The Carry Trade – What Exactly Is It?

You probably know that each different county sustains different monetary policies depending on their respective economies’ best interests, inflation perspectives, economic cycle, etc. I don’t want to get down into a full blown out course about macroeconomics here, so let’s just state that different countries carry different interest rates.

Well, Forex is nothing but the currency exchange market where people exchange some currencies for another at a set price (market price). Alright, so far so good. But like I just said one currency might yield a different interest rate than another one, so there is a differential that’s got to be paid (or charged) depending on which side of the coin you’re positioned. That interest rate differential translates to us Forex traders as what’s called “swap” in the Forex world lingo, and it’s cashed in (or deducted from) your account on daily basis by your broker.

The interest rates

The interest rates imposed by the world’s main central banks are, as of today, as follows:

USA: 5.25%
Europe: 4.00%
England: 5.50%
Japan: 0.50%
Switzerland: 2.50%
Australia: 6.25%
New Zealand: 8.00%

As you can see, the Yen yields only a 0.50% of interest, whereas the Sterling Pound gives out a quite beefier 5.50%.

But wait a second Hector… I think I might be into something here… what if I asked for a loan in Japan (paying a 0.50% interest rates) and invested it in England (netting a 5.50%)… couldn’t I make some free money? If I went long on GBP and short on JPY simultaneously… wouldn’t I be paid a 5.00% interest rate differential for my money? and what’s more… what if I leveraged myself to 1:100, 1:200 or even 1:400?

And that, my friend, is the core principle of Carry Trading: exploiting the interest differentials between the different currencies in order to pocket the swap. For example, some brokers give 25 US dollars/day per each lot of LONG GBPJPY that you hold overnight (if you’re short, you pay the swap to your broker!). LONG USDJPY is about 11 dollars/day per lot depending on the broker.

The results of Carry Trading

Pull a zoomed-out daily chart of USDJPY, GBPJPY, EURJPY, AUDJPY, CADJPY or NZDJPY. Do you see those massive uptrends all across the board? (again, please remember that this article was writen in June 2007) yup, they all have been rocketing up like there’s no tomorrow. Carry Trading has been *the* trading theme throughout the last year – everyone, their mothers and their flatmates have been shorting the Yen against all the other major currencies seeking for that juicy yield.

How long will it last? who knows, but as long as EUR, GBP, USD, AUD and NZD keep raising their rates (which they’ve been continuously been adjusted to the upside by their respective Central Banks during the last two years already) and Japan stubbornly sustains its almost-zero-percent interest rates policy, I don’t see why the overall upward market sentiment should change any time soon, at least from a fundamental macro-scope point of view.

How to implement the Carry Trading principles into actual trading?

Well, there are many swap-exploiting techniques flying around. I mean, you cannot just go long GBPJPY, NZDJPY or USDJPY out of the blue because you may eat up enormous drawdowns if you miss-time your entry. At the end of the day, even though the overall long term trend is up, we could easily see a period of market re-adjustment and price could fall hundred pips to the downside. Have a look at what happened to GBPJPY in late february / early march 2007 – it plummeted almost 2000 pips within few days! That would most likely annihilate any trading account.

So, what then?

Well, like I say there are many techniques out there. For example, some people open two twin trading accounts: one swap-enabled (under which they long the GBPJPY) and one swap-disabled (under which they short the GBPJPY). Basically they eliminate the currency pair fluctuation by taking opposite trades in different accounts and they slowly-but-steadily bank the swap on one of them.

Other technique is the so-called Carry Hedge Baskets , which basically advocates to open multiple trades on different currency pairs trying to annul each other’s volatility, and thus benefiting exclusively from the swap. For example: Go long GBPJPY (you are paid a very high daily swap) and go short CHFJPY (you pay a very small daily swap). By doing so, in one hand you short the Yen (long GBPJPY) and in the other hand you long it (short CHFJPY), effectively limiting the JPY-fluctuation’s impact on your basket. Then you just need to adjust the lot size according to different money-management factors such as pip-value, the average daily volatility for each pair, etc and voila! you have your own Carry Hedge Basket. These type of baskets are all about money-management engineering, and how ingeniously you hedge the different currency pair in order to cancel each other out as much as possible – remember that the point of these baskets is to keep the volatility to a minimum while profiting from the constant money flow coming from the positive daily swap. I have seen some wicked baskets juggling 10+ currency crosses in and out as needed!

You Know About Stop Loss Hunting? No?

We have all heard about stop-loss hunting. It happens with stocks, forex and other trading instruments.

What does it look like?

Good, good… but what the hell does that actually mean?! Well, let me show you a chart for a clearer view:

In the EURUSD 1H chart above we have a clear downtrend. Moreover, there’s a rather obvious down-trendline that probably most traders have drawn on their respective charts. Alright, in this scenario, where are most traders to place their stoplosses? well, probably few pips above that trendline, isn’t it?

Big dogs (institutional traders, investment banks, hedge-fund managers and the sort) know this. They can “smell” where retail traders (us) have placed our stoploss orders, and they more obvious the trendline or the support/resistance level the better for them. Since those guys have the muscle to spike price under some specific conditions they mercilessly raid our stoplosses in order to shake us out of our positions.

How do they do it? well, they usually wait for volume dryouts in the market so they can indeed move the market with their massive orders. News announcements are their favorite time due to the high volatility market conditions. This is exactly what happens:

1) They wait for price to reach that hot level (in the previous example, that’d be the trendline near-abouts).

2) Then when trading volume is thin in the market (right at the news announcement, or during an off-peak time of the day, etc), they slap their massive orders into the market just enough to drive price beyond that key level.

3) All those poor people’s stop losses get triggered!

4) And here is the beef of it all: a stop loss order is nothing but a pending order opposite to your current position. In the previous example, since we were in a downtrend, most of the people who were short EURUSD also had a pending buy stop order (meaning their stoploss order) few pips above that trendline. Are you with me so far? so effectively what we have is a bunch of buy stop orders triggering at once, which actually enhances and accelerates the breakout thrust even further!

5) At this time, we have many people (AKA stoploss orders) wanting to buy EURUSD. And if someone buys EURUSD, that means that there must be someone else SELLING -shorting- EURUSD to them… Guess who is shorting EURUSD off those stoplosses? BINGO! the Big Dogs are feeding their positions off those stoploss orders because they know that the breakout is in fact only a fake breakout (since they popped it out of the blue at the end of the day) and soon the downtrend will resume as expected. So what they are effectively doing is re-loading short in a downtrend by forcing those buy stop orders to trigger. Evil, isn’t it?

Please note how the stoploss run (both to the upside and to the downside) happened very quickly, within one or two bars and usually with long-wicked bars. The breakout-thrust happens very quickly because, like I said before, all those stoploss orders triggering in cascade accelerate the move. And once all those stoplosses have been dried-out, price falls back down just as quickly!

That is why it’s very dangerous to trade through news announcements if we are near a significant level of support/resistance – you never know, there might be some Big Dog out there ready to breach through that level of support/resistance hoping to raid some -YOUR- stop loss orders.