Last week, the U.S. dollar made a sharp recovery against the world’s most heavily traded currencies on news that the Federal Reserve, the Bank of Canada, the Bank of England, the European Central Bank, and the Swiss National Bank were adopting several measures intended to address pressures in short-term lending markets. By injecting short term funds through a broader range of counterparties and against a broader range of collateral than open market operations, Central Banks hope to promote the efficient dissemination of liquidity when the unsecured interbank markets are under stress. However, this was not good news for the performance of our portfolio since we held several short positions against the U.S. dollar. In fact, over the last week the DailyFX Dynamic Carry Trade Basket was down by nearly 810 pips. The biggest losses were taken in the long position we held in the Sterling against the U.S. dollar (-295 pips), in the long position we took in the Australian dollar (-263 pips) and in the long position we held in the New Zealand dollar.
[B]Additional Information[/B]
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. Follow the performance of the DailyFX Dynamic Carry Trade Basket
[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.
[B]Protective Stop-Loss[/B]
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.
[B]Position Sizing[/B]
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.