During this week, the Japanese yen staged a spectacular rally against the world?s most traded currencies as losses linked to subprime debt pushed investors to pare holdings of higher-yielding assets funded by loans in Japan. Moreover, USDJPY volatility as implied by one month OTC options climbed to 18 percent, nearly two times the average volatility of the past year
As a result of this carry unwind storm, the DailyFX Dynamic Carry Trade Basket fell by nearly 1289 pips during the last week. The portfolio biggest losses were taken in the long positions we held in the Australian dollar (468 pips), Sterling (422 pips) and in the Short position we have in the Japanese yen (84 pips). A small share of the portfolio losses were offset both by interest payments and by gains in the short positions we held in the Swiss Franc (+87 pips).
On Friday, the Federal Reserve gave us some reasons for optimism in the week ahead. The portfolio recovered some of the losses after the Federal Reserve Board approved a 50 basis point reduction in the primary credit rate to promote the restoration of orderly conditions in financial markets.
During this week, USDJPY volatility as implied by one month USDJPY options climbed to 18 percent, nearly two times the average volatility of the past year
[B]What is Carry Trade[/B]
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.
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.
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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