CARRY TRADER

The carry trader is interested in playing the interest rate differentials for receiving income
by buying the pairs that pay income to the account. The goal of a carry trade account is to get a superior return on the equity through interest. The carry trade will
almost always be part of forex as long as interest rates around the world differ. Money
tends to flow where it is perceived to get the best return. The most famous of the carry
trade pairs is buying the New Zealand dollar–Japanese yen (NZDJPY). The NZD offers
8.0 percent interest, while the JPY offers 0.50 percent. This means that the gap between
them is 6.75 percent paid to the trader if done right. Another part of any carry
trade portfolio has been the AUDJPY playing off the 6.25 percent interest rates behind
the aussie. A third pair common to carry traders has been the British pound–Japanese
yen (GBPJPY) using the high rates of the pound at 5.75 percent. Carry trades have
been the domain of very large institutional trading, but they are available to new
traders.
Carry trading has become extremely popular. A sure sign that the success of that
strategy was coming to an end was a taxi driver’s asking about carry trades. The risks
of carry trades need to be recognized. The risks of large drawdowns while one waits for
interest to be paid is substantial. Let’s first take a closer look at the mechanics of the
carry trade for the retail trader.
The first concept that needs to be learned is how a carry trade account works differently
from a regular forex account. The account is the same, but the trader has two
important focuses. The first is the balance of the account. As interest payments come
in, the balance totals will increase. The second is the equity of the account. This is the
liquid value of the account if everything was sold. There will be volatility in the equity
because the value of the pair bought will vary. The concept is that even though there
is risk of losing equity, ultimately, if you hold on, the interest rate will reimburse the
account. This is a tricky trade because there can be substantial volatility in the equity
values.
Figure 14.10 shows the weekly NZDJPY and GBPJPY. These are the two major carry
trade currency pairs. We can see that for a substantial period of time those buying these
pairs and holding them not only got high interest rates but also benefited from the fall
of the yen. But as interest rates in Japan increase, the carry trade becomes less attractive
and holds greater risk of losses as the yen rises against the other pairs. A carry
trade portfolio looks to capture interest rates, but the equity value of the account will be
volatile.
A real-world example shows this very well. The trader trading a $30,000 account
had on a mix of pairs. Until a major sell-off of the yen on February 27, this account performed
approximately 5 percent per month. But it incurred a loss of equity of $6000, or 20
percent, in one day. Those who held on to the carry trade positions the week after February
27 suffered further losses. But the carry trade was not eliminated. The difference in
interest rates in the carry trade pairs continued to appeal, and the prices recovered weeks
later. It’s important to keep leverage low in carry trade accounts to enable sudden large moves to be sustained. Jes Black, a forex trader and money manager at Black Flag Capital,
observed that:
Typically, the carry trade is leveraged. With a $10,000 account, and trading minis,
you should not exceed 10 times leverage. If you have more trading capital,
you should look to diversify the various carry trades to reduce your risk. You could
also look to do hedging strategies whereby you equalize your U.S. dollar exposure
to net zero. Example: long USDCHF and short USDMEX. Both collect a carry, and
you have effectively brought your dollar exposure to zero, much like a long/short
equity manager attempts to do.




By ABE COFNAS