and we believe the rate cut is likely trigger a major rally in the U.S. stock market and help all classes of risky assets, including carry trades. Good luck with your trading for the week ahead!

Is the Carry Trade Alive or Dead? Click here to access the DailyFX Carry Trade Forum

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Additional Information
 
Making profitable carry trades are not as easy as they use to be. Therefore we have created a dynamic carry basket that changes when the monetary policy outlook for a central bank changes or if there is significant event risk ahead. 
 
What is Carry Trade
All that is needed to understand the carry trade concept is a basic knowledge of foreign exchange and interest rates differentials. Money shifts from around the world in seek of the highest yield and the benefit of trading currencies is that you are dealing with countries that have interest rates, which are charged or received every single day. If you are positioned on the side of positive carry, you have the right to earn that interest, which can be quite lucrative over time.
 
Protective Stop-Loss
Substantial gains made from interest rate differentials provide undeniable evidence that the carry trade strategy has been very successful over the past few years. Still, this strategy involves significant risks and an adequate protective stop is required. We are using a protective stop-loss equivalent to five times the average true range. Stop losses are activated when we have a weekly close below the specified stop level.
 
Position Sizing
Our position size varies according to each currency volatility. Generally, the more volatile the currency is, the fewer lots we trade. For example, let's assume you have $10,000 and you are trading 10K lots, you decide to limit your risk per trade to 3% or $300 and the 90 days average true range for the EURUSD is 100 pips. In this case, if you go long EUR/USD you could buy 3 lots, since ($10000 * 3%) divided by (0.0100*10K) = 3 lots. In case the final result is not an integer you should always rounded it down to limit your exposure.  

 

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